FTTC is Key Risk for UK ISP TalkTalk as Citigroup and Morgan Stanley Differ

Global financial services firm Morgan Stanley and banking giant Citigroup (Citi) have both warned that new TV (sport) and broadband offers from BT and Sky Broadband (BSkyB) will put pressure on TalkTalk’s future, yet while one has downgraded its expectations the other has done the opposite.

Last week Citi put out a positive survey for BT, which saw the firm upgrade the operators shares from “neutral” to “buy“. The move was thanks in no small part to the perceived attractiveness of the new free BTSport offer. Citi also retained its “buy” status for Sky, which is despite a warning that one million of Sky’s TV subscribers could take BTSport.

The news was not so good for TalkTalk, which has banked heavily on its new YouView (IPTV) based Plus TV service helping to reduce churn and attract new customers. However, despite a steady return to subscriber growth (here), Citi still cut TalkTalk’s rating from “neutral” to “sell” because over a quarter of the providers broadband customers have Sky TV and 9% of the rest say they would switch to BTSport.

Citi Statement on TalkTalk

“We downgrade our estimates consistent with guidance for higher TV costs and slower net cost savings and reduce our forecasts for broadband customers. As a result we see downside to consensus and downgrade the stock to sell with a 200p ex dividend target price.”

TalkTalk refused to give ISPreview.co.uk a comment on the matter but they did point us in the direction of Morgan Stanley, which recently put out a somewhat opposite statement to that of Citi. According to Morgan Stanley, TalkTalk’s Free Cash Flow To Equity (FCFE) “can rebound 60% in FY15e from cost cutting and some upselling” and thus its price target has been set at 240-280p (it’s currently trading at around 215p).

The firm’s AlphaWise survey also found that only 1.7% of TalkTalk’s broadband respondents said they were “Very Likely” to subscribe to BTSport and only 4.2% said they were “Somewhat Likely”, although crucially it’s noted that this was before BTSport was branded “free”. The ISPs management has also previously said “that their customer base is just not interested in watching paid sport content“, which appears to be supported by the survey.

But Morgan Stanley wasn’t all smiles and warned, once any “limited” subscriber loss to BTSport was removed from the equation, that TalkTalk still faced some threats to its future. For example, it would need to recoup is TV investment and find a way of upselling their budget-level ‘Essential‘ package subscribers to ‘Plus TV‘. But the “Key Risk” area is said to be the ISPs superfast fibre optic based broadband (FTTC) service.

Morgan Stanley said:

“At the end of March 2013, TalkTalk had a fibre customer base of 73k, or 2% of the broadband customers. Fibre is gross profit accretive, but the gross margin percentage is dilutive. Demand for fibre amongst TalkTalk customers is modest, and we forecast 22% of the base eventually on fibre.

Whilst still gross profit accretive, the gross margin percentage will be hit from wholesaling BT’s fibre offering. TalkTalk’s charges to BT would increase from c.£7 to £14, which is not fully offset by higher retail prices. BT, for now, can independently decide its own fibre Openreach pricing.”

In our opinion we think that TalkTalk isn’t doing enough to promote its FTTC packages. In particular the ISP appears keen to keep pushing its superfast service as a “boost” (upgrade) to their standard broadband package, which could be off-putting to new customers and can cause confusion about subscription fees (especially when special offers are running). TalkTalk could address this by developing a third “fibre” package alongside its Essentials and Plus TV options.

The update also included some interesting predictions about Ofcom’s current TalkTalk induced probe into whether or not BT was “abusing a dominant position” by conducting an “alleged margin squeeze in superfast broadband pricing”(here).

Morgan Stanley said that the initial investigation will likely continue over Summer 2013, and potentially in November or December of 2013, Ofcom could be in a “position to decide whether there are grounds for further investigation“. If further investigation is merited, then there could be a statement of objections by Ofcom, which could be due in Spring or Summer 2014, with a decision at the end of 2014 or early 2015. An outcome in TalkTalk’s favour would no doubt help its prospects but the issue remains highly contentious.

Finally Morgan Stanley’s update also included an interesting survey of satisfaction among the markets largest broadband ISPs.