Starhub Ltd: Credit Profile Improves after Cost Cuts

On 24 June, Starhub Ltd (“Starhub”) decided to extend the deadline to stop services over its hybrid fibre-coaxial (“cable”) network due to overwhelming demand for its cable-to-fibre promotion. Customers under the previous cable broadband plan may switch to the new fibre subscription at a discounted rate while enjoying a free trial of Starhub’s pay-tv service. We think the decision to stop providing services over its cable network will result in lower fixed costs, while increased demand for fibre services will result in a significant increase in broadband and pay-tv revenues this year.

Last month, Starhub reported decent 1Q19 results with a 6% YoY growth in total revenue, driven mostly by higher contributions from revenue in its network solutions (+9% YoY) and cyber security services (+41% YoY) segments. The company’s recent dividend cut, restructuring efforts, and higher EBITDA are positive for bondholders, but future cash flows may be curtailed by a competitive market and larger-than-expected capital expenditures (“capex”) for its fifth generation (“5G”) technology infrastructure.

About Starhub

Starhub was incorporated in May 1998 and was awarded licenses to provide basic telephone service and mobile services to the public by the Telecommunication Authority of Singapore. In 1999, the company started providing internet services through its acquisition of Cyberway, and was licensed to roll out third generation (“3G”) network services in 2001. In the following year, Starhub merged with Singapore Cable Vision, and started providing cable TV and cable modem internet services. In 2004, Starhub partnered with NTT DoCoMo for the deployment of its 3G network and was listed on the Main Board of the Singapore Exchange.

Singapore Technologies Telemedia (a wholly-owned subsidiary of Temasek Holdings) controls the telecommunications service provider via its 75% stake in Asia Mobile Holdings Pte Ltd, which, in turn, owns a 55.8% stake (as at 12 Mar 19) in Starhub. The company’s link to a quasi-sovereign entity with triple-A credit ratings is credit positive as it increases access to capital and lowers its cost of funding, which would be beneficial to the long-term viability of the company’s bonds.

Starhub reports revenue in five operating segments that represent the primary businesses of the firm: 1) Mobile: the provision of voice and data usage services through postpaid and prepaid subscription plans, including allowing customers to make international calls and roaming services; 2) Pay TV: sales from household subscription-based TV plans where customers pay to view programs; 3) Broadband: sales from the delivery of internet services through its cable and fibre technology networks to subscribers; 4) Enterprise Business: sales to business entities of customized solutions including managed and voice services, cloud, cyber security, and data analytics; and 5) Sales of equipment: revenue from sales of equipment such as mobile handsets and smart home gear.

Starhub in its early years

In the first few years after its initial public offering (“IPO”), Starhub experienced the highest growth rates with high net income and EBITDA margins. The company reported a loss of S$54.7m (see Table 1) during its IPO year in 2004. Revenue grew 16% YoY in 2005 and the telecoms group became profitable after pursuing a strategy to bundle its mobile, TV, and broadband services to subscribers. In that year, the number of households with more than one subscription grew 18% to 337,000. Notably, Starhub’s bank borrowings also declined from S$320m to S$243m and its debt-to-EBITDA ratio fell from 0.99x to 0.53x.

Liquidity was low as the level of cash and cash equivalents dropped sharply to S$50m in 2006. In 2007, Starhub’s EBITDA improved to S$643m as the number of mobile customers grew to 1.75m. The company’s bank loans more than tripled to S$963m in two years as the group drew down on its banking facilities to fund its operations.

By the end of 2008, management turned cautious about the business operating environment and implemented a number of cost-cutting measures. Free cash flow (after dividends) improved to ~S$144m in 2009 from ~S$68m in the preceding year as marketing expenses declined, while trade payables increased and amounts due from related parties declined. As a result, Starhub’s cash position increased 82% YoY to S$234m in 2009.

The broader economy slowed down in 2009, but Starhub’s mobile customers kept growing. The regulation to allow mobile number portability helped increase the number of postpaid subscribers from 891,000 in 2008 to 939,000 in 2009. Consequently, the total number of mobile subscribers reached 1.91m. EBITDA, however, stayed nearly at the same level around S$650m as earnings also remained flat during the two years of receding economic growth.

Table 1: Selected financial metrics between 2004 and 2009

Mobile service segment

Starhub’s mobile market share has declined from 29.4% in 2010 to 26.4% in 1Q19, amidst intense competition among network operators and the increased number of mobile virtual network operators (“MVNO”). In 2014, the Infocomm Development Authority of Singapore, now known as Infocomm Media Development Authority (“IMDA”), considered introducing more competition to the mobile market by allowing the three major telecommunication providers to host MVNOs on their networks.

The number of mobile service providers increased from three in 2014 to eight in 2018. In 2015, Liberty Wireless signed an agreement with M1 to offer mobile services and launched Circles.Life in 2016. Two more MVNOs — Zero1 and Zero Mobile — entered the mobile market subsequently, and in 2018, MyRepublic partnered with Starhub to launch their own mobile plans to consumers. At IMDA’s 2016 New Entrant Spectrum Auction, TPG Telecom outbidded MyRepublic to become the fourth licensed mobile network operator, and launched its mobile service in the city-state this year.

The strong competition in the market affected Starhub’s pricing power and elevated marketing expenses. The company’s market share of mobile customers dropped to a low in 2018 (see Table 2), coinciding with the increased number of industry players. The marked drop in the number of prepaid mobile subscribers after FY2017 may be due to more attractive price plans from competitors. We suspect prepaid consumers, who tend to be more price sensitive, may have increasingly turned to SIM-only, no-contract plans from the MVNOs.

Table 2: Starhub’s business performance across selected segments

Possible spectrum auction and fifth generation network

According to an announcement on 17 May 19, IMDA may be planning to auction parts of the 800Mhz, Time Division Duplex (“TDD”) 1900Mhz, and Frequency Division Duplex (“FDD”) 2100Mhz spectrum bands due to higher enterprise demand and the need to continue 3G services up till 2025. Mobile network operators including Starhub that are interested in the auctions may bid for the spectrum bands based on the reserve prices of 1) between S$100,000-S$900,000 for the 800Mhz band; 2) S$450,000-S$900,000 for the TDD1900Mhz band and 3) S$10m-S$15m for the FDD2100Mhz band.

IMDA is also inviting interested industry players to submit proposals for the fifth generation network that is expected to come online in 2021. The spectrum rights will last between 12 to 15 years consisting of two lots within the 3.5 gigahertz airwave. 5G operators will pay annual fees of S$2.12m to IMDA, while the initial deployment of the 5G network could cost up to S$174m. 5G uses high frequency bands with short propagation ranges that require large investments to install in-building cellular signal boosters. Due to spectrum constraints in the first few years, 5G network operators will be sharing the infrastructure to reduce upfront costs.

Telecommunication service providers like Starhub may face increasing capital expenditures in the coming years from high capital outlays for 3G network maintenance and 5G deployment. Starhub’s yearly capital expenditure has averaged S$317m in the recent five years and excessive capital spending would be credit negative for the firm. Sky-high bidding for spectrum bands is a possibility. The arrival of TPG Telecom saw significantly higher prices during IMDA’s spectrum auction in 2017. Starhub paid S$349.6m for 60 spectrum lots across various bands, S$282m of which will be recognized in 2019.

Broadband and Pay TV segments

Starhub’s broadband segment has fared better than its mobile segment in terms of churn rate and subscriptions. Average monthly churn rates are lower and have remained stable at around 0.8% while the number of broadband subscribers have increased over the years. Starhub has been promoting its fibre network broadband to existing cable broadband customers, which, according to the company, will help mitigate its fixed costs and move to a variable cost model.

Starhub’s pay TV segment has seen a significant decline in subscribers amidst increased popularity of online streaming, digital downloads, and over-the-top (“OTT”) streaming services. The arrival of popular content streaming firms such as Netflix and Amazon Prime has caused a drop in the number of pay TV customers. The management expects more competition within the pay TV segment moving forward, as content owners like Disney are also expected to launch their own streaming services.

Enterprise business

We think that the driver of Starhub’s future profitability hinges on the performance of its enterprise business segment, which unlike its mobile, TV, and broadband units, has been improving through the years. Revenue from enterprise businesses increased from S$224m to S$510m at an annual rate of 6% between 2004 and 2018. The telecommunication group is venturing into new business areas such as data analytics, cyber security, communication technology, and cloud services. Starhub’s recent joint venture in cyber security and the purchase of D’Crypt Pte Ltd (“DPL”) highlights the firm’s intention to meet the growing digital demand of its enterprise customers, targeting data analytics and cyber security needs within firms in the start-up community.

D’Crypt Pte Ltd

On 15 Dec 17, Starhub agreed to purchase DPL, a cryptographic and digital security firm with existing clients in the military and government sectors for a maximum consideration of S$122m. DPL will be a wholly-owned subsidiary of Starhub upon deal completion, which is expected to take place in the first half of 2021. Starhub has already acquired 65% of DPL in January 2018 and paid S$57.5m for the stake. In 2018, DPL contributed revenue of S$25.3m and profit of S$2.5m to the group.

Ensign InfoSecurity Pte Ltd

On 5 Sep 18, Starhub partnered with Temasek subsidiary, Leone Investments, to form Ensign InfoSecurity Pte Ltd (“Ensign”), a combined entity consisting of Starhub’s cyber security Centre of Excellence, Accel Systems & Technologies Pte Ltd, and Certis Cisco subsidiary Quann World Pte Ltd. Ensign is valued at S$260m and Starhub holds an effective interest of 60% in the newly formed entity. Starhub expects yearly revenues in excess of S$100m from the new joint venture company.

Ensign will focus on customers in the corporate and government sectors with a suite of cyber security solutions, systems integration, and managed services. StarHub will work with Ensign to provide customized solutions for customers that will meet their combined needs for connectivity and cyber security. We think securing more government contracts and increasing dependence on the government for revenue is credit positive as it increases the likelihood of government support in times of need. Working at cyber security in the government sector is a sensitive area that may be available to only a selected group of contractors.

Recent financial performance

As shown in Figure 1, Starhub’s revenue from enterprise services has been expanding in proportion to overall revenue since 2004. Total revenue remained flat in 2018 at S$2.4 billion, and management expects the group’s service revenue to see a 0-2% decline this year.

Last year, net income declined to S$201m from S$274m in 2017 on higher fixed expenses. On a quarterly basis, EBITDA increased from S$111m in 4Q18 to S$162m in 1Q19 on the back of lower marketing and promotion expenses, staff costs, and operating lease expenses. Free cash flow (after dividends) improved to negative S$27m in 1Q19 from negative S$110m in 4Q18, after management cut dividend payouts by approximately 44%.

Looking ahead, management intends to pay out at least 80% of the company’s earnings, or S$0.09 per share (on a yearly basis), whichever is higher. We expect Starhub’s net income to increase to more than ~S$350m this year (higher than S$201m in 2018) on increased pay TV and fibre broadband subscriptions, together with higher enterprise business revenue. The firm’s cash flows should also improve with the dividend cut and a capex guidance of 11-12% of revenue (on top of the outstanding commitments for 4G spectrum rights of S$282m) from management.

Figure 1: Starhub’s financial performance since 2004

Adoption of new accounting standards

Starhub applied SFRS(I) 1 and SFRS(I) 15 in 2017 and 2018, which resulted in material changes to revenues from the mobile, broadband services, and equipment sales segments. Restated 2017 mobile and broadband revenues, for example, were 25% and 13% lower respectively as sales of prepaid phone cards for which services have not been rendered are deferred and accounted as a contract liability on the balance sheet. Revenue is recognized over time upon usage of the prpaid phone cards, and upon expiry, any remaining value of the prepaid cards is recorded in the income statement.

Restated equipment sales in 2017 more than doubled from S$204m to S$532m under the new accounting rules, as the sale of equipment is immediately recognized at the point in time when control of the equipment has been transferred, being at the point when the customer takes delivery of the product and accepts the equipment. When the customer places the order for the mobile handset online, the transaction is recognized as a contract liability until the handset has been delivered to the customer. As a result of the adoption of new standards, current assets in 2017 were revised S$201m higher and current liabilities were S$21m lower.

Borrowings and credit profile

Starhub’s two bonds and perpetual security currently have bid yields between 2.8% and 4.6%, with a total outstanding amount of S$720m. Starhub’s other borrowings include unsecured bank loans amounting to S$508.3m in 1Q19. Interest rates on the bank loans ranged from 1.57% to 4.64% in 2018, higher than the 1.29-2.98% range in 2017. In our opinion, the rising costs on the unsecured bank loans reflect the lenders’ weaker perception of Starhub’s credit quality.

Figure 2: Starhub’s bond prices and yields

Figure 3 shows that loan rates have risen in tandem with weakening credit quality between 2015 and 2018. Rates at the top of the range increased to 4.64% in 2018 from 2.98% in 2015 as Starhub’s debt/EBITDA increased to ~2.2x from ~1.0x. During the past three years, Starhub’s ability to pay interest expenses, measured by the ratio of capex-adjusted EBITDA to interest expense, dropped to ~8.56x in 2018 from ~21.59x in 2015. Bottom-of-the-range loan rates grew at a steady pace between 2011 and 2018. The loan rates may be pegged to Singapore dollar benchmarks, but we think that (top-of-the-range) loan rates increasing in 2018 to its highest on record reflects higher issuer credit risk.

Figure 3: Loan rates and credit profile

Notes on Starhub’s bonds

We compared Starhub’s bonds against debt issued by telecommunication providers of similar leverage profile. Companies that share a similar debt-to-total asset ratio as Starhub include British Telecommunications PLC, Vodafone PLC, and Iliad SA. Our comparison also includes Singapore Telecommunications Limited (“Singtel”) as both companies operate in the Singapore market.

The results are shown in Figure 4, a plot of the bonds’ credit spreads and maturity. The relative attractiveness of the individual notes are determined by their credit spreads. After adjusting them for the issuer’s net debt-to-EBITDA ratio, the credit spreads are a measure of the bond’s credit risk premium (earned by investors) after accounting for the issuer’s indebtedness and recent operating performance. Bonds to the top left of Figure 4 are potentially more attractively priced, as they are essentially credits with low net debt-to-EBITDA ratios and high credit spreads.

Among Starhub’s three existing debt issues, we are more inclined towards the STHSP 3.950% Perpetual Corp (SGD). The perpetual note has dividend stopper and pusher covenants, as well as an option for the issuer to call back the issue on its first call date on 16 Jun 22 (or on any distribution payment date thereafter). If the perp is not redeemed on its first call date, the distribution rate on the note will reset to the sum of the prevailing ten-year SGD swap offer rate plus 271.5 basis points. On 26 Jun 19, the ask yield to worst for this issue was 4.1% at 99 cents on the dollar. We are neutral on STHSP 3.550% 08Jun2026 Corp and STHSP 3.080% 12Sep2022 Corp as they have significantly lower spreads, and therefore are less attractively priced than the company’s perpetual note.

Bonds of Singtel have low credit spreads and this is, in part, reflective of its A+ credit rating (by S&P). On the surface, it is our view that Singtel has a higher credit quality than Starhub given that Singtel is a multinational operator with a domestic market share larger than that of Starhub. Additionally, Starhub carries a higher debt-to-total asset ratio than Singtel, and operates with a meaningfully smaller revenue base. Nonetheless, compared with Singtel’s bonds, we think the STHSP 3.950% Perpetual Corp (SGD) is still more attractively priced with a higher credit spread as shown in Figure 4.

Figure 4: Relative valuation

Conclusion

In view of the abovementioned factors, we feel that the overall outlook for Starhub has weakened somewhat as the company has lost its product differentiation advantage. The company’s technological edge in the cable network during its early years has waned with the advent of the fibre optic cable. Starhub invested in high speed fibre optic network but did not have exclusive access to the network, as regulators made the fibre optic technology open to its competitors.

The increased number of OTT players and MVNOs have disrupted the respective business segments, leaving Starhub with little competitive advantage to retain or expand its customer base. Unlike the incumbent mobile operators, MVNOs are asset light and their highly competitive price plans have given them more market share in the mobile market.

With regard to its credit profile, we are neutral on Starhub as an issuer due to a competitive market and the cash burn possibility of deploying infrastructure for 5G technology. However, Starhub’s links to Temasek Holdings is credit positive as it indicates higher potential for institutional support in a financially distressed situation. We would be highly concerned if the ultimate parent company reduces its stake in the firm from its present level of 55.8%.

Any regulatory development that would put Starhub in a favorable market position such as special access to 5G equipment or implementing a streaming tax on OTT players, would be credit positive for the company. We expect Starhub’s profit to be significantly higher this year due to recent cost-cutting measures, and possibly higher revenue from its pay TV and broadband segments. The other potential upside is the outperformance of its enterprise business as Starhub may secure more project revenue with Singapore’s ongoing Smart Nation initiative.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.