Key Summary: The first quarter of 2018 (1Q18) saw a major headwind in the telecommunications industry, with the revenue of the big-three mobile operators declining for the first time at a -5 percent year on year (yoy) run rate. Note that this was likely due to a one-off adjustment related to the recognition of revenue in 2017 from the “push” method of distribution. We think the effect will continue until the second quarter and we await the final SIM registration numbers. We believe that mobile revenue will continue to grow, driven by data revenue, albeit at a slower pace. The state of play:

Big-3 mobile revenue declined 5 percent yoy in 1Q18. We saw large downward adjustment in the average revenue per user (ARPU) of 28 percent yoy while the 1Q18 subscriber number grew on a yoy basis but fell 5 percent quarter on quarter (qoq) owing to a large drop in Indosat’s subscriber base.

We believe this was primarily due to the SIM registration ruling and will likely continue until 2Q18 before normalizing in the second half of 2018 (2H18). Big-3 data revenue grew at 15 percent yoy despite large subscriber write-offs, but legacy revenue continued to suffer with a 19 percent yoy decline. Given that legacy revenue continued to form around half of the revenue base, overall mobile revenue suffered.

Referring to our first point, the decline was likely exaggerated by SIM card write-offs, and we believe that without the one-offs, overall mobile revenue would likely have grown by a mid-single digit.

Big-3 EBITDA growth disparity is large, but it is hard to calculate the real EBITDA growth until a normalized figure is available. For 1Q18, XL Axiata had the strongest EBITDA growth at 7 percent yoy, compared with declines at Telkomsel (-10 percent yoy) and Indosat (-39 percent yoy). While drastic, Indosat’s EBITDA decline also reflects the substantial amount of write-offs in the subscriber base, resulting in mobile revenue declining 27 percent yoy and an even greater impact on EBITDA.

Telkomsel’s subscriber base also fell on a qoq basis but to a lesser extent, while XL increased its subscriber base.

Two large drivers are forcing EBITDA down: i) a one-off hit in revenue base owing to the SIM deregistration, and ii) accelerated substitution of legacy revenue by data revenue. We think we will have more clarity on point (i) toward the end of 2Q18 when we understand the final subscribers better, and believe ISAT will likely be most affected.

We think point (ii) is ongoing and will likely slow the industry mobile revenue growth in 2H18 through 2020 to a mid-single digit as opposed to 9-11 percent in 2014-1H17.

In our view, the first factor will be a headwind for earnings until 1H18, while the second factor could be a tailwind in 2019 especially if the data revenue proportion crosses 50 percent by end-2018, thereby driving EBITDA growth in 2019-2020.

Free cash flows are generally healthy for Big-3, suggesting the situation is not that dire (Table). Despite the weak 1Q18, cashflow trends remained positive in 1Q18. PT Telekomunikasi Indonesia (TLKM) recorded Rp 3.2 trillion in free cash flow, PT XL Axiata (EXCL) had Rp 1.2 trillion, while PT Indosat (ISAT) had Rp 0.6 trillion.

Although one quarter of free cash flow does not paint a full picture, our scenario analysis shows that the companies would still be free cash flow positive even with a higher capex base (likely higher in 2Q18-4Q18), although ISAT could face more problems due its high leverage.

We believe the situation would be different from that of ISAT in 2012-2013 (it saw negative cash flow and had to increase its leverage) or that of EXCL in 2012-2014. Note that given ISAT’s higher leverage among the Big-3, we think it would be more susceptible to a mobile revenue slowdown.

Two events that would mark the bottom: 1) a clearer picture of the 2Q18 subscriber base and hence the normalized level of revenue and EBITDA post the SIM deregistration/inventory destocking, and 2) a slowdown in the ARPU decline; as long as data consumption continues to accelerate, implying a slower ARPU decline, we should see mobile revenue growth return.

We think that these events will unfold over the next three months, hence our preference for TLKM as the market leader and EXCL with the largest exposure to data.

Stock preference (TLKM/EXCL): We find Telekomunikasi Indonesia (5 percent dividend yield, on our estimates) and XL Axiata (highest proportion of data revenue among Big-3 at 65 percent of 1Q18 revenue) attractive from the standpoint of valuation and longer-term growth potential, and have Buy ratings for both.

The downside risks are weaker-than-expected mobile revenue growth for EXCL and mobile subscribers for TLKM. We have a Reduce rating on Indosat given its worst EBITDA decline in 1Q18 among the Big-3 and the weakest network quality as measured by the Open Signal report for December 2017.

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The writer is head of research with PT Bahana Sekuritas.

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