Time to Play Defense: 5.4% Dividend Yield with a Highly Defensive Moat.

Netlink NBN Trust (SGX: CJLU) is the sole appointed “Network Company” for Singapore’s Next Generation National Broadband Network (NBN).

The trust group’s network, which spans nationwide, delivers high-speed internet access throughout Singapore. It also designs, builds, owns and operates passive fibre network infrastructure for Singapore’s NBN.

Netlink is listed as a business trust, which means that it does not have any restrictions on borrowing levels and it also pays out 100% of its cash available for distribution as a dividend.

Dividends paid out in FY18 amounted to 4.88 Singapore cents per share, which translates to a dividend yield of 5.4% at the last traded price of S$0.90.

Based on its business model and balance sheet, I feel that Netlink NBN Trust is an excellent dividend play. The 2 unique features of this business are;

1. Natural barriers to entry to protect its monopolistic advantage.
2. Well-positioned to deliver long term value and growth

Business Overview

#1 – Fibre Network

Netlink Trust’s main business segment is the design, build, own and operation of the fibre network. With respect to the use of the network for end-user connections, the network provides 3 separate connections;

1. Residential  
2. Non-Residential
3. Non-Building Address Point (NBAP)

#2 – Other Businesses

Other than the fibre network infrastructure, Netlink Trust also has businesses in the following segments

• Segment Fibre: Provides “segment” fibre connections to Requesting Licensees
• Ducts and Manholes: Provides licenses for shared use of their ducts and manholes
• Co-location: Lease co-location space within Central Office to users to host active network equipment, servers etc.
• Central Office

Lease remaining space to Singtel to house their own equipment

Competitive Advantages

I will be focusing on 3 key points that provide Netlink Trust with its competitive advantage.

#1 – Predictable, Regulated Revenue Stream

Netlink Trust derives most of its revenue from residential end-user connections, which comprise of a “one off” installation charge and a recurring monthly connection charge for each connection. Another point to note is that 79.4% of its revenue is recurring.

The recurrent 79.4% revenue is based on a return on asset base (RAB) pricing regulated by IMDA. The pricing is reviewed every 5 years and the next review is only due in 2022. As a result, Netlink Trust is expected to receive a predictable, regulated revenue stream. 

#2 – Sole Provider of Residential Fibre Network in Singapore

Currently, Netlink Trust has the only fibre network with nationwide residential coverage in Singapore. As of September 2019, there were approximately 1.38 million residential connections supported by the network, representing about 90% of all residential homes in Singapore.

#3 – Extensive Network Leading to Natural Barriers to Entry

Since 2009, Netlink Trust (known as OpenNet at that time) invested a significant amount in designing and building the network infrastructure. In FY19, its network is made up of over 10 Central Offices and approximately 93,000km of fibre cables.

Building another fibre network of such scale to achieve the same network coverage would be both logistically and financially challenging. As such, this provides high barriers to entry in the creation of similar networks.

Areas of Growth

While it is important to have a competitive advantage, a business must also be able to grow in order for it to increase its DPU in the future.

i) Increasing Residential Fibre Subscriptions

Residential connections account for 60% of Netlink Trust’s revenue. I foresee that this will increase as we have a few upcoming housing development projects in Singapore like Punggol, Tengah and Paya Lebar.

ii) Opportunities in NBAP segment

While Non-Building Address Point (NBAP) segment is still in its infant stage, Netlink Trust has the capacity to take advantage of new opportunities as and when they arise. Especially in the development of new fibre-based initiatives such as the Singapore government Smart Nation. One such initiative that we are familiar with is the upgrading of “Wireless@SG” in terms of hotspots and speeds offered.

As of now, they are already involved in “Phase 1” of the Smart Nation Platform Project and they are vying to be the network provider of the additional phases in the coming years. With its wide network reach, I believe that Netlink Trust is among the forerunners to support future Smart Nation initiatives.

Business Risks

It sounding quite rosy for Netlink Trust so far, but we should also consider the risks arising from its operations.

– Regulatory Risk

Netlink Trust operates in a highly regulated environment, with its primary regulator being IMDA. The pricing terms that Netlink Trust is permitted to charge for its services are subjected to review by IMDA every 5 years. This is a double edge sword as IMDA reserves the right to increase or decrease the fees. The next review is due on 2022 and this is something that investors should take note.

Although unlikely, there can be no assurance that future policies or regulatory outcomes will not have a material adverse effect on the operations and financial performance.

– Competition Risk

While Netlink Trust has a dominant position in the residential segment, it is not the case for its non-residential fibre network space. Retail Service Providers(RSP) like SP Telecom have begun to invest in their own fibre networks in Singapore’s Central Business District and large business parks. (see source https://www.straitstimes.com/business/companies-markets/sp-telecom-to-build-alternative-fibre-network-with-intelligence)

As Netlink Trust is not permitted to offer network services, this means that demand for Netlink Trust’s network will be lower in areas where RSP have their own fibre networks. However, do note that non-residential connections only account for 8% of its total revenue. Hence, even if competitors “steal” half of its businesses away, it is only 4% of its total revenue.

– Substitution Risk

The environment that Netlink Trust operates is very much driven by technological changes. With the rapid advancement in technology, Netlink Trust’s network could become obsolete in the future and may require huge capital investment to replace and/or upgrade its network infrastructure to remain competitive.

One such concern is the rollout of 5G connectivity, where theoretical speeds of up to 1Gbps can be achieved. Although it seemed likely that 5G could displace fibre-based fixed broadband services, I do not think that it would be the case for the next few years due to the limitations of wireless broadband.

• Have you ever done a “Whatsapp” call and face connectivity issues? This is because wireless connections may suffer from network congestion and degradation due to obstruction by walls.
• The rollout of 5G requires high capital expenditure into infrastructure. This could lead to higher cost of transmitting data through mobile network as compared to fibre broadband. Also, I would prefer to stream a Netflix movie using my unlimited data fibre broadband as compared to my 9GB a month wireless mobile data plan.
• As stated in their IPO prospectus, management view wireless broadband as complementary and not a substitute for fibre as it cannot provide the same reliability and average speeds of fibre connections.

Financials

As a business trust, Netlink Trust distributes dividends based on its surplus cashflow.

Due to its high depreciation from a front-loaded CAPEX, its DPU could be more than its accounting profits. As such, we would be looking at its cash flow instead of earnings to determine if Netlink Trust can sustain its payouts.

Free Cash Flow

Free cash flow is the amount of cash generated after accounting for reinvestment in non-current assets by the company. In Netlink Trust’s case where they pay 100% of its surplus cash, essentially we can use the free cash flow formula to determine if the current dividend payout is sustainable. The formula is as follows;

Free Cash Flow = Cash from Operating Activities – Capital Expenditures

From the FY19 Annual Report, net cash generated from operating activities is S$229.6mil while Capex for FY19 is S$71.1mil. Hence, by finding the difference, we have our Free Cash Flow at S$158.5mil

Now let’s take a look at the distribution paid out to shareholders. Distribution paid out in FY19 was S$221.3mil.

At first sight, it seems a little excessive, so as we dive deeper into the Annual Report, we found our answer in Note 34.

It seems that FY18’s distribution of S$126.2mil was also accounted for in FY2019 and actual FY19 distribution of 2.44 cents per unit is S$95mil. Do take note that total DPU for FY19 was 4.88 cents (meaning the remaining 2.44 cents per unit will be paid out in FY20). Hence, total distribution out of FY19’s cash flows is S$190.1mil.  

Hence, from the Annual Report, we find that the total distribution has exceed the free cash flow by about S$30mil. If we base on the information above, it seems that the dividend payout is unsustainable. But before we come to any conclusion, let’s take a look at other factors in their financials.

Debt

We look at their debt to see whether it would become a credit risk in the near term. Nobody wants to invest in a company that is having trouble paying off their debts.

Gross debt/EBITA is 2.6x and Interest cover is also quite high at 13.5x. In my opinion, Netlink’s balance sheet is still quite healthy and they are still able to support their dividend payout.

I would also like to point out that Netlink Trust has taken on additional debt of $45.0mil to fund capital expenditure. This could be the reason why they were able to pay out more than their FCF.

Management probably felt that the use of debt at a pretty low interest at 2.82% to finance CAPEX is probably more efficient than forking out cash from its pockets.

In other words, it’s cheap money.

To better illustrate this, imagine that you have to invest in an expensive machine for a 10 year project. Besides paying for the machine, you have to take into account the maintenance cost and other miscellaneous items that is not included in the price you paid for the machine. This could put a dent in your finances and affect your cash flow as you have committed a huge capital upfront for a long term project.

Thus, it makes better sense to use debt financing to purchase this machine as it frees up your working capital to earn better returns than the interests it can cost you.

Dividend Growth

For a dividend play, I’m not only looking at the sustainability of the dividend payout.

It is also important to look out for dividend growth. For Netlink Trust to increase their dividend consistently, an important factor they must have is revenue growth. The Q1FY20 results are quite promising and considering their areas of growth and assuming that capex is consistent at around $60-$80mil, I am confident that Netlink Trust is able to consistently increase their dividend payouts over the years.

Conclusion

Netlink Trust is an interesting dividend play due to its competitive advantages in their extensive infrastructure network which makes it very difficult for competitors to come in. By continuing to upgrade and improve on their network, it creates natural barriers of entry.

I am optimistic about their growth prospects on two fronts; the increasing residential fibre connections (recurrent revenue) as well as the opportunities in the NBAT segment.

Their solid balance gives investors assurance that they are able to sustain their dividend with a high probability of increment.

Of course, investors must beware of their business risk, especially on the technological front which could result in a drastic change of this investment thesis.

I also gave the benefit of the doubt to the management for exceeding their FCF and taking on an additional loan to pay dividends. However, investors should also be wary if a substantial amount of loaned capital is used to fund the dividends in the future. Paying money using future money is definitely not sustainable in the long run.

At a current price of $0.90, Netlink Trust translates to about a dividend yield of 5.4% which makes it attractive for a resilient dividend play with a moat.

Cheers.

Disclaimer: The Moss Piglet is vested in Netlink Trust since inception at $0.81. 

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