iwl downgrades uec to a "hold"
The following is an extract from InvestorWeb's report on UEC, dated 24th July 2003.
According to IWL, UEC is considered fully priced on the basis of: 1) a 30%+ premium to net tangible asset backing; 2) MC now being closer "to the replacement value of UEC's assets"; and 3) UEC trading on a 10x EV/EBITDA multiple which "can no longer be considered undervalued".
Uecomm has done something that few of its small network operator telco peers have achieved anywhere in the world - moved to profitability.
The company unveiled a net profit after tax of $3.4m in H1 2003, although this figure included a $2.56m tax credit.
More significantly UEC reported EBITDA of $8.6m, representing a healthy EBITDA to sales margin of 28% (and comparable to the much larger Optus).
Strong cash flow from operations of $12.1m (representing a margin of nearly 40% and higher than Telstra's) seems to support the ongoing viability of UEC's small carrier business model, although it seems unlikely that such margins could be maintained in subsequent reporting periods given UEC's lack of scale.
2) Alinta Keen To Divest
It was also confirmed yesterday that United Energy's 66% shareholding and $80m funding facility had been formally transferred to Alinta Limited and AMP Henderson.
Alinta does not see UEC as a core holding and will divest if the right opportunity presents itself. Possible buyers include SingTel/Optus and Telecom New Zealand.
Utilities around the globe have painfully discovered that it is not easy to compete against the incumbents in telecommucations - disasters include Williams, Energis, Scottish Power, Downtown Utilities, and many others - but some have not given up yet.
UEC's result holds promise that profitable business models, that is, those that generate positive free cash flow may evolve as lessons are learned. So there is no urgency for Alinta to divest UEC.
3) Success Builds Customer Confidence
UEC's result, which included the signing of some $33m in sales contracts over the last six months will also support efforts to establish the company's brand and credibility in the target corporate and government customer segments.
Corporates are hesitant at purchasing critical data communications services from unestablished companies like UEC which may not be around in a few years or which are unable to match service level guarantees offered by the larger carriers.
4) Sensible Strategy
UEC is well positioned to achieve a sustainable niche in the broadband market as industry growth picks up. This is attributable to its strategy of focusing on the last mile bottleneck particularly outside metropolitan CBD areas where there is latent demand from corporate and Government customer segments and limited competing fibre optic capacity even from incumbent operators such as Telstra.
While UEC does not need Alinta as a parent shareholder, it does ultimately need a parent with deep pockets given the capital intensive nature of the telecommunications industry.
The issue will come to a head when UEC's $80m line of credit to Alinta (currently drawn down to around $46m) becomes due for repayment in 2007 but a divestment before this date is highly likely.
One advantage that UEC has over its peers (such as PowerTel) is that UEC's line of credit ($80m) is to its 66% parent ALN.
Should Alinta be still holding its 66% UEC stake when this facility is fully drawn UEC could end up with a clean balance sheet via a debt for equity swap, similar to the UK experience when Thus was spun off from Scottish Power.
This effectively provides a safety net under UEC, at least for the next few years and improves the prospects of ALN achieving a premium upon divestment.
5) Price Rise warrants Downgrade
Following a 70% gain in UEC's share price since we initiated coverage with a BUY on May 1st, we are downgrading the recommendation to HOLD.
This is due to UEC's share price move from trading at a conservative 30% below its net tangible asset backing which includes around $120m (23 cents per share)of fibre optic cable in the major capital cities (CBDs and business corridors) to a 30% premium.
The current share price is now closer to the replacement value of UEC's assets .
From a fundamental valuation perspective, UEC is trading at an EV/EBITDAmultiple of 10x and can no longer be considered undervalued.
Strengths 1) Management UEC's Chairman Peter Shore and CEO Peter McGrath have considerable experience and are widely respected within the telecommunications services industry. 2) "Last Mile" Bottleneck UEC owns and operates fibre optic networks (around 2000km in total) in the Australian CBD and metropolitan regions of Melbourne, Sydney, Brisbane and Gold Coast including many areas where there is undersupply of bandwidth. 3) Accelerating growth After massively underperforming prospectus forecasts in 2001, UEC has demonstrated strong growth in sales (up 34% in H1 2003) and a significant improvement in earnings (EBITDA of $8.6m in H1 2003) 4) Focused Strategy UEC's strategy to focus on selling services to high value customers such as large corporations, government bodies and other telecommunications service providers is sensible and closely aligned with its extensive CBD and metropolitan fibre network 5) High Margins UEC's ownership of large fibre optic cables in less contested areas, coupled with a low overhead cost structure enables it to enjoy substantial margins on sales made to corporate customers in these areas.
Weaknesses 1) Parent Shareholder Alinta Gas has reluctantly inherited its 66% shareholding in UEC as part of the United Energy acquisition and does not view the holding as a core asset, thereby potentially exposing minority shareholders to the risk of a "fire sale" 2) Lack of Scale UEC's lack of coverage in regional areas puts it at a disadvantage relative to a national operator such as Telstra in a industry where economies of scale is a competitive advantage 3) Pricing Pressure An oversupply of competition (Telstra, Optus, Telecom New Zealand, PowerTel, MCI) particularly in some segments (eg CBD areas) continues to put downward pressure on prices for data services 4) Free Cash Flow Negative UEC has yet to achieve free cash flow break-even in an extremely capital intensive industry and there is no indication on when and if this is likely to occur given the uncertainties associated with a small carrier business model. 5) Funding UEC has drawn down $46m of its $80m line of credit to United Energy (now Alinta Gas) and will require a source of further funding for growth and to repay the loan by 2007 in this extremely capital intensive industry 6) The accelerating draw-down has weakened UEC's balance sheet
Opportunities 1) Large Data Services Market The data services market in Australia is valued at between $2.5 billion and $5 billion and demand in this sector for fibre broadband is expected to grow strongly 2) Market Share Gains As one the smallest of the broaband infrastructure operators in Australia with a market share of below 2%, UEC has the opportunity for substantial growth though market share gains. 3) Consolidation UEC could become an acquisition candidate as organic growth opportunities for the larger players dry up. 4) Alternatively, the pursuit of economies of scale and scope is likely to trigger consolidation/merger activity amongst the smaller operators. 5) It is possible that parent shareholder Alinta Gas could recapitalise UEC via a debt for equity swap similar to the UK recapitalisation of broadband carrier Thus by its parent Scottish Power in 2001.
Threats 1) Business Model Viability The viability of a small carrier business model has yet to be established anywhere in the world. There is a risk that UEC may not achieve an acceptable return on equity from its business operations as a stand-alone operator. 2) Competition The dominance of larger integrated carriers such as Telstra and SingTel/Optus enables them to "squeeze" the smaller operators on data services pricing. The entry of Nextgen could also hurt Uecomm although there is also scope for an alliance in areas where they have complementary networks. 3) Capital Expenditure/Funding Lack of access to funding beyond the current $80m line of credit may curtail UEC's ability to win customers and move to a free cash flow positive position. 4) Customer Resistance There remains real evidence that larger corporates are hesitant at purchasing critical data communications services from unestablished companies which may not be around in a few years or which are unable to match service level guarantees offered by the larger carriers
