SFBQF - KDDI: Negative Impact From Network Outage Appears Transitory

Summary

• KDDI suffered a network outage in July 2022, but the negative impact on user churn appears transitory.
• The company has the scope to grow data ARPU via 5G, is well-capitalized, and remains a stable generator of free cash flow.
• With the shares trading on PER FY3/2024 12.4x and a dividend yield of 3.5%, we reiterate our Buy rating.

Investment thesis

The negative impact of KDDI's ( OTCPK:KDDIY ) network outage incident in July 2022 appears transitory. The company continues to convert users to 5G raising data ARPU, generating stable free cash flow generation, and continues to increase dividends. We reiterate our buy rating.

Quick primer

KDDI is Japan's second-largest mobile carrier with around 32% of the mobile subscriber market share with its 'au' brand. It operates fixed-line operations with a cable television channel and has a top market share as a mobile operator in Mongolia and Myanmar. Its largest shareholders are Kyocera (KYOCY) with 14.5%, and Toyota Motor ( TM ) with 13.7%. Its key peers are NTT ( OTCPK:NTTYY ), SoftBank Corp. ( OTCPK:SOBKY ) and Rakuten ( OTCPK:RKUNY ).

Key financials with consensus forecasts

Our objectives

We update our view on KDDI from March 2021 where we rated the shares as a buy; the shares have relatively outperformed over the last 12 months versus its global peers. Recent trading has been weak, given the major service outage experienced in July 2022 where 22.71 million people were said to be affected by voice services, and 7.65 million by data services. KDDI said it will compensate ( page 13 ) 2.71 million users heavily affected by the network outage by returning two days’ worth of their monthly basic fees and plans to pay ¥200 to all of its 35.89 million subscribers, including those receiving the extra compensation. Given the reputational issues since the incident with the race for 5G customers accelerating, we want to see whether the shares present an opportunity.

Network failure is not a terminal issue

KDDI’s network failure began on July 2 2022 as the firm was changing a setting on a router for its core network. Maintenance workers input an incorrect setting disrupting the mobile connection. While trying to fix the glitch, the carrier experienced heavy concentrations of traffic in other parts of the network which exacerbated the outage.

On a positive note, the promised compensation payment is expected to cost around JPY7.3 billion/USD56 million, amounting to less than 0.5% of the annual FY3/2023 estimated revenue. The expected decline QOQ in ARPU in Q2 FY3/2023 which experienced the outage was visible but not acute, with voice-related ARPU dropping 1.2% QoQ, and value-added ARPI (data and other services) growing 18.9% QoQ but driven by primarily by electricity fees (KDDI and other carriers act as power utility companies).

Whilst the optics of falling voice ARPU is negative, after a slight jump in user churn in July 2022, total user numbers in September 2022 recovered back to June 2022 (pre-incident) levels ( page 11 ). We put this down to KDDI's prompt action and a decent PR exercise to admit to their mistakes and conduct a positive campaign of business improvement. All in all, we conclude that this incident is unlikely to cause long-term damage to the company. There is some concern over the churn rate hitting 0.94% in Q2 FY3/2023 (versus below 0.7% for FY3/2022), but this can be partly explained by the outage.

Longer term outlook

In a mature domestic market, KDDI's strategy focuses on user retention combined with offering new services and products to raise ARPA (average revenue per account). The company has been successful in this regard, although the pace of growth has limitations. The company is gradually gaining scale in financial services, energy, and digital transformation. Other market verticals under consideration include education, mobility, and healthcare.

In the shorter term, the company will experience users shifting over from 4G to 5G, which naturally brings higher pricing as pre-set data volumes are replaced by 'all-you-can-eat' data plans. With 5G penetration at 44.3% in September 2022, there is still some way to go to increase data ARPU.

The company remains well-capitalized, with a net debt-to-equity ratio of around 15%. The company continues to generate free cash flow on a stable basis, although consensus expects cash conversion ratio to fall below 50% which is a slight concern given the company's need to balance business investment and shareholder returns (closer to 100% is preferred). An indication of improving future returns is the ROIC which remains comfortably high at around 10%.

While no major developments are currently disclosed, Toyota is working with KDDI on the potential of connected cars . Whilst we expect efforts to be focused more on R&D as opposed to commercial activity, there is potential for the carrier to have more revenue-generating opportunities from mobility-related services.

From a competitive standpoint, we believe KDDI will remain the number 2 carrier in Japan with a 30% market share, with Softbank remaining in third and Rakuten ( OTCPK:RKUNY ) remaining a relatively minor player.

Valuation

On consensus forecasts (see Key financials table above), the shares are trading on PER FY3/2024 12.4x, a free cash flow yield of 7.4%, and a prospective dividend yield of 3.5%. Whilst the dividend yield is not very high, the rate of DPS growth is higher than sales or net income which is positive.

Risks

Upside risk comes from user churn dropping visibly into H2 FY3/2023 as the company experiences no long-lasting effects of the network outage, and customers revert to more normalized behavior.

The shift to 5G by users accelerates into H2 FY3/2023, allowing overall ARPU to rise above market expectations.

Downside risk comes from an unlikely repetition of a network outage, which could trigger an exodus of customers as well as trigger a negative directive from the telecommunications regulator.

The company struggles to limit user churn, resulting in KDDI conducting expensive discounting and marketing campaigns to stem the flow.

Conclusion

KDDI has managed the network outage incident well, and any damage to its reputation appears temporary. The telecom sector's positive attributes are stable and defensive earnings, stable free cash flow generation, and improving shareholder returns - and KDDI continues to provide them. On undemanding valuations and a stable outlook, we reiterate our buy rating.

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