iiNet vs TPG Telecom (IIN, TPM)

This is what a DSLAM looks like
This is what a DSLAM looks like

In the hotly contested consumer broadband market, the 2 key players are iiNet and TPG Telecom. Despite TPG’s Pipe Networks business, both are pretty pure consumer internet plays which should make comparison fairly straightforward.  Apart from the 2 integrated giants Telstra and Optus, TPG and iiNet are the biggest broadband operators in Australia, and unlike Telstra and Optus, their core business is consumer fixed broadband.

Turning to the consumer broadband industry as a whole, while the market is beginning to reach saturation, there are segments, currently off-limits to TPG and iiNet, which will be contestable via NBN.  This doesn’t just include remote towns, there are significant subscriber opportunities for the 2 million households on Telstra HFC (which under the current structure will be removed in a deal with NBN) and Pair Gain systems (which other players can’t service).  As long as the NBN allows iiNet and TPG to use existing elements of their own network (to give them an advantage over straight resellers) and the opportunity to earn a decent margin on NBN-delivered services, iiNet and TPG are still exposed to plenty of organic growth opportunities.

The outback isn't the only part of Australia that will benefit from NBN
The outback isn't the only part of Australia that will benefit from NBN

To go beyond organic growth, iiNet and TPG both augment their core offerings with home phone, mobile, and internet TV services to increase ARPU (Average Revenue Per User), offering bundled services to encourage takeup.  The home phone in particular will become a big contributor for both parties, as these on-net services generate high margins and ARPU.  As the market continues to heat up, smaller players who don’t have the scale to deliver these offerings at the right price are likely to get consumed by larger ones chasing growth.  iiNet has a particularly good track record with integrating their acquisitions.

Turning to some basic statistics:

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Both are currently selling for under 15x earnings, with IIN being slightly cheaper.  Looking at the growth of these businesses for the past 5 years, TPG has made an impressively swift transition to profitability, turning 6% revenue growth into a doubling of earnings. Operating cashflow was $172M in FY10 and should exceed $200M in FY11.  PIPE’s fibre infrastructure will give TPG a better platform to target the enterprise and mid-market business segment compared to iiNet, whose offerings are squarely centred on the SME business segment.

iiNet has also maintained its momentum, growing EBITDA by 20% and earnings by 36% for FY10.  Operating cashflow was 62.1M.  The big difference is how margins are tracking for HY11 – iiNet’s EBITDA margin has held steady while TPG’s has grown to 41%.  I expect to see even greater profitability improvements for TPM as they migrate the offnet Soul home phone business to on-net TPG, and grow home phone subscribers organically with their bundled offers.  iiNet’s should increase albeit by a lower rate.

iiNet have made a number of bolt-on acquisitions over the past couple of years, including Westnet, Netspace and AAPT’s consumer division.  The most recent acquisition of AAPT demonstrates the strength of iiNet’s management, who have successfully reduced the number of TIO complaints by aligning products and call centre resources with iiNet’s internal best practice.  iiNet’s innovation is also impressive, building their next generation of the BoB home phone in-house to better control quality, and being first to market with fetchtv.

I don’t own either of these stocks (apart from indirectly through my shares in Amcom, who own 23% of iiNet).  I think both are reasonably well priced and both should show NPAT growth above the market, however right now they aren’t attractive enough to provide sufficient “margin of safety”, particularly when you factor in industry uncertainty due to NBN.  If we have a repeat of 2009 (triggered, perhaps, by a US Treasury default) and the All Ordinaries drops to 3000, I’m going to be buying these.  Broadband is a basic utility, whether or not you’re in a global depression.