Development of the telecommunications profit pool Jan Silvis
Development of the telecommunications profit pool
EXECUTIVE SUMMARY: The South African telecommunications profit pool has grown rapidly since the commercialisation of Telkom in the early 1990s. However, our analysis suggests that growth in the profit pool is under pressure and that the risks to forecasting future free cash flows have increased. The industry is also currently attracting record levels of new capital investment and returns on those investments are likely to be lower than those achieved in the past. Jan Silvis elaborates.
Historical perspective
The South African telecommunications market has grown rapidly since the early 1990s. In 1993 Telkom, then predominantly a fixed-line voice provider, converted from a government department to a commercial business. Around the same time, the South African mobile voice industry was born with the establishment of Vodacom and MTN.
Today South Africa's business and private telecommunication needs are met by a large number of telecommunication infrastructure and service providers. Over time their offering has broadened to include a range of products such as fixed-line voice and data, mobile voice and data, and value-added services.
Industry revenue pool
One of the factors we consider when valuing individual companies is the underlying growth trend of the broader industry.
Graph 1 presents the South African reported revenue history for the three large listed operators as a proxy for the local telecommunications industry.
Reported revenue is up 16 times in 16 years and, on a combined basis, these three operators have shown a stable compound revenue growth rate of 19.0% per year. This secular increase in revenue has comfortably outpaced inflation of 6.8% per year over the same period and is mainly indicative of the value that mobile communication has created for society.
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It is tempting to believe that this high and stable historical growth trend in reported industry revenue will persist and thus continue to support the investment case for most telecommunication companies in South Africa. However, our analysis indicates such a simplistic conclusion is inappropriate. No industry can maintain revenue growth in excess of nominal GDP over the very long term. After an extended period of high growth we would argue that the risks are to the downside.
Industry profit pool
As investors, we are more interested in a company's free cash flow than its revenue. It is therefore more relevant for us to examine the trend in operating profit, rather than reported revenue.
Graph 2 tracks the development of the telecommunication industry profit pool over time. This proxy for industry profits aggregates the unadjusted operating profits before interest and tax for the three large listed operators.
Graph 3 illustrates the same information adjusted for the effects of inflation.
Profits have been increasing dramatically as telecommunication companies capture some of the value they create for society. Operating profits are up 13.3 times in nominal and 4.6 times in real terms. Put differently, industry profits have grown at the exceptional compound annual rate of 17.5% in nominal and 10.1% in real terms. However, closer inspection of the profit pool development over time highlights three interesting observations which inform our future expectations:
1. Revenue growth does not equal operating profit growth
Growth in industry profits has not kept up with growth in industry revenues. One of the reasons for this observation is the way in which operators disclose reported revenues and costs.
At individual operator level, each operator includes revenue (cash inflow) from two sources in its reported revenue:
- Business and retail subscribers i.e. external subscriber revenue
- Other telecommunication operators connecting to their network to reach their subscribers i.e. interconnect revenue
2. Unlike revenue, the profit pool has not grown in a straight line
Despite stable revenue growth, the industry profit pool has grown significantly below trend in the past three years. The following factors have contributed to slower profit growth:
2.1 The voice market is maturing
- Voice services still contribute approximately 80% of industry revenues, but revenue growth has declined to single digits.
- The voice traffic carried on Telkom's fixed-line network has declined by approximately 25% over the past five years.
- Mobile SIM card penetration now exceeds 100% of the population, and the annual growth rate of voice traffic carried on mobile networks is declining.
2.2 Competition is increasing
- Market liberalisation: The previous regulatory framework segmented the telecommunications market by licensing narrow classes of services (voice or data) and prescribing the use of specific technologies (fixed or mobile networks) to deliver those services. The new licensing regime defines broader classes of service (voice, data and value-added services) and aims to be technology neutral. In practice, this means that the incumbent operators now compete on more levels, for example, Telkom will now offer mobile voice and data services and the mobile operators can now self-provide the fixed data links between their towers.
- Technological changes: The adoption of new technologies, such as voice over internet protocol (VoIP), has converged voice and data services. Now traditional data market participants, like the internet service provider Internet Solutions, can compete with the incumbent operators in the voice market.
3. The operating profit pool has declined in real terms
Graph 3 shows that when adjustments are made for the effects of inflation, the industry profit pool peaked in 2006 and actually declined in 2008. It is interesting to note that, in real terms, the Telkom fixed-line voice and data business currently earns a similar level of operating profit as in 1993.
In sharp contrast to the annual price increases typical of most consumer goods like food, beer, cigarettes or luxury goods, telecommunication unit prices (per minute or per megabyte) have tended to decrease over time. The main reason for this trend is that operators have shared some of the technological and scale cost benefits they have enjoyed with their customers in their efforts to attract and retain subscribers. Since 1993 the secular growth in mobile voice and data traffic volumes has more than offset the impact of declining real unit prices, resulting in increasing profits. However, in a mature and more competitive market, operators are likely to find it more difficult to manage the relationship between revenue and both operating and capital costs to their advantage. In real terms the operating profit pool may well decline further.
Investment implications
Growth in the overall telecommunications profit pool in South Africa is under pressure, and we believe that risks to forecasting future free cash flows have increased. The industry is currently attracting record levels of new capital investment. The returns generated on those investments are likely to be lower than those achieved in the past. When we evaluate listed telecommunication operators and service providers as potential investment opportunities, we consider these lower return expectations in valuing their South African operations.
A telecommunication company which has been part of our client portfolios for some time is the MTN Group. South Africa currently contributes 21% of MTNs earnings before interest, tax, depreciation and amortisation (EBITDA) and a little less than 30% of the Group's consolidated earnings. In valuing the MTN Group we consider both the headwinds faced by its subsidiary in South Africa and the remaining growth potential in relatively immature markets such as Nigeria, Ghana and Iran.
