This week the team at CBG, the fund underlying the TAMIM Australian Equity Growth & Income Individually Managed Accounts (IMA), take an in depth look at their investment thesis for Vocus Communications Ltd (VOC.AX).
This week the team at CBG, the fund underlying the TAMIM Australian Equity Growth & Income Individually Managed Accounts (IMA), takes an in depth look at their investment thesis for Vocus Communications Ltd (VOC.AX)
Stock Picking - Vocus Communications Ltd (VOC.AX)
In February 2016 Vocus merged with M2 to become a full-service vertically integrated telecommunications company that sells to consumers, businesses and government customers across Australia and New Zealand. In essence the merger brought infrastructure together with infrastructure. The purchase of NextGen in June 2016 further built out the infrastructure footprint.
M2 was established in 1999 and developed, manufactured and distributed digital messaging systems for small businesses. Through a series of acquisitions and organic growth, the company became a national reseller of broadband, fixed voice, mobile, energy and insurance services to predominantly consumer and small businesses.
Vocus was in launched in 2008 and provided IP transit wholesale services to the Australia and New Zealand telecommunications markets. Through a series of acquisitions and organic growth, Vocus expanded to provide fibre, ethernet, internet, data centre and voice services to corporate, government and wholesale customers.
Initial investment view:
This is a challenger telco story. VOC has grown organically and by acquisition to become Australia’s fourth largest telco. It now has scale and backhaul assets to compete on a level footing with the other majors and an efficient and lower than peer cost base which will boost its competitiveness.
The NBN will be an industry changing event whereby incumbents with their own networks will lose their competitive advantage. For consumers, NBN will provide the network and Retail Service Providers (RSPs) will sell on the basis of price and quality of customer service. This will be advantageous for challengers with lower costs to serve. While TLS is still likely to dominate the space, we expect them to cede some market share.
Broker estimates have EBITDA growing at a 3-year Compound Annual Growth Rate (CAGR) of 14% and EPS at 18% highlighting strongly ahead of market growth expectations. Even halving the expected growth rate would see VOC still grow ahead of market.
Despite the growth outlook, VOC trades in line with the market. VOC is now trading on 9.8x FY17F consensus EBITDA (8.1x FY18F) and 15.4x FY17F consensus EPS (13.0x FY18F) and offers a 3.3% yield.
Post the recent pull back, it looks to be cheap vs its own history and peers, especially factoring in the growth outlook. For comparison, the All Industrials ex financials is trading on 11.0x and 10.3x FY17 and FY18 EBITDA respectively (source: UBS) and 19.6x FY17 EPS (17.7x FY18F EPS), with 10% EPS growth.
While results in the short term are likely to be messy given the transactions undertaken over FY16, and risks remain over integration, we believe the core business is solid and VOC will be a strong competitor in a highly competitive market.
What is the industry outlook?
The telco sector is highly dependent on the regulatory environment and technological change. The rollout of the NBN in particular is set to change the industry landscape.
NBN will assume control of the 'last mile'. This essentially removes the ability of existing RSP's to differentiate on cost structure on the access network i.e.: i) the incumbent (TLS) loses ownership of the Customer Access Network (in return for NBN cash payments), ii) RSP's with significant DSLAM infrastructure (e.g. TPM / IIN) will see costs rise from a ULL cost of c$15-$17 today to c$43 per user under NBN, and iii) even infrastructure-light RSP's (e.g. VOC) will no longer receive scale discounts for last mile network access.
This suggests a more level playing field will exist post NBN with respect to network access. Of course RSP's will also seek to differentiate via fixed operating costs, bundled content, differentiated offerings, service levels etc. This gives challenger Telcos like VOC a viable platform for growth.
The Figure below from UBS illustrates the level of vertical integration in both Australia and NZ. It’s clear that players are now on a level playing field.
As NBNCo now assumes control of last mile network access: 1) Marginal cost curves lift materially for both the incumbent TLS, and RSPs which have been sweating DSLAM investments, 2) Industry competition may increase as cost curve differentials between RSPs narrow (at least for the customer access network), and 3) Decline of legacy revenue pools such as voice will accelerate.
One way falling industry returns are likely to manifest is via lower fixed margins: for both the previous owner of the last mile - TLS (compensated via government NBN payments), and for players with large 'on-net' subscriber bases (e.g. TPM / Optus). Margins will likely remain relatively more stable for resellers (VOC):
The team at TAMIM
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.