Description

Investment Idea

Idea: Nippon Telegraph and Telephone Corp (Ticker: 9432 JP)

Summary:

NTT is a $101b market cap, incumbent telecom operator in Japan, that I believe will almost double over the next 3 years. It has two main businesses that generate 90% of its EBITDA and cash flows. The Mobile business, called NTT Docomo, and the domestic fibre broadband business. Both these businesses are benefitting from declining capex intensity. The mobile business has the majority of subscribers already using LTE while the regional broadband business is mostly on fibre broadband. NTT is also benefitting as Softbank has been forced to run the Japan business for cash generation and have skimped on investment. A moderately improving EBITDA in combination with declining capex is leading to NTT throwing out a lot of FCFs trading currently at 9.1% FCF Yield, rising to 12.1% FCF Yield by CY 2020E. As part of a new policy, first stated in 2015, NTT will use a lot of the FCFs to buyback shares to increase ROEs and also boost EPS growth. This has led to EPS growth of 60% over last two years and I forecast EPS to increase by another almost 65% over next 3 years. Using an average of 15x P/E, 6x EV/EBITDA and 6% FCF Yield for 2020E, gives me an average 3-Year target price of NTT of ¥15k which would generate a 188% return on the share price today.  

Company information:

NTT is a Japanese telecom firm that comprises of the following segments. Regional Communications is the fibre and broadband business including the sub-segments NTT East and NTT West. Mobile Communications consists of NTT Docomo which is one of the three main mobile providers in Japan along with KDDI and Softbank. NTT Docomo is listed and NTT owns 66.7%. The mobile and broadband businesses generate the vast amount (85%) of EBITDA currently. The Data Communications business comprises of NTT Data which is also listed and NTT owns 54.2% currently. NTT Data is an IT service provider. Long distance and International Communications comprises of long distance telecom operations as well as services such as cloud and data center services. Other businesses is mixture of real estate, finance, construction businesses.

The decline in the fixed line voice business since 2000 has been offset with the rollout of the fibre business called Flet’s Hikari. Meanwhile the mobile business has been strong since its launch and has recently re-accelerated with the LTE rollout where it is gaining share.

Let’s examine each segment individually.

Regional Communications Business

The Regional business comprises of two companies NTT East and NTT West of roughly equal size that have split the country’s geography between them. The decline in the telephone subscriber line and related ASDL broadband business has been offset by the fibre broadband business called Flet’s Hikari.

The company is continuing its fibre rollout and growing its Fibre subscriber base and is on track for its 4% growth in its March 2018 business plan target, and expects a similar pace going forward.

The ARPUs of both the fixed line and the Fibre business are declining despite the growing subscriber base.

The declining ARPUs lead to overall slightly declining revenues

Although the EBITDA of the business is stable and cash flow is starting to increase as the peak Capex phase of the fibre rollout is well behind us.

Mobile Communications Business

The mobile business comprises of NTT Docomo. It is one of three major players in the Japan mobile market including KDDI Softbank. Softbank had been very aggressive trying to gain market share for about a decade from 2005 till 2015 at which point Softbank eased off discounting in the market, eased off aggressive capex spends and started to realize higher EBITDA and cash flow gains. Softbank’s focus has shifted to other segments including Sprint and it is happy to let the Japan mobile business spin off higher cash flows. This has allowed KDDI and NTT Docomo to also allow price rises, and after a decade of falling, mobile ARPU’s increased for the first time in 2016 and even more in 2017.

The recent launch of docomo Hikari, which bundles mobile with fibre business, has also reversed mobile ARPUs.

The mobile business has also recently seen the success of the LTE rollout payoff as the rollout gathers pace.

Part of the reason their subscriber growth has picked up pace is that they didn’t stop investing into the network like Softbank and as of Sep 2017, almost half their LTE base stations are “Premium 4G” enabled, which means almost 800Mbps speed (one of the fastest in the world) and it is allowing them to continue to add subscribers.

The increased subscribers from the LTE launch as well as increasing ARPU from the fibre bundling is feeding into much higher revenue growth.

All this has allowed EBITDA of the mobile business to finally increase after a decade of intense competition and stagnation. At the same time, capex intensity is declining and the business is finally in a position to throw out a lot of cash flows.

NTT Docomo reported adjusted FCFs of JPY 665m for FY17 and claims it is on track for JPY 710m for FY18 during its half-year report.

Data Communication Business

The Data Communication business comprises of the publicly listed company NTT Data. NTT  Data  Corporation  mainly  provides  large  scale  system  integration  and  networking  system  services.  System  integration  involves  data transmission system design, sales, leasing, and services. It is an IT Services business with very strong relationships in the local market. The business has been growing at 7% CAGR sales growth for a decade while maintaining 6-7% operating margins and 16-18% EBITDA margins. The low operating margins and strong relationships is the reason the domestic business is stable and not under threat from the Indian IT firms.

NTT decided in 2016 to expand its international business from 30%. In 2018 it expects Japan to be half the business and Overseas be half. And it has a goal that in another 5 years it will have equal presence in Japan, US and Rest of World. As part of this plan it acquired the former Dell Services in Nov 2016 for $3.1b funded with debt. The average interest rate on the new debt is less than 1%. This has dramatically increased the company’s backlog and resulted in deal wins in the U.S. federal public sector with the U.S. Department of Homeland Security, U.S. Department of Justice, and Centers for Disease  Control and Prevention.

The company expects sales to increase by an additional JPY 300b in FY Mar 2018 as a result of the acquisition.

Long Distance & International Communications Business

This business includes NTT Communications which has a cloud business and Hikaru TV business, a South African headquartered IT business called Dimension Data, and a few other businesses.  NTT Comm is a stable business with little growth and stable 10% operating margins. The division’s EBITDA and operating income was negatively effected in 2017 with a one-off restructuring charge in the Dimension Data business of ¥60b and which should reverse in 2018 and allow the division’s EBITDA margins to return to 14%. Also while the stable NTT Comm business is not growing, a bunch of other businesses including Dimension Data are still growing strong.

NTT Valuation

Putting together the valuation.

Other businesses includes a publicly listed real estate company called NTT Urban Development and a large number of smaller businesses that are generally stable

While the business already generated almost JPY 20b in cash flows over last two years, I have Free Cash Flow generation ramping up to closer to ¥12b-¥13b per year for a 11-12% FCF Yield. In addition the company is utilizing this cash flow to ramp up dividends as well as aggressively buying back its shares and retiring the treasury stock. This has led to EPS growing by 62% over 2015-2017. If the company continues to buy back stock at the same pace, as well as benefits from earnings growing as well, EPS should grow by another 65% over 2017-2020.

To calculate a 3-Year target price, I have used a number of different metrics for the CY 2020E financials, including a reasonable 15x P/E multiple (currently trades 14x with lower ROEs), 6x EV/EBITDA, and a 6% FCF Yield.

I believe the stock will almost triple over the next 3 years as it generates approx 35% FCFs, which it channels into increased dividends and buybacks, and benefitting from the high operational and financial gearing in the company.

Appendix

Catalyst

FCFs, buybacks, re-rating