Sunday, 23 June 2019

Where Do Astrea Bonds Stand Along PE Fund Lifecycle?

Now that the allocation for Astrea V 3.85% bonds is released, everyone can go back to their regular activities and forget about it. However, if you, like myself, hope to get a piece of the equity portion of Private Equity (PE) investments one day, then we should continue to learn and understand more about PE. Today's discussion is on the typical lifecycle of a PE fund and where do the 3 Astrea bonds stand along the lifecycle. This has major implications on the risks of the bonds, as we shall discuss later.

A PE fund usually has a lifecycle of around 10 years and comprises 4 phases. These 4 phases usually overlap. See Fig. 1 below (source: The Ultimate Guide to Private Equity).

Fig. 1: Lifecycle of PE Fund

In the first phase, the General Partner (GP) who runs the PE fund, will source for new investors and get their commitment to provide capital as and when needed to invest into promising companies. When capital commitments reach the target fund size, the fund will close. 

In the second phase, the GP will source for promising companies to invest into. This is usually called the Investment Period, as the fund is busy investing into companies. During this phase, the fund can invest in any new companies so long as they satisfy the criteria in the investment mandate.

After buying into the companies, the fund will work with the companies' management to enhance their operations such that they can achieve a higher valuation than what the fund paid for. The typical duration that a fund holds onto a company is about 5 years, but could exceed 10 years for an under-performing company.

When the time is ripe, the fund will seek to exit the company, either by IPO, sale to another company, or even sale to another PE fund. This is known as the Harvesting phase. During this period, the PE fund is not allowed to invest in new companies, but is allowed to invest additional money into existing companies, known as follow-on investments.

Finally, before the stated lifespan of the fund is up, the GP has to exit all remaining companies, return all proceeds to investors and dissolve the fund. The 10-year lifespan is not a fixed timeline, as GPs can request for extensions of 1-2 years so that they do not need to carry out a fire sale of the remaining companies.

Based on the above lifecycle of a PE fund, investors of the PE fund (known as Limited Partners) will contribute capital in the early years of the fund before receiving distributions in the later years when the PE fund exits its investments. The cumulative cash inflow over the lifecycle of the PE fund resembles a J-Curve. See Fig. 2 below.

Fig. 2: PE J-Curve

For an investor in a PE fund, where the fund is along its lifespan matters. In the early years, there is significant capital outlay as the PE fund invests into new companies. There are also significant risks in streamlining the company for greater efficiency. In addition, the company might struggle under the usually significant debt load placed upon it by the PE fund. Not all of the companies will prosper and make money for the PE fund. 

In the closing years of the PE fund, although there is no further capital outlay, the cash distribution from the PE fund is declining as it exits more and more companies. Also, whatever companies remaining in the PE fund might be under-performing and might not be worth much. If a company is attractive to other buyers, it probably would have been sold before the 10-year lifespan of the PE fund is up and not get left behind in the fund.

Thus, if the PE J-Curve shown in Fig. 2 is accurate, the sweet spot is around the 5th year of the PE fund. In addition, exits should be timed before the 10-year lifespan is up.

In Jun 2016, Azalea first introduced PE bonds to the market with Astrea III bonds. 2 years later, it launched Astrea IV bonds and just last week, it launched Astrea V bonds. The weighted average age of funds at the time of launch and scheduled call date of the 3 Astrea Class A-1 bonds are as follow.

Bond Wt Age of Fund Scheduled Call (Yrs)
Astrea III 6 3
Astrea IV 7 5
Astrea V 5.4 5

Their lifespans superimposed onto the PE J-Curve are shown in Fig. 3 below.

Fig. 3: Lifespan of Astrea Bonds Relative to PE Fund Lifecycle

Astrea III bonds (blue line) will last from the 6th to 9th year of the underlying PE funds that Astrea III invested into. This is the sweet spot that we discussed earlier -- enter around the 5th year and exit before the 10th year. It is probably the safest of the 3 Astrea bonds. In fact, it has just been announced that this bond would be redeemed as scheduled in 2 weeks' time.

Astrea IV bonds (purple line) will last from the 7th to 12th year of the underlying PE funds. The PE funds are generating a lot of cash currently, with total net distributions (after deducting capital calls) of USD243M in Astrea IV's first year of existence. This is equivalent to 22% of its portfolio value at the time of IPO. However, as shown in Fig. 3, the amount of distributions is expected to decline moving forward.

Astrea V bonds (brown line) will last from the 5th to 10th year of the underlying PE funds. Compared to Astrea IV bonds, there is a little more risks initially, as the companies in the PE funds are less mature and less ready to be exited. Furthermore, there are higher capital calls expected. But if these risks in the initial years can be overcome, Astrea V bonds will have less risks towards the end compared to Astrea IV bonds, as cashflows towards the tail-end would not have declined as much.

When you look at the risks of Astrea IV and Astrea V bonds, some of the safeguards that Azalea put in place for the bonds start to make a lot of sense. Let's talk about Astrea V bonds first, as it is simpler. As mentioned, one of the key risks for it is higher capital calls. This is mitigated by the capital call facility that allows Astrea V to borrow money from the banks to meet the capital calls.

For Astrea IV bonds, the key risk is not receiving sufficient distributions towards the tail-end to redeem the bonds in full. Although there is liquidity facility to meet interest payments in the event of shortfalls in distributions, there is no equivalent liquidity facility that Astrea IV can borrow from to redeem the bonds. Money to redeem the bonds can only come from the distributions from the underlying PE funds. However, towards the tail-end, such distributions are declining and might not be sufficient to redeem the SGD242M bonds in full.

In fact, it would be unfair to bondholders if it were to happen, considering that in the initial years of the bond, the underlying PE funds are generating a lot of cash, most of which are passed through to the sponsor. For the first year of Astrea IV, out of total net distributions of USD243M, all classes of bondholders (Class A-1, A-2 and B) were paid only USD26M in interest. Other expenses during the same period totalled USD7M. If there were no safeguards in place, the remaining USD210M (equivalent to 86% of net distribution of USD243M) and another USD15M in existing cash would flow to the sponsor. This money can leave Astrea IV as dividends to shareholder and repayment of shareholder loans instead of being retained within Astrea IV. Once the money leaves Astrea IV, bondholders have no recourse to Azalea as the shareholder/ sponsor to redeem the bonds in full. Recall that the bond is not guaranteed by either Azalea, or its parent, Temasek?

To prevent this scenario from happening, Azalea has put in place a safeguard that part of the distributions have to be set aside in reserves accounts for the sole purpose of redeeming the bonds. For the first year of Astrea IV, a total of USD80M has been set aside. Hence, the distributions flowing to the sponsor is reduced from USD225M to USD145M. This ensures that there will be sufficient cash to redeem the bonds when they mature, even though distributions from the underlying PE funds are declining.

In conclusion, PE bonds are not a simple matter of buy-and-forget. Investors need to understand where they stand along the lifecycle of PE funds and also what investor protection they have. Azalea has done a good job protecting investors from losses, but investors still need to protect themselves by learning more about PE investments.


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Sunday, 16 June 2019

Astrea V 3.85% Bonds – Understanding What You Are Buying Into

It has been exactly a year since I last blogged. My last blog post was on Astrea IV 4.35% bonds. Coincidentally, Astrea's management, Azalea, has recently launched the IPO for Astrea V 3.85% bonds. One year has passed. What do I think about Astrea bonds?

If you read last year's blog post on Would I Invest in Astrea IV 4.35% Bonds?, you would know that I was not too keen on Astrea IV 4.35% bonds. A large part of the reasons had to do with Private Equity (PE) bonds being a new asset class and there was too little time to properly analyse whether it would be a good investment. Given the time constraint, I relied on whatever understanding I had about fund of funds and leveraged buyout funds and concluded that I would not be applying for the IPO.

A week later, after the IPO had closed, I had more time to look at the structure of the Astrea IV bond and acknowledged that it could be a safe one, but only because of all the credit enhancement safeguards put in place. See Understanding the Safeguards of Astrea IV 4.35% Bonds for more info.

Thus, when the IPO for Astrea V 3.85% bonds was launched this week, the first thing I checked was whether it has similar safeguards as Astrea IV 4.35% bonds. It has. Still, it is necessary to re-iterate that being PE bonds, Astrea bonds are not traditional bonds and it is important to understand the risks of the underlying assets. Below is a summary of the risks that I am aware of.

Understated Loan-to-Value Ratio in Fund of Funds

Astrea V bonds invest in 38 PE funds run by independent PE fund managers. Its stated Loan-to-Value (LTV) ratio for the Class A bonds (comprising Class A-1 and Class A-2 bonds which have equal seniority) is 34.8%. This means that for Class A bonds to start losing money, the value of the underlying investments has to drop by 65.2%. However, the underlying PE funds have their own debts and these debts are not considered when computing the LTV ratio of 34.8% for Astrea V bonds. The true LTV ratio after considering the debts in the underlying PE funds (i.e. look-though basis) is likely to be much higher. This ratio matters. See Would I Invest in Astrea IV 4.35% Bonds? for an example.

High Leverage Used by Buyout Funds

80% of the Astrea V investments are in buyout funds. As discussed in Would I Invest in Astrea IV 4.35% Bonds?, buyout funds use a lot of debts when acquiring companies. Typical debts is in the region of 6-7 times Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA). High debts at the underlying PE funds, couple with a Fund of Fund structure, underestimates the true, look-through LTV ratio of the Astrea bonds.

Assurance of Net Asset Value

Astrea V has a portfolio value of USD1,342M. This is an important figure that is used to compute the LTV ratio. After the debacle of the Hyflux preference shares and perpetual securities, it became clear that asset values should not be taken at face value. Hyflux's main asset, Tuaspring Integrated Water and Power Project, which has a stated Net Asset Value (NAV) of $902M as at end of Financial Year 2017, could not be sold at close to book value. Given that PE investments are illiquid assets, what is the assurance that the portfolio value of Astrea V is really as stated?

This question was posted during the Astrea Investor Day in Jan 2019 and during the public roadshow on Astrea V bonds conducted with SGX Academy on Saturday. Azalea's management replied that the NAV of PE funds is checked by reputable auditors. In addition, there are secondary markets where PE funds are traded. The value at which they are traded is close to the NAV reported by the PE fund managers. Furthermore, when the PE investments are disposed of, Azalea cross-checks the sale value against the reported NAV. In most cases, the sale value exceeds the reported NAV.

PE in a Potential Bubble

PE investments have generated better returns than public equities in the last 20 years. This has resulted in a lot of funds flowing into PE investments, and increased competition between PE fund managers to find good deals. This has led to assets being purchased at higher prices. At the same time, the debts used by buyout funds to acquire companies has been on the rise. At some point in time, the PE boom will probably end, potentially leading to falls in NAV. See Bain & Company's report on Private Equity: Still Booming, but Is the Cycle Near Its End? for more info.

At Saturday's roadshow, Azalea replied that this is also a good time for selling assets in the PE funds that Astrea V has already invested in, which will result in cashflows coming back to the Astrea bonds. Furthermore, as most of the PE fund managers have a lot of experience running PE funds, they believe that the PE fund managers will be able to navigate the environment.

While I agree that this is a good time for selling assets in PE funds, this also means that the high asset prices are reflected in the portfolio value of Astrea's investments. In the event that asset prices correct, Astrea's portfolio value will also decline. This will lead to a rise in the LTV ratio, but there is a safeguard in place if the LTV ratio exceeds 50%.

Conclusion

Although I believe Astrea IV and V bonds to be fairly safe for retail investors, I cannot emphasize enough that the reason this is so is because of the credit enhancement safeguards that Azalea painstakingly put in place. Also, for investors interested to buy Astrea bonds, please understand what you are buying into.


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Sunday, 17 June 2018

Understanding the Safeguards of Astrea IV 4.35% Bonds

Astrea IV 4.35% bonds are unusual retail bonds as they are backed by Private Equity (PE). There are 5 safeguards put in place by the issuer to ensure that cashflows from PE investments are adequate to meet the obligations of the bond. These are:
  • Reserves Accounts
  • Sponsor Sharing
  • Maximum Loan-to-Value (LTV) Ratio
  • Liquidity Facilities
  • Capital Call Facilities

To understand why these safeguards are important and necessary, let us consider a hypothetical scenario in which I wish to issue Boring Investor bonds to retail investors to raise capital to invest in public equities listed on the SGX. Cashflows for the bonds would come from sale of equity investments and dividends from investee companies. 

Generally, the Straits Times Index (STI) generates annualised returns of 7% in capital appreciation and 3% in dividends on average. To entice investors to my Boring Investor bonds, I would probably have to pay interest rate of 5% on the bonds. The first question that comes to mind is how do I ensure that I could meet the 5% interest obligations on the Boring Investor bonds on a sustainable basis when I could only receive 3% dividends from the equity investments? There are several things I can do, as described below. 

Maximum Loan-to-Value (LTV) Ratio

Supposed I intend to invest $1M in the SGX equities. At a dividend rate of 3%, the maximum dividends I could get from the equities annually is only $30K. Based on the bond interest rate of 5%, the maximum amount of Boring Investor bonds I could issue is $30K / 5%, or $600K. The maximum Loan-to-Value (LTV) ratio that can be supported by dividends on a sustainable basis is only 60%. Thus, by setting a maximum cap on the LTV ratio, I can better ensure that bond holders are paid on time.

Liquidity Facilities

There will be times when the economy is not doing well and the investee companies have to cut dividends. When this happens, I might not get sufficient dividends from the equity investments to pay interest to bond holders. I will need to borrow money temporarily from the banks to pay the bond interest.

Capital Call Facilities

There will also be times when some companies need to issue rights issues to raise money. Given that most the funds raised from the Boring Investor bonds have been invested in the SGX equities, I might not have sufficient funds to subscribe to the rights issues and buy additional shares in the companies at a bargain. To guard against this, I can set up a credit line with the banks to temporarily borrow money to subscribe to the rights issues.

Reserves Accounts

Given the unpredictable nature of the cashflows from dividends and sale of equity investments, it is prudent to set up a sinking fund to save some excess cashflows after paying the bond interest and other necessary expenses. The amount to be set aside for the sinking fund each year is a pre-determined amount, but it is only set aside if excess cashflows are available. The sinking fund will be topped up until there are sufficient funds to redeem the Boring Investor bonds in full. This would increase the likelihood that the bonds could be redeemed in full when they mature.

Sponsor Sharing

Generally, after meeting all the obligations mentioned above, any remaining cashflows would belong to the sponsor shareholder. However, as an additional gesture of goodwill, I can share the remaining cashflows 50:50 with bond holders if certain performance threshold is met by a certain date. The cashflows shared with bond holders would be used to top up the sinking fund mentioned above, if it is not full yet. 

Conclusion

As you can see above, cashflows from equity investments (more so for PE investments and PE funds) are unpredictable, irregular and discretionary whereas interest and principal repayment obligations of bonds are fixed and mandatory. There is a need for some of the above-mentioned safeguards (known as credit enhancements) to ensure that bond obligations can be met when they fall due. If there were no credit enhancements, and the fixed and mandatory bond obligations were solely funded by the irregular and discretionary cashflows from equity investments, defaults on the bonds would likely happen at some point in time. 

Thus, the Astrea IV 4.35% bonds are safe mainly because of the safeguards put in place. It is not a bond, but a structured bond. The credit ratings for Astrea IV 4.35% bonds are expected to be "A(sf)", with "sf" denoting structured finance. To avoid confusion with traditional bonds, it is best to refer to the Astrea IV 4.35% bonds as structured bonds, just like we differentiate structured deposits from fixed deposits. 

Did I invest in Astrea IV 4.35% bonds? No, I did not. I prefer to invest in traditional bonds in which the underlying cashflows are sufficient to meet the bond obligations without any credit enhancements. 


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Monday, 11 June 2018

Would I Invest in Astrea IV 4.35% Bonds?

Recently, Temasek launched a Private Equity (PE) bond for retail investors known as Astrea IV 4.35% bond. It is the first PE bond open to retail investors. Would I invest my money in this bond?

First of all, let us understand what this bond is all about. This bond is issued by Astrea IV Pte Ltd, an indirect wholly owned subsidiary of Temasek, to hold a portfolio of PE investments. The investments are managed by 27 General Partners in 36 PE funds and invested in 596 companies. 86.1% of these funds are invested in buyouts, with 12.3% in growth equity and 1.6% in private debt. 

Buyout funds are funds that privatise publicly listed companies, cut the excesses in the companies and streamline their operations to make them more efficient, and seek to exit the companies by selling them or listing them again. An example is Amtek Engineering, which was delisted from SGX in 2007 after being bought out by a PE fund, and was relisted as Interplex Holdings in 2010. And the story did not end there. Interplex Holdings itself was delisted in 2016 after being bought out by another PE fund.

The issuer, Astrea IV, has 3 classes of bonds, as follow:
  • Class A-1 - SGD242M 4.35% senior bonds that are open to retail investors and which are the subject of this post.
  • Class A-2 - USD210M senior bonds open only to Institutional and/or Accredited Investors. Class A-2 bonds have the same seniority as Class A-1 bonds.
  • Class B - USD110M bonds junior bonds open only to Institutional and/or Accredited Investors. 

The structure of the bonds is such that Class A bonds have priority to interest payments and bond redemption. In addition, it can borrow money from banks to make interest payments in the event that there are insufficient cashflows to do so. Moreover, its Loan-to-Value (LTV) ratio is capped at 50% of the portfolio value. If this threshold is crossed, it will have to cut debt levels. Furthermore, Class A bonds are senior to Class B bonds and shareholder equity. For Class A bonds to lose money, the portfolio that Astrea IV invests in must lose at least 64.4% of its value. So, it is quite safe, isn't it? 

First of all, you need to recognise that Astrea IV, the company that you are investing into by buying the retail bond, is essentially a fund of funds. Although its LTV is capped at 50%, this is only at the Astrea IV level. The funds that Astrea IV invests into could have their own borrowings and these are not counted in the 50% LTV cap. After accounting for these borrowings at the lower levels (i.e. look-through basis), the leverage could be much higher. As a hypothetical example, Company A could have shareholder equity of $50M and bonds of $50M. Using this $100M, Company A invests into Company B. Company B borrows another $100M. Company B invests the $200M into a property. How much of the investment in the property is funded by equity and borrowings? The answer is $50M in equity and $150M in borrowings. Thus, even though the LTV at Company A's level is only 50%, on a look-through basis, the LTV is 75%! Does LTV on a look-through basis matter? For Company A's equity to be wiped out completely and its bonds to start losing money, the property's value only need to fall by 25% ($50M equity out of $200M asset value). So, LTV on a look-through basis does matter!

Secondly, most of the money are invested in buyout funds. Buyouts are usually highly leveraged operations. In the process of buying out companies, they take on large debts and usually pay a premium to acquire a 100% stake in the companies. After successfully acquiring the companies (which are usually cashflow-rich companies), they extract most of the cash from the companies to pay down their own debts. They also streamline the operations of the companies and load them with debts, such that the companies become more conscious about cutting costs and direct most of their cashflows to paring down the debts loaded onto them. Thus, the high returns of buyout funds are partly due to making the companies more efficient and partly due to the leverage employed. As an example, when 3G Capital teamed up with Berkshire Hathaway to buy Heinz for USD23.3B in 2013, they only forked out USD4.4B in capital each. The remaining was borrowed. (Note: Berkshire Hathaway also bought USD8B of preferred stocks paying 9% interest. I will leave it to readers to decide whether to classify this USD8B as equity or debt.)

Thus, in conclusion, Astrea IV is essentially a fund of leveraged buyout funds. I will not be investing in these bonds, even if its 4.35% coupon looks attractive.


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Sunday, 27 May 2018

Possibly The Worst Time to Invest – 4 Years On

This once-a-year post probably sounds like a broken record, but 4 years after I thought it was a bad time to invest (due to record high Dow Jones Industrial Average and record low interest rates then), the DJIA has not crashed yet, despite a series of corrections along the way, with the most recent one in Feb. I have 2 passive portfolios invested in index funds and adopting the portfolio rebalancing strategy. The plain vanilla portfolio has 70% in global equities and 30% in global bonds since Dec 2013, while the spicy portfolio has 70% in US equities and 30% in Asian bonds progressively built up over 2015. 

To-date, the plain vanilla portfolio is up by 31.4% while the spicy portfolio is up by 24.2% since they were started approximately 4.5 years and 2.5 years ago. Needlessly to say, had I worried about the high stock prices and low interest rates back then and not started the 2 portfolios, I would not be sitting on such paper gains. 

I am tempted to allocate more money from my active investments to the 2 passive portfolios, considering that all it takes is to monitor occasionally whether the relative allocation between the equities and bonds has moved significantly away from the initial allocation of 70% stocks and 30% bonds and rebalance them when it happens. In contrast, active investment requires a lot of hard work. I need to read the financial statements and annual reports, attend Annual General Meetings, understand pricing strategy and competitors' activities, etc. to understand how well the business is doing. Just take a look at M1, a stock that I blogged about recently. I spent no less than 6 posts (and another 3 posts on its competitors) to describe the various aspects of M1. Even then, there are probably still a lot of areas about M1 that I do not understand. Furthermore, the size of my M1 position is only 1/3 that of the 2 passive portfolios!

So, would I be worried if I were to invest more into the 2 passive portfolios and the crash finally happens? Obviously, I would be quite upset if it were to happen, but I would attribute it more to bad timing. One way to mitigate this risk is to spread out the investment, similar to what I did when I initiated the spicy portfolio. The plain vanilla portfolio was a lump-sum investment in Dec 2013, but the spicy portfolio was built up over 12 months in 2015. Furthermore, the rebalancing strategy will ensure that if stocks were to crash significantly, the bonds would be sold to buy more of the now cheaper stocks. There is inherent defence mechanism in the portfolio rebalancing strategy.

This time next year, I am not sure if I will be happy or upset over my 2 passive portfolios (which depends on whether the crash happens or not), but likely, it will be business as usual.


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Monday, 21 May 2018

Who Moved Starhub's Cheese?

Starhub has been facing declining profitability in the last few years. It even had to cut its 20-cent annual dividend last year, a dividend which it had held steady for 7 years. Why did Starhub face declining profitability and who moved Starhub's cheese? To discuss these questions, we need to first understand what were Starhub's competitive advantages in the past and how have they changed.

Starhub's Moats

Traditionally, compared to its 2 rivals, Starhub has the advantage of using its cable network infrastructure to deliver both cable TV and cable broadband services, thus enabling it to spread out the cost of operating the infrastructure over a larger number of customers.

In addition, compared to M1, which until recent years only offered mobile services, Starhub (and also Singtel) has the hubbing strategy which offers customers discounts if they sign up for 3 services, namely, mobile line, home broadband and Pay TV. The discounts range from 5% to 30% for different services. Thus, if a customer needs mobile lines, home broadband and Pay TV, he would find it attractive to sign up all services with Starhub (or Singtel) and enjoy the hubbing discounts. This hubbing strategy has allowed Starhub and Singtel to gain market share relative to M1 in the post-paid mobile services market. See Fig. 1 below for the changes in market share of the 3 telcos and the percentage of households who are members of Starhub's Hub Club.

Fig. 1: Post-Paid Mobile Service Market Share

Hence, for a long time, Starhub had been enjoying a moat which seemed impregnable. 

Cable Broadband

The first crack in Starhub's hitherto impregnable moat is cable broadband. In 2010, the Next Generation Nationwide Broadband Network (NGNBN) started operations. Instead of only Starhub and Singtel being able to offer home broadband via their cable and ADSL networks respectively, the market was suddenly opened up to many other companies, including M1, MyRepublic, ViewQwest, etc. With more competitors, prices of home broadband dropped. In addition, as more customers switch from cable broadband to fibre broadband, there are less customers to spread the cost of operating the cable network infrastructure. See Fig. 2 below for the declining number of cable broadband customers. 

Fig. 2: Proportion of Cable and Fibre Broadband Customers

Although Starhub's cable broadband market share declined, its hubbing strategy is still intact. Customers who need mobile lines, Pay TV and home broadband, regardless whether it is cable or fibre broadband, would still find it attractive to sign up with Starhub to enjoy the discounts. Nevertheless, it should be noted that M1 is now able to offer a hubbing strategy for customers to sign up mobile lines and fibre broadband. Customers who do not need Pay TV would enjoy hubbing discounts with M1 but not Starhub and Singtel.

Pay TV

With faster and more reliable broadband speed comes the ability to watch videos online. Furthermore, online viewers are not restricted to watching video on the TV; they could watch it anywhere and on the move. This has resulted in cord-cutting by Pay TV subscribers, and this trend is not limited to Singapore alone. 

In Jan 2016, Netflix entered the Singapore market, offering not only a cheaper way of watching movies but also bringing in popular exclusive original content. See Is Pay TV Still A Reliable Cash Cow? for more information. Since then, the decline in the number of Pay TV subscribers at both Starhub and Singtel has accelerated, despite the retention power of their hubbing strategies. See Fig. 3 below for the number of Pay TV subscribers. 

Fig. 3: No. of Pay TV Subscribers at Starhub and Singtel

With the decline in Pay TV subscribers, there is further reduction in the number of customers to spread the cost of operating the cable network infrastructure. The traditional competitive advantage that Starhub has in the cable TV network infrastructure is irreversibly gone.

Furthermore, the proportion of households on Starhub's Hub Club has also declined. See Fig. 1 above. Thus, with the onslaught of streaming video on demand, even Starhub's hubbing strategy is no longer as impregnable. If anything, the hubbing advantage has tilted towards M1 which requires only 2 services instead of 3 services for Starhub and Singtel.

Mobile Services

Mobile Services is the largest segment of all 3 telcos. In the last few years, it has faced many headwinds. The traditional money generator for telcos, Short Message Service (SMS), has now been superseded by messaging apps like WhatsApp, WeChat, etc. Likewise, voice is also seeing a decline as it is being replaced by WhatsApp calls, Skype, etc. Only data is seeing increasing demand. But even in this area, competition has increased. In 2016, M1 launched data upsize plans that allow subscribers to increase their data bundles with a slight increase in monthly fees. This has the effect of reducing the excess data charges that subscribers pay when they exceed their data bundles. See Impact of Data Upsize Plans on Telcos for more information.

Also in 2016 and again in recent months, new virtual telcos known as Mobile Virtual Network Operators (MVNOs) have sprung up. These MVNOs buy network capacity from traditional telcos and resell to retail customers. They cater to niche customer segments and usually dangle attractive offers, such as Circles.Life's $20-for-20GB of data, ZeroMobile's Unlimited Everything and Zero1's unlimited data for $29.99. See Will MVNOs Cannibalise Telcos' Business?

In addition, there have been other disruptions to the telco industry, such as the SIM-only plans, which attract customers who do not need to change their phones every 2 years. These plans reduce the revenue but are value accretive at the EBITDA level. See Will SIM-Only Plans Cannibalise Regular Telco Plans? for more information. Finally, there is also the fourth telco which is scheduled to start operations in Jan next year. See Where Art Thou, TPG?

Conclusion

In conclusion, Starhub is facing headwinds in many business segments. The party that is moving Starhub's cheese is not a single actor. Many actors have been moving Starhub's cheese. 

P.S. I am vested in M1, Netlink Trust and Singtel.


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Monday, 14 May 2018

A Satisfied M1 Investor

I started investing in M1 in Jan last year. At that time, it was to take advantage of the crash in telco stocks due to fear of the fourth telco. Since then, I have added to my positions several times. My current position is now 5 times the initial one. This is because despite all the headwinds that telcos face, from SIM-only plans, data upsize plans, Mobile Virtual Network Operators (MVNOs) to the fourth telco, M1 has performed admirably. Below is a summary of what I like about M1.

SIM-Only Plans

When M1 launched SIM-only plans in Jul 2015, I had not invested in telco stocks yet. But my initial thoughts were that SIM-only plans would lead to a drop in revenue and a smaller drop in profitability, as SIM-only plans would lead to some subscribers downgrading from the more expensive regular telco plans with handphone subsidies to the SIM-only plans. See Impact of SIM-Only Plans on Telcos. As it turns out, although SIM-only plans indeed led to a drop in revenue, they are value-accretive at the EBITDA level, as they attract new customers in addition to existing subscribers who downgrade. An analogy would be the regular telco plans are like full-service airlines while SIM-only plans are like budget airlines. Although SIM-only plans cannibalise regular telco plans, they also create new demand of their own. See Will SIM-Only Plans Cannibalise Regular Telco Plans? for more information. The popularity of SIM-only plans (together with Circles.Life) has led to strong growth in M1's post-paid customer base. See Fig. 1 below for the growth rate (note: M1's post-paid customer base includes that of Circles.Life, the MVNO that works with it).

Fig. 1: Changes in M1's Post-Paid Customers

In this aspect, I have to acknowledge that M1 knows what it is doing and is doing better than I thought.

Data Upsize Plans

This is another initiative that M1 started in Mar 2016 before I became a shareholder. Again, I believed that this would lead to lower profitability, as subscribers who used to exceed their data bundles and pay excess data charges of as high as $10.70/GB now need to pay only $5.90 per month to upsize their data bundles. See Impact of Data Upsize Plans on Telcos

This time, I am not wrong about the impact on revenue and profitability, but M1 has bigger plans. Instead of stopping at 3 levels of upsize, M1 launched big data plans in Aug 2017, including an unlimited data plan. The big data plans are clearly ahead of competition, which is quite unusual since all telcos will try to match each other. See No Competition for M1's Big Data Plans for more information. M1's prices are comparatively lower than that of the other 2 telcos, so much so that I feel that M1 did not maximise profits by pricing them closer to the competition (but also see the section on Narrowband Internet of Things).

Mobile Virtual Network Operators (MVNOs)

Long before the recent spate of MVNOs like Zero Mobile, Zero1 and MyRepublic, M1 had already worked with a MVNO called Circles.Life in May 2016 to roll out mobile services to niche segments of customers that M1 did not cater for. Since MVNOs have to buy network capacity from traditional telcos, they will never be able to offer a better deal than traditional telcos on a sustainable basis. So, MVNOs are a way of getting some extra revenue from niche market segments without taking the risks.

I would like to say that the collaboration with Circles.Life has been a successful one. Customer numbers have been increasing as shown in Fig. 1 above. Furthermore, Singtel and Starhub have recently been copying M1 in working with MVNOs as TPG's timeline for setting up operations in Singapore by Dec 2018 approaches. As they say, imitation is the best form of flattery. 

I might be wrong in this aspect, but I somehow suspect that M1 learnt something useful from Circles.Life's operations. Customers of Circles.Life use an app known as CirclesCare to manage their plans, including activating additional services on-demand. See CirclesCare features. M1's app has similar features, which saves customers' time from not having to call the customer service line and reduces the no. of staff they need to service customers. 

Narrowband Internet of Things (NB-IoT)

NB-IoT is a new 4.5G network designed for machine-to-machine communications to facilitate Internet-of-Things (IoT). Like most other new services, M1 is the first telco to roll out this new service in Aug 2017. There are some advantages in being the first mover and the lowest cost provider in big data, but it is still a fairly new service and not many companies are ready to launch IoT devices, so it is worth watching whether this new service will bring in good revenue for M1.

In an earlier section on data upsize plans, I mentioned that although M1 has a cost advantage in big data, it has not taken advantage of it to maximise profits. This might be because M1 is trying to attract more companies to use its NB-IoT services. Once on board, M1 could upsell to customers its data analytics services to derive better value. Furthermore, compared to traditional 4G services that cater to individuals, NB-IoT has higher switching costs and hence, customers are less likely to switch to a different telco. See NB-IoT – The Next Frontier for Telcos for more information. Thus, I am willing to accept that M1 has priced its big data plans lower than necessary to capture this new market segment.

Overall

M1 is the smallest telco in Singapore. Perhaps cognisant of its small size, it has always been willing to try out new things. It is the first telco to launch 3G mobile services in Feb 2005, mobile broadband in Dec 2006, fibre broadband in Sep 2010, 4G mobile services in Sep 2012, 4.5G mobile services in Dec 2014, etc. Nevertheless, despite being the first to deliver, it has always come in last in terms of market share. Yet, it knows that if it is not the first to deliver, it will not only come in last, but also become irrelevant, given that it had no Pay TV, cable/DSL broadband and analogue/digital voice businesses (before the Next Generation Nationwide Broadband Network came on board and disrupted the playing field). To stay relevant and survive, M1 has to constantly innovate. Innovations are in M1's DNA.

The innovations mentioned in earlier sections represent a desire to disrupt itself and competitors to stay ahead of the competition. Contrary to conventional wisdom, the disruptions in the telco industry in recent years did not come from the fourth telco; they came from M1 (and Singtel to a smaller extent). All these disruptions have also made the fourth telco fairly irrelevant, even if TPG were to start operations in Dec 2018 as scheduled. M1 has established a clear lead in big data (for now) and a toehold in NB-IoT. Perhaps this time round, it would not come in last among the 3 telcos.

On my investment in M1, despite averaging down 4 times, I am still sitting on a small paper loss. Nevertheless, the actions that M1 took make me confident that it is a matter of time before the market recognises M1 is a technology disruptor rather than the disrupted and the share price recovers to my cost price. I am satisfied with my investment in M1.

P.S. I am vested in M1, Netlink Trust and Singtel.


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