Ask the analyst: Why does Telstra have a moat and TPG doesn’t?
Being part of an oligopoly isn’t always enough to be awarded a moat by our analysts.
Mentioned: Telstra Group Ltd (TLS), TPG Telecom Ltd Ordinary Shares (TPG), Woolworths Group Ltd (WOW), Coles Group Ltd (COL)
Welcome to Ask the analyst, where I put questions from myself and Morningstar readers to our equity research team.
If you have a question about an ASX firm or industry in our coverage, please email it to [email protected].
Today’s question
Today’s edition is a little different and was inspired by a question from Ned, a Morningstar reader based in Queensland.
Ned wanted to know why Morningstar has awarded Wide Moat ratings to the biggest players in certain Australian oligopolies, such as Telstra (TLS) and Woolies (WOW), but No Moat ratings to other members of the very same oligopolies like TPG Telecom (TPG) and Coles (COL).
Don’t the likes of TPG and Coles still have competitive advantages worthy of a moat, asks Ned, or do we think that most of the benefits in these oligopolies flow to the biggest company?
I thought it was a great question, so I enlisted the help of Brian Han to tackle it through the lens of Telstra and TPG’s mobile businesses. Johannes Faul also chipped in on the case of Woolies versus Coles for good measure.
Telstra versus TPG
Telstra and TPG split their operations up differently for reporting purposes. But they make money from the same basic activities: mobile telephony, fixed line (broadband) for users in the consumer, business and public sectors, and telecoms infrastructure.
Mobile is the biggest driver for both. Brian attributes roughly 60% of Telstra’s forecast EBITDA to its Australian mobile business, while TPG currently gets just over 50% of its overall earnings from its mobile business Vodafone Australia.
TPG will be more skewed to mobile soon because it has agreed to sell its wholesale, government and enterprise fixed line business and fibre network to Vocus. As we’ll see later, though, it will still get a bigger chunk of earnings from fixed line than Telstra.
Sniffing out moats
A narrow or wide Moat Rating from Morningstar is a vote of confidence in the company’s ability to generate excess returns on invested capital for a long period of time. At least 10 years for a Narrow Moat rating and at least 20 years for a Wide Moat rating.
High and sustainable returns on capital are not normal. Capitalism usually sees excess profits and returns competed away by others wanting a slice of the pie. A moat is a structural feature that stops this from happening and protects a company’s returns.
It can useful to consider moats within an industy from two angles - the moat potential of the industry itself due to its structure or nature, and competitive dynamics within the industry that determine moatiness at the company level.
The pharma business, for example, has high moat potential because patents can safeguard high profits from successful drugs for many years. But not every drugmaker has a portfolio of patented products worthy of a Wide Moat rating.
Moats in mobile
The Australian mobile industry has above average moat potential. This is because of a concept we call efficient scale.
With a population under 27 million, there aren’t that many Australians to sell mobile phone services to relative to the cost of building a network. And because most Australians already have mobiles, this market can only expect anaemic growth.
These realities provide an element of protection to incumbent players like Telstra and TPG. Why? Because they make the huge investments that would be needed to build a new mobile network very unattractive. It is a barrier and deterrent to entry.
Brian says that TPG experienced this for themselves a few years ago when they tried to build rather than acquire their way into the industry. After a highly costly attempt to start a network from scratch, they gave up and merged with Vodafone Australia instead.
Scale matters
Efficient scale isn’t the only deciding factor when it comes to competition, profitability, and returns on capital in the Aussie mobile industry. It is an industry where a lot of costs are fixed (i.e. they don’t grow linearly with revenue). So absolute scale matters, too.
Telstra is dominant here. With an estimated 17 million mobile telephony connections in place, it commands market share of around 50% and can spread network upgrades, overhead and advertising costs over a much larger revenue base than its peers.
This can also help Telstra be aggressive on pricing at times and protect market share while still making a decent profit. TPG’s Vodafone arm has struggled for years to take even 20% of the market, and we think it is less profitable than Telstra as a result.
Telstra’s fiscal 2024 report points to underlying EBITDA from mobile of $5 billion. On revenues of $10.7 billion, that’s an EBITDA margin of around 47%. TPG doesn’t split this out, but Brian estimates that its mobile margins are in the mid-thirties, a big difference.
This is not only down to Telstra’s costs being spread over more revenue, Brian says, but because Telstra’s unmatched network coverage helps it justify higher prices to customer groups, especially businesses and large enterprises.
Overall, Brian is confident that Telstra’s protection from new competition and cost advantage over the likes of TPG and Optus can underpin excess returns on capital inside its mobile business over his forecast period.
As for TPG, he doesn’t doubt that it benefits from efficient scale that deters new entrants. He just doubts that its current market share gives it enough scale to record profits high enough to deliver dependably high returns on capital. Hence its No Moat rating.
A supermarket sidebar
The case of Telstra and TPG’s mobile businesses shows that companies in the same oligopoly can have different competitive positions and levels of profitability. And, in turn, different prospects of churning out reliable ROICs over time.
You could point to a similar (but not identical) case in another industry that Ned highlighted in his initial question – Australian supermarkets. Why do we think that Woolies deserves a Wide Moat rating and Coles none?
These two companies don’t benefit from efficient scale creating a barrier to entry in the same way as the mobile firms do. But just like Telstra, Woolies’ additional scale has had a big impact on its profitability relative to its peers.
The most compelling piece of evidence our analyst Johannes Faul sees for this featured in the competition regulator’s recent investigation into supermarkets. The graph below shows that pre-tax margins in Woolies’ Australian food business (green line) have a sustainable edge over those at Coles.
Figure 1: EBIT margins at Australian supermarkets. Source: ACCC.
While the gap on the graph might seem small, Johannes says it equates to Woolies making 10-15% more profit on every single basket or trolley of shopping that passes through the tills.
As for why this might be the case, Johannes points to scale.
Woolies sells roughly 30% more goods than its rival, which allows them to leverage distribution, administration and marketing costs in a way that even Coles cannot. In turn, this consistently allows more revenue to fall to its bottom line.
In industries where fixed and leverage-able costs (like mass media advertising) make up a significant part of the cost base, being the biggest of the big comes with more perks than simply being part of the oligopoly.
