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8/3/2019 2011.09.28 BER TAL 29 Initiating Coverage of TalkTalk
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EuropeanTelecommunications
September 28, 2011
Robin B ienenstock (Senior Analyst) [email protected] +44-207-170-0511
Sam McHugh , ACA [email protected] +44-207-170-0544
John Kei th , ACA [email protected] +44-207-170-5077
Ef thymia Tsotsan i [email protected] +44-207-170-0502
See Disclosure Appendix of this report for important disclosures and analyst certifications.
In i t ia t ing Coverage of Talk Talk: What Propr ietary Survey Dat aTel ls Us About Consumer Needs; Market -Per form , PT 135p
Target Pric e Change / Est ima te Change in Bold
Ticker Rating CUR
26/09/2011ClosingPrice
TargetPrice
TTMRel.Perf.
EPS P/E
2010A 2011E 2012E 2010A 2011E 2012E Yield
BT/A.LN M GBp 171.00 170.00 40.7% 21.00 21.40 23.20 8.1 8.0 7.4 4.7%
OLD 185.00 21.20 23.10
TALK.LN M GBp 127.00 135.00 0.0% 3.90 15.50 16.60 32.6 8.2 7.7 6.4%
VMED O USD 24.48 44.00 25.0% -0.66 0.72 1.97 NM 34.1 12.4 0.7%
VMED.LN O GBp 1569.00 2700.00 29.0% -41.07 44.16 120.67 NM 35.5 13.0 0.6%
MSDLE15 936.900 96.04 102.64 114.59 9.8 9.1 8.2 5.2%
SPX 1162.95 85.28 98.73 112.55 13.6 11.8 10.3 2.2%
O Outperform, M Market-Perform, U Underperform, N Not Rated
* NB BT and TalkTalk both have a financial year ended 31 March, whereas VMED has a year end of 31 December. As such the year 2010A refers to the 12 monthsended 31 March 2011.
High l ights
In August, we wrote in depth about the UK fixed line market (telephony, broadband and TV) in our piece
"BT, VMED & BSkyB: Deep Dive on the UK Fixed Line Market Complementary Growth for How Long?".
In that piece, we outlined our belief that, in the short term, the market for broadband and pay TV will
continue to grow as new customers, increased demand for speed, counter-cyclical consumption of
connectivity and rising prices create a rising tide that floats all boats. We surveyed several thousand
consumers (including BT infinity customers) in the UK to understand what matters to consumers, and how
they rank companies' offers. As a result, we initiate coverage of TalkTalk, with a market-perform rating
and a target price of 135p, while we have also adjusted our BT price target to account for our latest
expectations for their pension deficit.
Consumer survey data shows that speed /quality of broadband connection and overall cost matter
most to most customers, but that there are clear segments with different emphases in the market.BSkyB and VMED are ranked as better services for things their customers care most about, followed byBT (that still lags the other two but scores better when we exclude PlusNet). Talk Talk and PlusNet bothscore badly versus low customer expectations on all fronts (PlusNet worse than Talk Talk), suggestingthat a segment slightly dissatisfied customers with a tendency to churn will persist (and that Talk Talk'srelatively lower customer acquisition costs may be an advantage in this segment).
Consumers score customer service as unimportant until something goes wrong as evidenced byTalkTalk's high 'refuse to consider' ratings amongst dissatisfied ex customers. This should improve as theintegration process for Tiscali is further behind the Company. Virgin Media and BSkyB appear to have
the most loyal customers (presumably as a result of their better offering relative to their customers'priorities).
VMED and Sky are attracting consumers for whom spend on TV, Broadband and Telephony is lessdiscretionary (and higher) than those at BT and TalkTalk. We think this is being driven by a trulydifferentiated product at both; obviously, a significant squeeze on the less well-off represents a risk, inour view, but these consumers look inelastic to us.
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BT and TT employ usage caps on broadband, which may help in the short term, (as consumers gravitatetowards this sort of pricing for high speeds). But these may create problems longer term, as customersreact badly to exceeding their cap and changing usage habits will make this a more frequent occurrence.
Virgin Media's superior infrastructure means they have first mover advantage in superfast broadband and
are well positioned to capitalise on consumers' demand for faster speeds and unlimited packages. 45% ofsub 16Mbps VMED customers say they are willing to pay an average of 7.63 a month to upgrade to aspeed of 30Mbps, while the limited roll out of BT infinity remains a defensive tool against line losses atBT.
There remains robust demand for Pay TV services in the UK, with some 29% of respondents without payTV saying they are or would be willing to consider purchasing pay TV in the future. We think theYouview will grow total Pay TV rather than threaten BSkyB and VMED, while the overlap of Sky TVwith broadband at BT and TalkTalk (~25%) represents significant upside for Sky and downside for BTand TalkTalk.
We rate TalkTalk market-perform with a price target of 135p. The company likely will deliver a
mixed bag of performance in the short term, with top-line headwinds offset by cost cutting and a
growing dividend, while longer term the company faces more structural challenges.
Near term, we expect recent price increases to provide some breathing space for the company, whilethe ability to cost cut and find efficiencies should help improve the Company's cost base, especially inthe context of a growing market and the economies of scale that brings. While other UK Plc dividendsare potentially at risk, TalkTalk's FY 2012 dividend represents a 6.5% dividend yield that looks like avery safe haven for income seeking investors.
Longer term, we expect a slow decline in their customer base as broadband customer continue toreturn to BT, and an increasing number move to Sky and Virgin Media. We would caveat this withtwo points the long term is by definition a long way away, and we think there will always be amarket for discount broadband, and if the regulator decides that BT's fibre pricing is in anyway anti-competitive TalkTalk may actually get some regulatory relief before the long term reaches us.
We derive our target price for TalkTalk through a combination of a long term DCF and ashorter term FCF/EV measure, from which we derive a blended price target of 135p. The DCFvaluation of 152p reflects a FCF to equity valuation using a long term FCF growth rate of -0.5% and acost of equity of 11.5%. On a FCF/EV basis we value TalkTalk at 128p using an 11.7% FCF yield (a15% discount to peer average. We derive our target price of 135p as a 33%/67% blend of these twovaluations.
We have updated our PT for BT to 170p, as a result of changes to our estimated pension deficit;we estimate the deficit to be closer to 7bn (8
thSeptember), up from 1.8bn on 30 June 2011, with
that we have upped our top-up payment assumptions to 500m (from 250m) annually from 2012. Wehave also updated our forecasts to account for the recent line rental increases which will become effectiveform 3rd December 2011. The impact has been to increase 2012 EPS by 1% to 21.4p and 2013 EPS by
0.6% to 23.2p. We have not changed our VMED forecasts, and maintain our outperform rating and pricetarget of GBp2,700/US$44.
Investment Conc lus ion
We rate TalkTalk market-perform with a price target of 135p. Short term the company shouldcontinue benefit from tailwinds in their position as a low cost provider in the harder macro economicclimate and the propensity of customers to switch their broadband and telephony to a single provider.
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Recent price increases and the potential for further cost cutting (as the company finalises the integration ofTiscali systems and customers) should provide some breathing space to the company. In the long termTalkTalk is structurally challenged; the reliance on BT for rental of local loops and BT for GEA access forfibre optic broadband will leave them exposed, as consumer usage habits increase the need for faster
connectivity and more capacity they will suffer the squeeze of the incremental access fees for GEA access.We do believe there will always be a market for low-end broadband, and they may get regulatory reliefsome way down the line. On a relative basis we expect them to underperform, but at the current price wedon't think there is much downside given upside risk to an already growing dividend, an underpenetratedpay TV market and the price inflationary UK fixed line market.
In the short term, we expect BT to continue to be relatively successful in their land grab vs TalkTalk andSky BT infinity delivered by FTTN is a short term solution, but reality is that VMED can simply boostspeeds to meet consumer demand. BT's top line declines continue to highlight the weaknesses facing thecompany, while cost cutting to maintain margins can only be a short/mid-term solution without shrinkingthe scale of the company. The investment case beyond the 200p level remains dependent on a return to topline growth, much of which will depend on growth in Openreach and wholesaled fibre, but this is likely tobe more limited than many expect. We rate BT market-perform with a price target of GBp170.
We thinkVMED is the long term structural winner in the UK, with superior infrastructure capable ofdelivering super-fast broadband, TV content and telephony, with customisable packages offering a tailoredservice to meet the needs of various market segments across their entire network. TiVo should give VMEDa platform to compete more directly with Sky in the Pay TV space, and while we think take-up is likely tobe relatively slow in the short term, the real benefits will come in the long term, as the flexibility of theplatform will allow them to meet changing consumer demands. We rate VMED outperform with a pricetarget of GBp2,700 /US$44.
Detai ls
In August wrote in depth about the UK fixed line market (telephony, broadband and TV) in our piece "BT,
VMED & BSkyB: Deep Dive on the UK Fixed Line Market Complementary Growth for How Long?",
outlining our belief that in the short term the markets for broadband and pay TV will continue to grow in
the near term, creating a rising tide floats all boats type scenario. This has provided a suitable backdrop
for an inflationary price environment, with BT and TalkTalk both recently increasing line rental fees,
together with Sky's recent price freeze will make for a stable pricing environment for the next 12 months
Our consumer survey data shows us that speed/quality of broadband connection and the overall cost are themost important factors in choosing a fixed line operator.
When asked to rank Content, Speed/Quality of Broadband connection, Customer Service and Overall Costin order of importance we observed that Overall Cost and Speed/Quality are the most important factors toconsumers in terms of their fixed line services, Exhibit 1. Content ranked third, followed by CustomerService lagging well behind in 4th place.
We have then disaggregated this data on a company by company basis to assess what the company's owncustomers demand from their operator these responses then form a customised benchmark against which
we assess how consumers perceive each company delivers against the 4 metrics. In order to do this weasked consumers to rank the brands (BT, BSkyB, TalkTalk and Virgin Media) from best to worst on thesame metrics.
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Virgin Media score best on a combination of overall cost and broadband speed/quality, and aredelivering above their customer expectations.
Sky screen highly on content, but our data also indicates they are now exceeding customer expectations inother areas. This is an ominous sign, we think, for BT and TalkTalk.
Interestingly BT scores on par with VMED in terms of Speed/Quality perception. We know that in terms ofdelivered speeds this is a fallacy, as VMED have been shown to significantly outperform BT. We thinkthat this is due to a lack of understanding amongst consumers, but an announcement is expected from theAdvertising Standards Agency in the next few weeks, addressing the issue of advertising 'up-to' as opposedto delivered speeds, which should improve VMED's results relative to everyone else immediately, Exhibit7.
In terms of interpreting the charts in Exhibits 2 6, a line (customers' expectations) that is within theshaded area (how the company is perceived to be delivering) shows the company is exceeding expectations.
Exhibit 1Speed/quality and overall cost are the most importantfactors in choosing fixed line provider in the UK
Exhibit 2BT customers expect high quality/speed and areasonable cost, which the company is currently
delivering on
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
-
0.5
1.0
1.5
2.0
2.5
3.0
3.5
Reasons for Choosing Fixed Provider in UK
Content
Speed /Quality
Service
OverallCost
BT (ex-Plusnet)
BT Customers
Expectations
CompanyScore
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Exhibit 3VMED score well on cost and speed/quality, while TiVoshould improve their content score going forward
Exhibit 4Unsurprisingly Sky customers rank content as the mostimportant, and the company are exceeding customerexpectations
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
Exhibit 5TalkTalk customers demand market leading cost, whichthe company is delivering, but the company is failing todeliver on service and speed/quality
Exhibit 6BT's value brand Plusnet does not screen favourably,and lags behind customer expectations are peers on allmetrics
Source:Bernste in proprie tary consumer survey (August 2011) Source: Bernste in proprie tary consumer survey (August 2011)
Content
Speed /Quality
Service
OverallCost
VMED
VMEDCustomers
Expectations
CompanyScore
Content
Speed /Quality
Service
OverallCost
SKY
Sky Customers
Expectations
CompanyScore
Content
Speed /Quality
Service
OverallCost
TalkTalk
TT Customers
Expectations
CompanyScore
Content
Speed /Quality
Service
OverallCost
Plusnet
PlusnetCustomers
Expectations
CompanyScore
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Exhibit 7A change in advertising rules will improve VMED's relative position immediately
Source: Ofcom, July 2011
Customer service scores low on the scale of consumer demands but can be a big negative
Consumers place customer service at the bottom of their needs from their fixed line provider, but we thinkit is worth pointing out that this is likely in the case where nothing goes wrong as has been evidenced byincreased churn at TalkTalk after the difficulties they had with transferring legacy Tiscali customers to theirown billing system. Our Survey data suggests that TalkTalk will face serious headwinds in attractingcustomer 35% of customers would be unlikely to consider TalkTalk as the provider of their broadband,and worse 28% of respondents said they would never consider TalkTalk, Exhibit 8. These percentages arehigh relative to their competitors, indicating that brand perception is an issue for TalkTalk.
When we drill down into more detail and ask customers who have left TalkTalk in the past 12 months, thepercentage saying they would never consider them rises to 38%, Exhibit 9.
85%
33%
103%
37%41%
0
10
20
30
40
50
60
VMED 50Mbps BT 40Mbps VMED 30Mbps TalkTalk 24Mbps BT 20Mbps Sky 20Mbps
UK Advertised vs Achieved Speeds
Advertised Speed Average Achieved Speed
97%
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Exhibit 8TalkTalk looks set to continue to face headwinds in attracting customers given recent bad press and consumerexperience
Source: Bernstein proprietary consumer survey (August 2011)
We think BT has been benefiting from TalkTalk's woes, but Sky and VMED will increasingly be the
beneficiaries
Some 55% of consumers surveyed, that had left from TalkTalk in the past 18 months have now moved BT,Exhibit 10. In many ways this should be expected, as clearly there was initial movement in custom fromBT to TalkTalk/Tiscali, but bad customer service experiences have meant that they are now returning to
BT, where on a relative basis they can be more confident in the customer service they receive. A further1/3rd of ex-TalkTalk customers are now at Sky, and 12.5% at Virgin. We think an increasing number willmove to Sky and Virgin, given responses given by current TalkTalk customers, Exhibit 11.
6%
50%
23%
12%15%
42%
20%
12%
4%
42%
29%
15%
2%
24%
35%
28%
0%
10%
20%
30%
40%
50%
60%
Al ready cons ideri ng Would be wi ll ing to consider Un li kely to consider Would never consider
How would you describe your willingness to move to the following broadbandproviders?
VMED Sky BT TalkTalk
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Exhibit 9While those customers who left them in the past aremuch less likely to go back
Exhibit 10While TalkTalk has primarily been donating broadbandsubs to BT
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
Exhibit 11Going forward we expect Sky and VMED to take more share from TalkTalk's churning customers
Source: Bernstein proprietary consumer survey (August 2011)
31%
38%
28%
29%
30%
31%
32%
33%
34%
35%
36%
37%
38%
Unlikely to consider Would never consider
Would customers who left TalkTalk in thePast 18 months consider going back?
54.2%
33.3%
12.5%
0%
10%
20%
30%
40%
50%
60%
BT Sky VMED
Where have TalkTalk customers gone?
6%
41%
28%
14%10%
7%
42%
27%
16%
8%5%
50%
25%
10% 9%
0%
10%
20%
30%
40%
50%
60%
Already considering Would be willing toconsider
Unlikely to consider Would never consider Indifferent
TalkTalk customers - How would you describe your willingness to move to thefollowing broadband providers?
BT Sky VMED
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VMED and Sky are attracting consumers where spend on TV, Broadband and Telephony is less discretionary(and higher) than those at BT and TalkTalk. We think this is being driven by a truly differentiated product atboth - superior connectivity and content at VMED, and content at Sky.
Virgin Media and Sky both offer something that BT and TalkTalk do not better connectivity and areputation for the best content respectively. This acts as a hook to customers, and the unique sellingpoints lends itself to higher customer loyalty and better prospects of up-selling and cross-selling within theirexisting customer base, and also makes them more defensive in a weak consumer environment.
To emphasise the fundamental difference between the offerings of BT and TalkTalk against VMED andSky (who have a USP in connectivity and content respectively) we observe that the relationship betweenhousehold income and spend on telephony, broadband and TV is much stronger at BT and TalkTalk (withan r-squared of 0.8122 and 0.7708 respectively, Exhibits 12 & 13).
Exhibit 12BT customer spend correlates strongly with theirhousehold income
Exhibit 13A similar pattern is observed at TalkTalk
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
The relationship is weaker at VMED and Sky (with an r-squared of 0.5764 and 0.5751 respectively,Exhibits 14 & 15), which we think is representative of the fact that their superior content (and connectivityat VMED) means they attract customers where spend on home broadband, telephony and TV is less
discretionary.
R = 0.8122
25
30
35
40
45
50
55
60
65
70
0 20,000 40,000 60,000
BT Average Customer Spend vs HouseholdIncome
R = 0.7708
25
30
35
40
45
50
55
60
65
70
0 20,000 40,000 60,000
TalkTalk Average Customer Spend vsHousehold Income
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Exhibit 14The correlation is lower at VMED, and
Exhibit 15at Sky, suggesting the spend is less discretionary
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
Virgin have experienced increasing demand for their 30Mbps and above services, Exhibit 16, which start ata 5 premium to their 10Mbps service, This is despite low consumer confidence levels in the UK, againsuggesting that consumers spend at Virgin is less discretionary.
Exhibit 16There is clearly demand for superfast broadband (30Mbps and above), and despite low consumer confidence VMEDhave observed increasing demand
Source: Company reports and presentations Bernstein analysis, GfK)
R = 0.5764
25
30
35
40
45
50
55
60
65
70
0 20,000 40,000 60,000
VMED Average Customer Spend vs
Household Income
R = 0.5751
25
30
35
40
45
50
55
60
65
70
0 20,000 40,000 60,000
Sky Average Customer Spend vs
Household Income
0%
10%
20%
30%
40%
50%
60%
-45
-40
-35
-30
-25
-20
-15
-10
-5
0
UK Consumer Confidence and % of VMED Gross Adds that are forSuperfastBroadband
UK Consumer Confidence % of Gross Adds on 30Mbps and above
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Virgin Media benefits from strong customer loyalty
When asked how they would reduce their spend if financial restraints meant they needed to, 37% of VMEDcustomers indicated they would remain with VMED and change package, compared to an average of 26%for the other three operators, Exhibit 17. While fewer VMED customers would opt to leave VMED (27%)
compared to 29% at Sky, 35% at BT and 35% at TalkTalk.
Exhibit 17Relative to peers VMED faces lower headwinds with consumers, with their customers showing greater levels ofloyalty
Source: Bernstein proprietary consumer survey (August 2011)
Usage caps may help BT and TT in the short term & create problems longer term.
Of those surveyed 44% of BT customers and 32% of TalkTalk, Exhibit 18, are currently on packages withdownload caps. We think a disproportionate amount of new to broadband customers are on data caps, andthat BT and TalkTalk have been capturing a disproportionate share of new to broadband subscribers as aresult (from which we think has been driving much of BT's recent subscriber growth and broadband ARPUdecline).
Changing usage habits will result in an escalator style market with consumers moving to unlimited
packages.
Some 57% of customers with data caps indicated they were already or would be willing to move tounlimited packages, Exhibit 18. This increases to 60-70% of customers who have exceeded data caps (BTcharge customers 5 for every 5GB they exceed their limit by, and TalkTalk charge a flat 5 for everymonth that you exceed your limit), so increasing usage demands are likely to lead to a move towardsunlimited packages.
37%
27%28% 29%
31%
35%
20%
36%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Change p ackage but remain with current operator Change operators
How would consumers reduce their spend on home telephony, broadband and TV iffinancial constrainst meant they needed to?
VMED Sky BT TalkTalk
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Exhibit 18BT and TalkTalk still have a high percentage ofcustomers on capped packages
Exhibit 19Around 1/3 of customers with caps have exceed them inthe past 12m
Source: Bernstein proprie tary consumer survey (August 2011) Source: Bernste in propr ietary consumer survey (August 2011)
Typical usage caps in the UK vary between 10GB and 40GB per month; however it is easy to see howincreasing demand for online media could lead to consumers easily exceeding these levels, Exhibit 20.
Exhibit 20Changing consumer habits mean that usage caps are exceeded more often
Source: Bernstein estimates
In terms of price points TalkTalk, Sky and VMED all look well placed to capitalise on a move byconsumers towards unlimited bundles, Exhibit 21, while our survey data shows that BT customers ondownload capped plans are more likely to be actively considering moving to VMED and Sky than those onunlimited plans, this is likely to drive churn higher at BT in the medium term, Exhibit 22.
44.0%
32.1%
56.0%58.6%
0%
10%
20%
30%
40%
50%
60%
70%
BT TalkTalk
% of Customers on Packages withDownload Limits
% Customers with Download Limits
o/w would/are considering going unl imited
33%30%
70%
63%
0%
10%
20%
30%
40%
50%
60%
70%
80%
BT TalkTalk
% of Customers with d/l limits whohave exceeded those limites
% With limi ts who have exceeded limits
% of these that would consider moving to an unl imitedpackage
Illustrative monthly internet usage
4 HD Movies (~5GB each) 19.53 GB
5 Music Albums (~100Mb each) 0.49 GB
10 Hours of YouTube (~600Mb per hour) 5.86 GB
16 Hours of Catch up TV (~650Mb per hour) 10.16 GB
8 Hours of Catch up HD TV (~2300Mb per hour) 17.97 GB
Sub Total 54.00 GB
Emails, Web Browsing, Video Chat, VoIP, Gaming, Social Networking, Tablet and Smartphone Use 6.00 GB
Total 60.00 GB
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Exhibit 21TalkTalk, Sky and VMED look well placed to attract customers looking to move to unlimited download packages
Source: Company websites, Bernstein analysis
Exhibit 22A higher % of BT customers on data caps are activelyconsidering moving to Sky and VMED than those onunlimited packages
Exhibit 23At TalkTalk data caps appear to make less difference
Source:Bernste in proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
7.259.58 11.25
26.6713.8012.25
13.90
14.60
0
5
10
15
20
25
30
35
40
45
Talk Talk Plus Sky Unlimited VM up to 10MB BT Unlimited Broadband
Blended Cost of Entry Level Unlimited Broadband and Calls plans
BB & Calls Line rental
21.05 21.83
41.27
25.15
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Sky VMED
% of BT customers that areconsidering moving broadband
provider
Download Caps Unlimited Downloads
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
Sky VMED
TalkTalk customers that areconsidering moving broadband
provider
Download Caps Unlimited Downloads
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Exhibit 26Some 29% of broadband customers without pay TV are, or would, consider purchasing it in the future
Source: Bernstein proprietary consumer survey (August 2011)
Exhibit 27We think the Pay TV market could grow to ~19.3m households in the long term, and up to 16.2m by 2015 (up from~13.7m today)
Source: Bernstein proprietary consumer survey 2011, Bernstein estimates
4%
25%
22%
35%
14%
0%
5%
10%
15%
20%
25%
30%
35%
40%
Already considering Would be willing toconsider
Indifferent Unlikely to consider Would never consider
Which of the following best describes your willingness to consider
purchasing pay TV services (only those who dont already have pay tv)?
Sky 9.31
Virgin Media 3.77BT Vision 0.60
Current Total 13.68
Current Pay TV Penetration 52.4%
Non Pay TV Households 12.43
% of consumers already or would consider purchasing pay
TV 29%
Additional Pay TV Households 3.61
Additional Penetration from YouView Subs (15% Uplift) 2.05
Long Term Pay TV Household Potential 19.34
Forecast Pay TV Market 2015 16.20as a % of Forecast Broadband
Customers
o/w BSkyB 10.02 172%
o/w Virgin Media 4.24 85%
o/w BT YouView 1.46 20%o/w TalkTalk YouView 0.47 12%
UK Pay TV Subscribers (millions) - 30 June 2011
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We estimate that 25% of TalkTalk and BT broadband customers currently have Sky TV, and are
increasingly at risk of churning to Sky as a result.
Our survey data suggest that ~1/4 of BT and TalkTalk broadband customers take a TV product from Sky.This represents a significant downside risk to both BT and TalkTalk as it makes compelling economic sense
for these customers to also take their broadband and telephony from Sky saving them 17.85 a monthcompared to BT (or 42% of their BT bill), assuming they wish to keep their Sky TV, Exhibit 29.
Similarly TalkTalk customers would save 8.26 a month (on non-promotional pricing). As Sky TV growthslows, the company have confirmed they will be increasingly focused on converting single/double play TVcustomers to fully bundled double/triple customers. In addition recent price increases announced by BTand TalkTalk, and a price freeze announcement from Sky are likely to raise consumer awareness of this factand sped up the process.
Exhibit 28We estimate some ~25% of TalkTalk and BT customershave Sky TV
Exhibit 29Sky broadband represents compelling value for Sky TVcustomers who are currently take broadband from BT or
TalkTalk
Source: Bernstein proprie tary consumer survey (August 2011) Source:Bernste in propr ietary consumer survey (August 2011)
We think Youview will grow total pay TV, rather than threaten BSkyB and VMED
Youview is likely to tap into the lower end of the market where there is a potential window to cross sellcheap TV and catch-up TV services packaged with broadband, and we estimate this to be worth anincremental 20m to TalkTalk's top line by the end of FY 2015. While at VMED TiVo is the first massmarket connected set-top box, and we expect it to have more appeal than previous incarnations of the Vbox, helping VMED modestly grow their pay TV subscribers.
25.2% 25.5%
78.3%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
TalkTalk BT Sky
% of Broadband Customers with a SkyTV Subscription
0
5
10
15
20
25
30
35
40
45
Sky TalkTalkPromotion
TalkTalk(po st Sep 11)
BT
Unlimited Broadband and CallsHeadline Monthly Costs
Line Rental Broadband and Unlimited Calls
(17.85)
(8.26)
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Exhibit 30Launch of YouView to have more traction in the low end, focused at existing Freeview and not Sky/VMED customers,but will drive up penetration of pay TV in the UK to above 66% from the ~54% level today
Source: Company reports, Bernstein estimates
BT and TalkTalk will not have it all their own way in mass market connected TV, with Youview boxes alsoto be distributed direct from retailers (with basic catch-up TV functionality included, but without thecustomised functions that the ISP's can code into their own boxes for distribution).
We rate TalkTalk market-perform with a price target of 135p.
Near term TalkTalk will benefit from price increases, cost cutting and a growing dividend
Near term we expect recent price increases to provide some breathing space for the company, while theability to cost cut and find efficiencies should help improve the Company's cost base, especially in the
context of a growing market and the economies of scale that brings. However contrary to bears we expectthe company (much like other Telco's) to deliver on cost saving and synergies to deliver growing EBITDA,towards the long term target of 20% by FY2014.
We also see upside risk from the dividend. The company's dividend policy from FY 2012 will see thempay out 50% of net income (excluding exceptional) as dividends, driving dividends to grow to 8.11p pershare in FY 2012 (up 45% on FY 2011), and grow by a further 8% in FY 2013, Exhibit 36. Thecompany has low leverage and will cover the FY 2013 & 2014 dividend 2.0x over with equity FCF.While other UK Plc dividends are potentially at risk, TalkTalk's current 6.5% dividend yield looks like avery safe haven for income seeking investors.
In the long term TalkTalk is structurally challenged
The reliance on BT for rental of local loops and BT for GEA for fibre optic broadband will leave themexposed, as consumer usage habits increase the need for faster connectivity and more capacity they willsuffer the squeeze of the incremental access fees for GEA.
We expect a slow decline in their customer base as broadband customer continue to return to BT, and anincreasing number move to Sky and Virgin Media. We would caveat this with two points the long term isby definition a long way away, and we think there will always be a market for discount broadband, and ifthe regulator decides that BT's fibre pricing is in anyway anti-competitive TalkTalk may actually get someregulatory relief before the long term reaches us.
40.0%
45.0%
50.0%
55.0%
60.0%
65.0%
70.0%
0
2
4
6
8
10
12
Mar-07 Sep-08 Mar-10 Sep-11 Mar-13 Sep-14 Mar-16 Sep-17 Mar-19 Sep-20
Subscribers(Million)
UK TV Subscribers and Market Penetration
Virgin Media BSkyB (UK only) BT TalkTalk Penetration % (RHS)
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We are broadly in line with company guidance for FY 2012, Exhibit 31, but modestly behind consensusexpectations, Exhibit 32. Contrary to bull expectations we expect weakness in top-line growth from FY2013, as a result of headwinds in telephony only revenue, and slower customer growth expectations as aresult of the factors discussed above.
Exhibit 31SCB Forecasts vs Company Guidance for FY 2012
Source: Company Reports, Bernstein estimates
Exhibit 32SCB TalkTalk estimates vs Consensus estimates
Source: Bernstein estimates, CapitalIQ
TalkTalk FY 2012 Guidance FY 2011 Actual FY 2012 SCB Forecast
Revenue (m): Broadly flat 1,765 1,725
YoY Change -2.3%
EBITDA Margin: 17% - 18% 15.6% 17.7%
EPS: 15.5p to 16.5p per Share 13.5 16.2
Capex: 6% of Total Revenue 6.2% 6.0%Op FCF: 10% - 11% of Revenue 8.8% 10.8%
TalkTalk SCB vs Consensus FY2012
SCB Estimate Consensus Difference
Revenue 1,725 1,754 -1.6%
EBITDA 305 308 -0.9%EPS (adjusted) 0.159 0.156 1.9%
Margin 17.7% 17.5% 0.7%
TalkTalk SCB vs Consensus FY2013
million SCB Estimate Consensus Difference
Revenue 1,681 1,773 -5.2%
EBITDA 312 332 -6.0%
EPS (adjusted) 0.168 0.172 -2.4%
Margin 18.5% 18.7% -0.9%
TalkTalk SCB vs Consensus FY2014
million SCB Estimate Consensus DifferenceRevenue 1,637 1,790 -8.6%
EBITDA 316 351 -10.1%
EPS (adjusted) 0.17 0.19 -11.6%
Margin 19.3% 19.6% -1.7%
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We derive our target price for TalkTalk through a combination of a long term DCF and a shorter termFCF/EV measure, from which we derive a blended price target of 135p. The DCF valuation of 152p,Exhibit 33, reflects a FCF to equity valuation using a long term FCF growth rate of -0.5% and a cost ofequity of 11.5%. On a FCF/EV basis we value TalkTalk at 128p, Exhibit 34, using an 11.7% FCF yield
(a 15% discount to peer average, to reflect TalkTalk's lack of owned infrastructure. We derive our targetprice of 135p as a 33%/67% blend of these two valuations.
Exhibit 33TalkTalk's DCF valuation is 152p
Exhibit 34On a FCF/EV basis we value TalkTalk at 128p
Source: Bernstein estimates Source: Bernstein estimates
We have updated our price target for BT to 170p
The main drivers being changes in our estimated pension deficit, we now estimate that the deficit is closer
to 7bn (8th September), up from 1.8bn on 30 June 2011, Exhibit 35. We have accordingly adjusted ourassumptions on the level of top-up payments required for the pension deficit reduction (to be set as of 31Dec 2011 for the next 3 years) from 250m to 500m. We would also note that the top-up payments areset by agreement between the Trustees, the Pensions Regulator, and to a lesser extent the companythemselves. The payments are based on the trustee appointed actuary's valuation of the deficit as at 31 Dec11. The previous level of top-up payments (~500m pa) was set based on a ~9bn trustee deficit, and apayment period of 17 years which we note is longer than the usual benchmark of a maximum 10 yearperiod, and was in part set at that level so as not to jeopardise cash flow at BT. With successful cost cuttingthat has occurred over the past 3 years at BT, it is unclear whether a similar argument would carry as muchweight with the regulator, so we believe the risk remains on the downside for potentially higher paymentsover a shorter period.
We have also updated our forecasts to account for the recent line rental increases which will becomeeffective form 3rd December 2011. The impact has been to increase 2012 EPS by 1% to 21.4p and 2013EPS by 0.6% to 23.2p. We have not materially changed our forecasts for Virgin Media.
Cost of Equity 11.5%
NPV of 2012-15 0.60
2016 FCF 0.20
LT Growth % -0.5%
Cost of Equity 11.5%NPV Perpetuity today 0.91
NPV of 2012-15 0.60
NPV 2013 onwards 0.91
Implied share price () 1.52
TalkTalk DCF valuation (bn)
Unlevered FCF (FY2011) 0.18
Target FCF/EV 11.7%
(15% discount to peer Ave 2012)
Implied EV at target price 1.5Net Debt (FY2012) (0.4)
Equity 1.2
Shares outstanding 0.91
Implied share price () 1.28
TalkTalk FCF/EV valuation (bn)
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Exhibit 35We estimate BT's pension has reached ~7bn gross of tax as of 8th September
Source: Company reports, Bloomberg, Bernstein Analysis & Estimates,
08/09/2011 From 30
June 2011 30-Jun-11 31-Mar-11
m m
Opening PV of Retirement Liabilities 39,186 39,056 43,293
Service Cost 59 77 297
Interest Cost 426 599 2,323
Actuarial (Gains)/Losses 1,001 -33 -4,875
Employee Contributions 3 4 15
Benefits Paid -397 -520 -2,014
Other -4 4 17
RPI CPI impact 0 0 0
Closing PV of Retirement Liabilities 40,273 39,186 39,056
Reported 38,900
Trustees' Liability Valuation 45,822 42,937 42,421
Opening FV of Assets 36,564 37,232 35,439
Expected Return 464 603 2,244
Actuarial (Losses)/Gains -1,978 -750 234
Regular Employer Contributions 335 73 283
Deficiency Employer Contributions 0 0 1,030
Employee Contributions 3 4 15
Benefits Paid -319 -599 -2,011
Other 14 0 -2
Closing FV of Assets 35,083 36,564 37,232
Reported 36,700 37,222
IAS 19 Surplus/(Deficit) -6,983 -2,622 -1,824
IAS 19 Surplus (Deficit) net of tax -5,237 -1,967 -1,368
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Exhibit 36TalkTalk forecast income statement
Source: Company reports, Bernstein estimates
million FY2010 FY2011 FY2012e FY2013e FY2014e FY2015e
Broadband Revenue 1,086 1,247 1,292 1,328 1,338 1,349Non-Broadband Revenue 273 189 124 58 15 3
Corporate Revenue 327 329 309 295 285 278
Total Revenue 1,686 1,765 1,725 1,681 1,638 1,630
EBITDA 221 276 305 312 316 323
Margin % 13% 16% 18% 19% 19% 20%
Depreciation and Amortisation -70 -83 -85 -87 -89 -93
Profit before interest and taxation 151 192 220 225 226 230
Net interest -4 -18 -15 -13 -12 -10
Profit (loss) before taxation 147 174 204 211 215 220
Taxation -41 -52 -57 -53 -54 -55
Profit (loss) for the year 106 122 147 159 161 165
Headline Earnings (loss) per share
Basic (GBp) 11.8 13.5 16.2 17.5 17.8 18.2
Diluted (GBp) 11.2 12.8 15.5 16.6 16.9 17.3
Shares outstanding
Basic 892 898 907 907 907 907
Diluted 912 948 952 952 952 952
Dividends per share 4.65 5.60 8.11 8.74 8.89 9.08
YoY Change (%) 20% 45% 8% 2% 2%
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Exhibit 37TalkTalk forecast cash flow statement
Source: Company reports, Bernstein estimates
million FY2010 FY2011 FY2012e FY2013e FY2014e FY2015e
EBITDA 221 276 305 312 316 323
Working capital -2 -10 -12 -14 -16 -17
Capital expenditure -100 -110 -107 -101 -100 -102
Integration/restructuring costs -20 -54 -5 0 0 0
Operating free cash flow 119 156 185 196 200 205
Cash interest -3 -17 -15 -12 -11 -10
Cash taxes -2 -2 -2 -17 -35 -55
Equity Free Cash Flow 114 137 169 166 153 140
Dividends paid -251 -15 -57 -75 -80 -81
M&A net -239 7 0 0 0 0
Net purchase of own shares 0 0 0 0 0 0
Borrowings (net) 75 -72 0 0 0 0
Movements in demerger reserve -54 0 0 0 0 0
Other 394 -3 -45 -41 -36 -33
Change in cash and cash equivalents 19 0 66 51 37 26
Cash and cash equivalents -8 -8 58 109 146 172
Net debt -508 -438 -372 -321 -284 -258
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Exhibit 38BT forecast income statement
Source: Company reports, Bernstein estimates
million FY2010 FY2011 FY2012e FY2013e FY2014e FY2015e
RevenuesGlobal Services 8,513 8,047 7,699 7,460 7,372 7,291
Retail 8,124 7,748 7,363 7,127 6,899 6,736
Wholesale 4,388 4,210 3,935 3,851 3,824 3,830
Openreach 4,960 4,930 4,905 4,933 4,877 4,825
Other 40 38 37 37 37 37
Eliminations -5,114 -4,897 -4,545 -4,313 -4,092 -3,930
Total 20,911 20,076 19,393 19,097 18,917 18,790YoY change -2.2% -4.0% -3.4% -1.5% -0.9% -0.7%
EBITDA
Global Services 457 593 616 612 612 612
Retail 1,777 1,784 1,789 1,768 1,702 1,654
Wholesale 1,353 1,316 1,218 1,189 1,181 1,182
Openreach 1,960 2,132 2,158 2,190 2,155 2,121
Other 92 61 90 86 41 39
Total 5,639 5,886 5,872 5,844 5,690 5,609YoY change 7.7% 4.4% -0.2% -0.5% -2.6% -1.4%
BT Global Services contract and financial review charges -301 -192 -50 0 0 0
EBITDA pre specific items 5,639 5,886 5,822 5,844 5,690 5,609YoY change 56.7% 4.4% -1.1% 0.4% -2.6% -1.4%
Depreciation and amortisation -3,039 -2,979 -2,964 -2,949 -2,935 -2,920YoY change 5.2% -2.0% -0.5% -0.5% -0.5% -0.5%
Net finance expense (before specific items) -890 -845 -711 -609 -578 -550
Share of post tax profits/losses of associates & JVs 25 21 21 21 21 21
PBT pre specific items 1,735 2,083 2,167 2,307 2,198 2,160YoY change -1037.8% 20.1% 4.0% 6.5% -4.7% -1.7%
Specific items (before net interest on pensions) -449 -287 -179 0 0 0
Net interest on pensions -279 -79 200 -150 -150 -150
Specific items: net gains (losses) -728 -366 22 -150 -150 -150
Reported PBT 1,007 1,717 2,188 2,157 2,048 2,010YoY change -512.7% 70.5% 27.5% -1.4% -5.0% -1.8%
Tax - excluding specific tax -398 -452 -504 -502 -475 -465
Net on specific items 420 239 -5 38 38 38
Net income (reported) 1,029 1,504 1,680 1,693 1,611 1,583YoY change -638.7% 46.2% 11.7% 0.8% -4.8% -1.8%
Adjusted EPS 17.3 21.0 21.4 23.2 22.2 21.8
Reported EPS 13.3 19.4 21.6 21.8 20.7 20.3
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Exhibit 39BT forecast cash flow statement
Source: : Company reports, Bernstein estimates
million FY2010 FY2011 FY2012e FY2013e FY2014e FY2015e
Adjusted EBITDA 5,639 5,886 5,872 5,844 5,690 5,609Capital expenditure -2,480 -2,630 -2,686 -2,645 -2,634 -2,570
Interest -940 -944 -722 -650 -618 -587
Tax 349 -209 -438 -475 -492 -503
Change in working capital -163 -11 50 50 0 0
Other -73 131 155 0 0 0Equity Free cash flow (pre gross pension deficit payment
and specific items) 2,332 2,223 2,231 2,124 1,947 1,949YoY change 202.1% -4.7% 0.3% -4.8% -8.4% 0.1%
Specific items (cash) -399 -212 -150 0 0 0
Gross pension deficit payment -525 -1,030 0 -500 -500 -500
Equity Free cash flow 1,408 981 2,081 1,624 1,447 1,449YoY change 91.0% -30.3% 112.1% -21.9% -10.9% 0.2%
Dividends paid -265 -543 -583 -759 -825 -868
Other -65 28 -16 0 0 0
Change in net debt 1,078 467 1,591 0 0 0
Net debt / (cash) -9,283 -8,816 -7,225 -7,225 -7,225 -7,225
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Disclosure Appendix
Valuat ion Methodology
We derive our target price for TalkTalk through a combination of a long term DCF and a shorter termFCF/EV measure, from which we derive a blended price target of 135p. The SCF valuation of 152p,reflects a FCF to equity valuation using a long term FCF growth rate of -0.5% and a cost of equity of11.5%. On a FCF/EV basis we value TalkTalk at 128p, using a 11.7% FCF yield (a 15% discount to peeraverage, to reflect TalkTalk's lack of owned infrastructure. We derive our target price of 135p as a33%/67% blend of these two valuations.
Our valuation approach for BT combines a long term DCF and a shorter term FCF/EV methodology. On anEV/FCF basis we value BT at 1.73 based on the stock trading at a 10% discount to peers for the fiscal year2012/13. Our DCF valuation which factors in a 10.7% cost of equity implies a share price of 1.67. Ourblended price target of 1.70 is based on a 50%:50% weighting of the two methodologies.
We value Virgin Media on a blend of discounted cash flows (DCF) and enterprise value to free cash flowmetrics (EV/FCF). Our DCF valuation of Virgin Media is 2,813p based on a terminal growth rate of 1%and a WACC of 9.3 % falling to 8.5% by 2020 as the company de-levers and its high cost debt matures.
Our EV/FCF valuation of Virgin Media is 2,432p based on the company trading at a conservative 12.5%premium to the sector in 2011e due to its superior FCF growth prospects. We take a 50:50% blend of thetwo and add on a modest premium to arrive at our target price of 2,700p or US$44.00.
Risks
We view the major risks to achieving our target price for TalkTalk to include:
An announcement by Fujitsu confirming they will build a rural fibre network
A meaningful increase in demand for fibre amongst TalkTalk customers
A failure to deliver on cost-cutting and synergies from integration and closure of calling centres.
A decision by Virgin Media not to go ahead with an expansion of its cable network and/or to furtherupgrade cable speeds over the next few years.
Further customer service issues
We view the major risks to achieving our target price for BT to include:
The ability to complete its fibre build on time, on specification and within budget
A meaningful headcount reduction agreement with the Unions;
A decision by Virgin Media not to go ahead with an expansion of its cable network and/or to further
upgrade cable speeds over the next few years. A significant and near term revenue uplift from the end of net neutrality.
A significantly higher/lower pension deficit payments than forecast (currently ~500m)
We consider the major risks to achieving our target price for Virgin Media to be:
A significant expansion of BT's FTTH build plans;
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A failure to execute the company's strategy of growing its consumer mobile and business revenues;
A successful attempt by BSkyB to thwart the regulators and without key premium content from VirginMedia.
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Bernstein analysts are compensated based oproductivity and proactivity of investment ideainvestment banking revenues.
Bernstein rates stocks based on forecasts ofU.S. and Canadian exchanges, versus the Mcompanies), versus the MSCI Emerging Markof the Asia Pacific region, and versus the MSotherwise specified. We have three categorie
Outperform: Stock will outpace the mark
Market-Perform: Stock will perform in lin
Underperform: Stock will trail the perfor
Not Rated: The stock Rating, Target Pric
As of 09/27/2011, Bernstein's ratings were dis(0.5% banking clients); Underperform - 8.9%
represent the percentage of companies in ea(12) months.
Accounts over which Bernstein and/or their afthe following companies BT/A.LN / British Tel
Bernstein currently makes a market in the foll
12-Month Rating History as of 09/27/2011
Ticker Rating Changes
BT/A.LN M (RC) 11/19/10 U (RC) 10/11/10 M (RC)
TALK.LN
VMED O (IC) 02/11/11
VMED.LN O (IC) 02/11/11
Rating Guide: O - Outperform, M - Market-Perform, U - Under
Rating Actions: IC - Initiated Coverage, DC - Dropped Covera
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wing companies VMED / Virgin Media Inc, VMED.LN / Virgin M
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CERTIFICATIONS
I/(we), Robin Bienenstock, Senior Analyst(s)/Analyst(s), certify that all of the views expressed in this publication accurately reflect my/(our)personal views about any and all of the subject securities or issuers and that no part of my/(our) compensation was, is, or will be, directly orindirectly, related to the specific recommendations or views in this publication.
pproved By: NK
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