Indosat Awaiting New Catalyst

We think:
1. The sharp rally in the share price of 42% (+42% over the past 12 months) has priced in the mid-term positive prospects on the stock;
2. Indosat’s strong growth in 1H16 is likely to normalise going forward with the realignment of post Lebaran packages.
Positive catalysts will come from the active sharing regulation. Maintain NEUTRAL with a higher IDR6,700 TP (from IDR5,650, 8% upside) after rolling forward our valuation base to FY17. Our TP implies 3.5x/3x FY17-18 EV/EBITDA respectively.

Active sharing regulations being finalised
Indosat expects the active network collaboration with XL Axiata (XL) Axiata (EXCL IJ, BUY, TP: IDR4,900) to contribute towards capex/opex savings in the longer term. We gathered from management that the regulation on active sharing, ie spectum pooling and radio access network (RAN) sharing, is being finalised by the Government and likely to be made offiicial soon. There are no restrictions in terms of network site locations to be shared, although the greatest benefits can be extracted from outside Java where PT Telekomunikasi Selular (Telkomsel) is dominant.

Improvement in balance sheet from debt rebalancing
Indosat’s USD debt has fallen significantly to USD227.5m (1H15: USD1.2bn) – representing 14% of overall debt. Accordingly, net debt/EBITDA has declined to 1.85x in 1H16 (1H15: 2.22x). Management is targeting to reduce its USD debt exposure to 10% in the longer term.

A good quarter
Indosat reported strong 2Q16 revenue, EBITDA and subscribers (subs) growth of 9%, 12% and 18% YoY respectively. This was aided by the new Freedom Combo plans introduced in early 2016, strong Lebaran uptake and the improvement in commercial execution with an expanded 4G footprint. We expect revenue and EBITDA growth to normalise in 2H16, as the promotional packages are progressively removed. We expect subs addition to ease given the high base of Lebaran sign-ups and maintain our topline growth assumptions of 8.8%, 10.9% and 9.1% for FY16-18 respectively.

NEUTRAL call maintained with higher DCF TP
We roll forward our valuation base to FY17 with TP raised to IDR6,700 (from IDR5,650). We think the sharp price appreciation (+42% over the past 12 months) has baked in the improvement in Indosat’s operational momentum to some extent.

Our preferred exposure to the Indo telco sector remains Telekomunikasi Indonesia (Telkom) (TLKM IJ, BUY, TP: IDR5,000), given its superior fundamentals. We also like XL as a laggard play with the latter’s recovery posing a key downside risk to Indosat. Other key risks include:
i. Stronger-than-expected competition;
ii. Higher-than-expected capex.

2Q16 Results In line With Expectations
Good performance driven by data service revenue. Indosat’s data traffic grew 46% QoQ in 2Q16 while voice traffic expanded by 8%. This was at the expense of yields, which declined to IDR28.5 per megabyte (MB) (-18% QoQ; -19% YoY) and IDR122 (-6.1% QoQ, -11.4% YoY) respectively.
Indosat reported 1H16 revenue of IDR13.9trn (+10.5% YoY), which was supported by a strong growth in cellular revenue of 13.4% YoY.

The 1H16 revenue was at 47.8%/47.5% of our/consensus estimates respectively, while EBITDA was at 48.2% of our numbers and 48% of streets. The company’s cellular revenue increased significantly in the period under review on the back of increases in the topline contributions of:
i. Data;
ii. Voice;
iii. Short messaging service (SMS);
iv. Value added services (VAS).

This revenue was offset by interconnection topline
We think that this also indicates the success of Indosat’s promotional packages, like IDR1/seconds for voice and Freedom Combo packages (bonus 10 gigabyte (GB) 4G data).

Data traffic increased significantly
In 2Q16, Indosat introduced several packages like Freedom Combo and IDR1/second for voice. As a result, it saw data traffic increase significantly in 2Q16 to 93.6 terabytes (TB), or a 103% YoY growth.

Meanwhile, voice traffic was also increased by 16% YoY to 16bn after the company introduced the IDR1/second package to call the same or other operators.

Sacrificing data yields
The improvement in the data traffic was at the expense of data yields. In 2Q16, data yields declined to IDR28.50 per MB (-18% QoQ, -19% YoY). This was deeper than Telkom’s 13% QoQ drop. We expect Indosat’s data yields to normalise in the 2H16. This is as the company would have finished the Freedom Combo’s promotional packages.

Valuation & Recommendations
Maintain NEUTRAL, with the DCF-based TP lifted to IDR6,700 (from IDR5,650). We roll forward our valuation base to FY17 with the TP raised to IDR6,700. This is premised on:
i. Risk free rate of 8%;
ii. Market risk premium of 6%;
iii. Equity beta of 1.03;
iv. Terminal growth of 1.5% or a 10.5% WACC.

Indosat’s share price has risen by 42% over the past 12 months (YTD: +13%), outperforming the JCI by 28%. We think the sharp price appreciation has factored in the improvement in the company’s operational momentum to some extent. We advise investors to take some profit in the near term.
Our preferred exposure to the Indo telco sector remains Telkom, given its superior fundamentals. We also like XL as a laggard play, with the latter’s recovery posing a key downside risk to Indosat.

Other key risks include:
i. Stronger-than-expected competition;
ii. Higher-than-expected capex.

Downside risks are:
i. Stronger-than-expected competition from a rejuvenated XL;
ii. Higher-than-expected capex;
iii. A change in the current rational competition environment.