Can TPG successfully stave off pending NBN 'profit crunch'?

With the market having already priced in some significant synergy benefits resulting from recent acquisitions, there's growing concern that the share price growth experienced by TPG Telecom (ASX: TPM) – up 26% in the past 12 months, compared with a 13.5% fall in the S&P/ASX 200 index – may have finally reached the point where those expecting similar rates of momentum going forward are setting themselves up for disappointment.

To help put into context the growth rate experienced by the telco giant – which began in the 1980s as a single store selling computer hardware in Sydney – the market cap has gone from $1 billion only five years ago, to just under $10 billion today, which puts the stock in some pretty rare company.

Admittedly, the stock's recent performance has warranted the market's attention, having delivered a net profit of $202.5 million for the six months ending January 31 – well above analyst expectations and 90% higher than the same period a year earlier.

The result included almost a full six months of Perth-based telco iiNet bought by TPG for $1.56 billion in 2015. The successful integration and financial performance of iiNet has arguably helped to improve profit margins.

With 1.842 million customers in total, TPG – now Australia's second-largest provider of fixed-line broadband behind Telstra and ahead of Singtel-Optus – has worked hard to boost its market share ahead of the National Broadband Network's (NBN's) completion, which will slash profit margins as competition intensifies.

What the NBN will effectively create is a more level playing field by charging all telcos a hefty wholesale price for the use of its infrastructure, and this is where margins are expected to get compromised.

While TPG is still growing its customer base, it's planning to offset any NBN profit crunch by lifting the sales of products that use TPG's own infrastructure to cut down on costs, and is speeding up the construction of its fibre-to-the-basement network, which will compete head-on with the NBN.

TPG is currently generating strong earnings growth, boosted by the iiNet acquisition and access cost savings; and apart from a long-term funding gap of around $273 million, the company's balance sheet looks pretty good.                 

Net-debt to equity is decreasing, and earnings per share (EPS) growth is expected to continue delivering exceptional growth experienced over the last five years; with EPS of $0.41 (F) in 2016, expected to grow to $0.48 and $0.55 in 2017 and 2018 respectively.

Meantime, return on equity (ROE) is forecast to remain high at around 21% until 2018.

However, there's growing concern that after enjoying the recent share price rally, TPG's shareholders are on the cusp of experiencing the fuller impact of an impending NBN-driven margin crunch.

At face value, the implications for the share price – which is trading 24% above one 12-month target price of $9, and 22% above its intrinsic value, and on a price to equity (P/E) of 27x – don't look particularly encouraging.

There's concern that the progressive impact of the NBN will culminate in a negative $170 million hit on EBITDA over the next few years.

However, a more bullish outlook puts a $13.40 12-month price target on TPG, based on its ability to grow the enterprise market through its own extensive infrastructure assets, including AAPT, iiNet and Pipe Networks.

It goes with saying that executive chairman David Teoh will fight hard to stave off falling profits by diversifying into new areas of business, using more of its own infrastructure, and more use of wireless technologies, while also maintaining a ruthless focus on costs.

Current market conditions do present shareholders with the opportunity to lock-in some gains and buy back in at more attractive price.

Those looking to buy need to take a longer term view, and enter on the dips, don't rush this one.

Patience entering this stock is likely to be rewarded.