The TPG Telecom Ltd (ASX: TPM) share price grew very strongly between 2011 and 2016 on the back of a series of acquisitions. This included the acquisitions of retail telcos AAPT and iiNet.
This significantly increased TPG's market scale. It became the second-largest fixed broadband provider after Telstra. However, since then the TPG share price generally failed to gain momentum. This is despite solid gains over the past few months.
Is TPG a good long term buy and hold option for investors?
Let's first take a closer look at TPG's business model.
TPG continues to face NBN headwinds
Consumers are migrating from TPG's legacy of fixed voice and broadband networks to the lower-margin National Broadband Network (NBN). As this continues, this is negatively impacting TPG's earnings before interest, taxes, depreciation and amortization (EBITDA) and placing downward pressure on the business's price for shares. In addition, there has been a recent decline in the profitability of its existing NBN customer base.
This trend is reflected in TPG's financial results for 1H20. Total revenue only grew by a very modest 1% to $1,246.5 million. While underlying EBITDA actually declined by 6% to $399.1 million.
All retail telcos in Australia are in the same boat here. The margins that they receive by purchasing wholesale fixed broadband services from the NBN are wafer-thin and not growing. As their legacy networks shrink further, their overall profitability is also declining.
Higher margin fixed voice still contributes a very significant 29% of gross profit in TPG's consumer segment. So, profitability will be further impacted as legacy fixed voice is transitioned over to NBN plans over the next few years.
This impact can also be seen from observing TPG's mix of group broadband subscribers. Only 1,403 of a total of 1,940 broadband subscribers at the end of last year were on NBN plans. As the remainder transition to lower margin NBN products, this will further impact profitability.
In addition, NBN average revenue per user (ARPU) has been steadily declining. It has dropped from $67.4 million in 1H19 to $67.0 million in 2H19 and $66.4 million in 1H20.
Merger with Vodafone places TPG in a stronger position
In March, the ACCC decided not to appeal the Federal Court's decision to approve the merger of TPG with Vodafone.
I believe that the merger will place TPG-Vodafone in a potentially stronger position to compete with its two main rivals: Telstra Corporation Ltd (ASX: TLS) and Optus. In particular, TPG-Vodafone will be well placed to roll out a competitive 5G offering, driven by Vodafone's current network.
However, competition will remain tough in the fixed broadband sector. Vodafone currently has a very limited fixed broadband option, so the merger doesn't provide much initial benefit in that market segment.
Are TPG shares are good long term buy?
I believe TPG's merger with Vodafone places it in a potentially good position to grow revenues over the next few years.
However, I still have some concerns about declining margins on TPG's fixed broadband network over the short term. I am therefore not quite convinced it is in the buy zone right now.
This view may change in the months ahead, as we gain more information about the details of the merger.
