• StarHub’s 4Q18 underlying earnings were 10% below our estimates. 
• Cyber security business and digital transformation efforts may offset cost savings from other operations. 
• FY19F dividend yield of 4.9% not appealing enough to await earnings recovery in FY20F.
• Downgrade to HOLD with a revised Target Price of S$1.92. 

Earnings Rebound Delayed While 4.9% Dividend Yield Is Less Appealing Than Its Peers

• STARHUB LTD (SGX:CC3)’s staff cost savings are likely to offset by
  1. expansion efforts of Ensign as StarHub scales up its cyber security operations and
  2. digital transformation efforts.
• We cut FY19F/20F earnings by 8%/11%. The new dividend policy of 2.25Scts per quarter or 80% earnings payout ratio in FY19F, whichever is higher, might translate into 4.9% dividend yield (vs our 5.5% expectations) not appealing enough to await earnings recovery in FY20F.
• NETLINK NBN TRUST (SGX:CJLU)’s 6.3% yield and SINGTEL (SGX:Z74)’s 5.7% yield are more attractive coupled with their superior earnings trajectory.

Where We Differ

• We were over-optimistic on StarHub’s cost transformation efforts earlier. Now we are inline with consensus on FY19F earnings but our FY20F earnings are still higher than consensus on the back of shut-down of its co-axial network.

Potential Catalysts

• Any network issues at TPG or weaker than anticipated uptake of TPG’s mobile plans could boost StarHub’s share price.

Valuation

• Downgrade to HOLD on a slower than expected recovery.
• We cut our DCF-based Target Price to S$1.92 (WACC of 7%, Terminal growth of 0%) from S$2.45 earlier as we revise down our FY19/20F earnings projections by 8%/11% on a slower than expected recovery.

Key Risks to Our View

• Bear case valuation is S$1.50 if TPG causes severe disruption.
• StarHub could see a 2% drop in FY19F EBITDA under this enario vs our base case.

What's New - Earnings Rebound Likely to be Delayed

Underlying earnings of S$42m (-19% y-o-y, -26% q-o-q) was below our expectations of S$47m.

• Cost of equipment sold dipped 11% y-o-y primarily due to the on-going migration of postpaid subscriber base to SIM-Only plans and lower volume of premium handsets sold. Cost of services also declined 6% y-o-y with StarHub’s on-going efforts to cut content costs as part of the restructuring of StarHub’s pay-TV business.
• Marketing expenses climbed up on the back of accelerating fibre migrations, bringing EBITDA to S$ 111m (-22% y-o-y, - 25% q-o-q). Excluding one-off adjustments of S$26m pertaining to postpaid mobile revenue and adjustments to an onerous contract, StarHub reported an underlying EBITDA of S$137m in 4Q18.
• Faced with higher overheads and shrinking profits, in 3Q18 StarHub announced cost-cutting measures aimed at achieving S$210m in cost savings over a three-year period starting from 4Q18 onwards. However, these costs savings failed to materalise in 4Q18 as StarHub reinvested part of these savings to expand its cyber-security venture, resulting in staff expenses growing by 11% y-o-y.
• Depreciation and amortisation expenses for the quarter edged up 14% y-o-y (13% q-o-q) largely owing to the adoption of SFRS 16, which requires the capitalisation of certain operating lease assets of StarHub. Accordingly, StarHub reported an underlying net profit of S$42m (-19% y-o-y).

Variable dividend policy from FY19.

• StarHub is transitioning to a new dividend policy whereby the telco plans to pay a quarterly cash dividend of ~2.25 Scts per share for FY19F, guaranteeing 9 Scts per share, down from the current 16Scts annual dividend. With this, StarHub is switching from a fixed to a variable dividend policy from FY19F and plans to distribute at least 80% of net profit each year.
• The management has indicated that any payment above 9 Scts to be in line with the new dividend policy would occur in the last quarterly payment for the year.

4Q18 service revenue of S$457m (-7% y-o-y, flat q-o-q) was below our expectations.

• StarHub reported 4Q18 mobile service revenue adjusted for one-offs of S$ 208.6m (-7% y-o-y, -2% q-o-q) driven by growing uptake of SIM-Only plans, and lower data add-ons, IDD and voice usage. The one-off S$16.6m contribution pertains to a loyalty program for mobile customers.
• StarHub’s post-paid mobile ARPU fell S$3 q-o-q to S$41 in 4Q18 with the launch of cheaper SIM-Only plans with bigger data bundles issued towards the end of the quarter.
• Revenues from Pay TV services dipped 4% q-o-q (-19% y-o-y) with the loss of ~14,000 subscribers, marginally below the previous quarter’s loss of ~15,000 subscribers. Enterprise segment proved to the only resilient business segment and continued on its growth momentum.

A look at Company's listed history – what drives StarHub’s share price? 

• Refer to Appendix A in the PDF report attached. 

Outlook for 19/20F

StarHub to capitalise some opex with the adoption of SFRS 16.

• Adoption of SFRS 16 will result in some operating leases being capitalised as right-of-use (ROU) assets leading to higher depreciation and amortisation charges from FY19F onwards. This should result in StarHub’s opex relating to operating leases edging down while D&A attributable to the capitalised leases will drive D&A expenses higher.
• While this should result in a favorable improvement in EBITDA, it is unlikely to trickle down to benefit StarHub’s earnings due to higher D&A.

Migration to fibre and accelerated depreciation of the HFC network to weigh on FY19.

• In November 2018, StarHub announced plans to cease providing broadband and Pay-TV services using its Hybrid Fibre Coaxial (HFC) Network by June 2019, ahead of the earlier proposed date of disconnection in 2020.
• We expect to see a sharp rise in StarHub’s cost of services in FY19F as migrations to NBN accelerate, partially offset by reduction in content costs with the on-going restructuring of StarHub’s Pay TV business. Accordingly, HFC Network will be fully depreciated by 1H19, placing a further burden on StarHub’s income statement in FY19F

Staff cost savings likely to be eroded by the expansion of Ensign.

• In 3Q18, StarHub entered into a joint venture agreement with Certis Cisco, a wholly owned subsidiary of the Temasek Group, to pool the cybersecurity assets of StarHub and Certis to create Ensign, a pure-play cybersecurity service provider. While the combined operations were marginally profitable at the point of formation, 4Q18 turned into a loss-making quarter for the cybersecurity company which reported losses of S$12m.
• Cyber security operations are heavily labour intensive. The S$30m staff cost savings that StarHub accrued is likely to be overridden by the expansion efforts of Ensign as StarHub scales-up cyber security operations.
• After factoring the above cost escalations, we have revised down our FY19/20F net profit by 8%/11%.

Source: DBS Research - 15 Feb 2019