Investing for tomorrow

Nippon Telegraph and Telephone Corp (NYSE, NTT) is a recovery story in more ways than one. Formerly state owned, it is Japan's biggest Telco with more than 60 million fixed line customers and 50 million mobile subscribers. The group therefore offers exposure to both a resurgent sector in a recovering economy and equity market.

"DoCoMo's 3G subscriber growth continues to outstrip that of rivals. At the end of September, the number of subscribers topped 40 million, up 25 percent in nine months."

As Members will know we believe that sentiment towards the telecoms industry is turning increasingly positive, and for good reason. We have already seen this reflected in the out-performance of a number of our Telco stock recommendations.

At the macro level we believe that Japan still remains on the cusp of a significant, prolonged revival.

As such we recommended buying NTT around $27.83 in February (FAT53). Our actual entry price was $27.08. The stock's performance since has been disappointing; however the long term reasons for investment remain in our view, despite short term price weakness.

From a charting perspective, NTT had a notable setback in May, with prices breaking below support at $24.75. As evident on the daily chart, this triggered a three-month decline before the stock price established a low of $20.82 in August.

Although there was a firm initial rebound back as high as $24.33, the stock has been struggling to sustain these gains over the past three weeks. In our opinion, this suggests that further consolidation and base building is required before we see a return above the $24.33 to $24.75 region.

We believe that a candid reassessment confirms that the foundations remain in place for a long term recovery in earnings and NTT's stock price.

As a reminder, NTT operates through four main subsidiaries. NTT East and West are the group's two regional fixed line units. Long-distance voice and data services are under the banner of NTT Communications. 60 percent owned NTT DoCoMo is the group's cornerstone mobile business while network communication systems rest with NTT Data.

We acknowledge that first quarter results do not instill massive confidence, particularly for the shorter term investor. However, for the longer term, headline operating numbers indicate that NTT is continuing to build a solid launch pad from which to deliver sustained gains in both market share and profitability in the coming years.

Net profit for the quarter to 30 June 2007 actually increased 3 percent to 149.6 billion yen, buoyed by tax benefits from share buybacks at DoCoMo.

However, operating profit declined by 17 percent to 299.2 billion yen on revenue which dipped 1.5 percent to 2.6 trillion yen. Underperformance in the key cellular business offset a more encouraging result in broadband operations.

Today, NTT's fortunes are very much reliant on those of NTT DoCoMo, which accounts for around 80 percent of group operating earnings and half of turnover. So, no surprise that weaker numbers here are taking a toll on sentiment. Net profits declined 25 percent on the back of increased handset selling costs and price cuts, in an ultra competitive market.

DoCoMo now has around 53 percent of the market and is in intense competition with rivals KDDI and Softbank.

There are signs that customer attrition is stabilizing and average revenue per customer is on the rise. We therefore believe it credible that management at DoCoMo are sticking to full year operating profit forecasts of 780 billion yen, which would represent a small increase on the previous year.

And longer term we believe it remains pertinent to look beyond 2G, and consider where future growth lies. Particularly given the Japanese consumer's inclination for the latest technological innovations. Encouragingly, DoCoMo's 3G subscriber growth continues to outstrip that of rivals. At the end of September, the number of subscribers topped 40 million, up 25 percent in nine months.

DoCoMo continues to keep the heat on competitors with a wide range of handsets and a focus on network quality, speed and coverage. 3G subscribers now represent three quarters of the total cellular base, and rising. As such we expect ongoing earnings gains as average revenues per user (and the growth potential thereof) are markedly higher for 3G than for 2G.

Management's ongoing commitment to innovation will also spur subscriber and revenue gains in our view. NTT is rolling out a number of new features including downloadable music services and the ability to use a mobile phone as a credit card or e-wallet (Osaifu keitai).

Meanwhile we expect to see the changes in the sales mix at the company's fixed line businesses continuing. That is a migration to 'new wave' offerings such as broadband, and internet-protocol telephony (phone services that use the internet), which offset weakness in traditional fixed line revenues. Indeed this is indicative of experiences across the telecoms sector.

And investment in 'new wave' should place NTT in an excellent position to prosper longer term. The company is investing about 3 trillion yen through to 2010 to lay an IP-based network that combines conventional telephone and web services.

NTT has around 7.4 million fiber optic customers and now believes a target of 20 million by 2010 is realistic. These lines enable high-speed video downloads and high-definition images, and will fuel profitability longer term in our view. The first of several key 21st Century products is a high definition TV service, scheduled for launch in March.

We expect that the take up of new fiber-to-home technologies will accelerate. Japan's telecommunications sector and customers are the most dynamic in the world. Broadband speed is amongst the fastest. Over half the country's 90 million mobile users are signed up to 3G, and Japan leads the world in wireless internet users with 70 million subscribers.

So all in all, we are confident the performance of the fixed line and mobile businesses will improve going forward.

Meanwhile, the data systems division is already turning in a robust performance. NTT Data reported a 22 percent rise in operating profits to 20 billion yen, with dedicated marketing efforts continuing to deliver contract wins across the board.

Medium term, we also have every confidence that NTT's full year group targets can be met. The group expects a net profit of 460 billion yen on group revenue of 10.7 trillion yen in the year to March.

So at the micro level the outlook for long term growth at NTT is heartening in our view. The company should also benefit from the ultimate resurgence in Japan's economy. And as outlined in last week's review of The Japan Equity Fund we believe the 'better days' are not too far way.

From a charting perspective, NTT remains within a large long term base formation. Given the size and duration of this pattern, we believe that once a sustainable upward trend emerges, substantially higher levels are achievable in time.

NTT remains a highly attractive exposure to the ongoing global recovery in the telecoms sector, in an economy which is also undergoing a revival in our view. A trailing price earnings multiple of just 7 times continues to make NTT a solid investment proposition.

Also over the longer term, and as the carry trade unwinds, we anticipate the yen strengthening further relative to the dollar. Accordingly, currency gains could potentially bolster overall returns.

Given the positive outlook and potential for future gains, NTT will remain held in the Fat Prophets Portfolio.