The TPG Telecom Ltd (ASX: TPM) share price is down more than 40% in just a few short months.
What is going on?
Investors in the telecommunications industry have enjoyed a stellar run over the past five years, as the larger players took advantage of a highly fragmented industry. Telstra Corporation Ltd (ASX: TLS), the incumbent, did not partake in much of the merger and acquisition activity for regulatory reasons. However, Vocus Communications Limited (ASX: VOC) and TPG Telecom went on a frenzy.
Most notably, TPG Telecom acquired iiNet in a move to spread its wings right across the country and ramp up its subscriber base. The market loved the idea of the company's acquisition spree, too. In the five years leading up to the recent fall, which came about as a result of weak profit expectations, TPG Telecom shares rose 780%.
But, the kicker is that the telco roll-up story was always going to hit a roadblock — it was a classic case of: Be in it for a good time, not for a long time.
Why?
The telecommunications industry is destined to be a highly competitive market.
Are TPG Telecom shares seriously cheap?
Market fragmentation, characterised by many smaller companies vying for a slice of the pie, produces value for the largest players which can generate synergies in combining back office functions (e.g. customer service) by undertaking acquisitions. But sooner or later they cannot rely on the strategy because the market will mature and only a few large companies will remain. We are at that point now.
However, if we factor in the NBN Company and its wholesale fibre network, which makes it easy for new resellers to begin marketing to consumers, profit margins can be expected to fall. In this environment, Vocus Communications has a more attractive business model than TPG Telecom due to its extensive infrastructure, in my opinion.
That does not mean TPG Telecom will fail to grow at all but it means investors' expectations of growth should moderate, in my opinion. And at 19 times last year's profits, TPG Telecom shares are not that cheap considering the subdued growth outlook.
Foolish takeaway
TPG Telecom shares look to be trading below their fair value — but they are not a bargain. While I think its shares are better value than many other shares listed on the ASX, if I had to choose between it and Vocus Communications I would buy the latter.
