I always find that in these kinds of major price upheavals, it pays to go back to basics, do some detailed analysis, and try to estimate what the situation will be in FY18 and FY19. In the past I have been suckered in (by shorters and panicked sellers) to sell on bad news and live to regret it when a basically good company with temporary problems recovers and prospers in the next year or two. Sure, there are also the obvious trading opportunities which many take advantage of. My detailed analysis follows:
NEXTGEN
On the announcement of the takeover in June, there was a $94M EBITDA annual run rate for the 6 months ending Dec 15. This should really have grown to around $100M for FY17 EBITDA, given “mid-to-high single digit growth” and being a little conservative. In the Nov 16 announcement, the 8 month underlying EBITDA of $41M, or $66M extrapolated to annual, is effectively a $34M annual miss. VOC gave three causes of this miss: customer cancellations, re-signing contracts at lower margins and slowing sales. The good news is that these problems developed between the announcement and settlement when VOC did not have control. They now have control, and I expect these problems will be mostly fixed over the rest of FY17 and FY18.
The NEXTGEN assets cost over $1B to build over more than a decade. VOC bought it for $700M, most of this with equity at around $7.55 per share. This is good news for current shareholders as it means that dilution at purchase was much less than it would have been now at the current share price. We will be glad of this when NEXTGEN is operating properly.
The NEXTGEN assets are a strategic asset for VOC, giving them greater control of their cost base and expanding their product suite. NEXTGEN’s assets have low utilisation (I think someone at the AGM said around 10%), so there is huge scope for improving utilisation and adding to margins.
VOC previously guided that the NEXTGEN acquisition would lead to “high single digit EPS accretion”. This should occur mostly by the end of FY18, with some to come in FY19.
Expected cost synergies are still being stated at $30M, going straight to the PBT line. $26M of this will still be delivered by end FY18 and $28M by end FY19. There will also be potential capex synergies of around $8M and additional synergies on the revenue side. So, if VOC can get NEXTGEN operating well again by the end of FY18, the $100M starting EBITDA would have an additional $27M added during FY19 plus any capital and revenue synergies, plus new earnings from the NWCS and any other organic growth before then. It would be reasonable to expect NEXTGEN to contribute >$140M to EBITDA by FY19, which would put it on a Purchase Price/EBITDA level of 5. That is not overpaying. FY19 starts in only 19 months’ time.
Overall, I consider the $34M miss this FY as substantial. Although I am not surprised at some of the market reaction, I consider this issue will be irrelevant by FY18 – FY19.
CURRENT OPERATIONAL PROBLEMS
At the AGM, the following operational problems were identified:
* A lag in the conversion of new sales to revenue. This is only a problem because of the high rate of signing new corporate customers. This problem is being rapidly addressed and is expected to normalise by January 2017, after the appointment of 19 new staff to improve provisioning. For this to be even mentioned at the AGM, it would have to be a material negative impact on EBITDA. My analysis will assume a 1% impact, or around $5M off EBITDA. This is a one-off and should be added in full to FY18 EBITDA.
* NEXTGEN problems. Covered in full above. I would expect VOC to recover the approx. $34M EBITDA loss over FY18 and FY19, as well as cost synergies of $30M, capital and revenue synergies, NWCS earnings and organic growth. I expect EBITDA from NEXTGEN to increase to approx. $115M by FY18 and $140M by FY19.
* Outages on VOC’s primary broadband supplier’s provisioning platform. These issues have largely been addressed, and are not expected to recur. As for item 1, for this to be even mentioned at the AGM, it would have to be a material negative impact on EBITDA. My analysis will assume a 1% impact, or around $5M off EBITDA. This is a one-off and should be added in full to FY18 EBITDA.
* High churn rate of 2.6% per month for consumers on copper broadband. VOC plans to address this by supplying NBN ready modems, unified agent console and contact centre solution. This problem will also reduce as large numbers of customers are transferred to NBN, where the churn rate is much lower. As for item 1, for this to be even mentioned at the AGM, it would have to be a material negative impact on EBITDA. My analysis will assume a 1% impact, or around $5M off EBITDA. This is a one-off and should be added in full to FY18 EBITDA.
* Capital expenditure for FY17 is higher than previously guided at $186M. This is still under 10% of revenue, and includes $32M of IRU (due to high rate of customer growth and migrating of customers to NBN), and $84M in growth capex, also due to high growth and new opportunities. I do not see this as a problem. Capex is trending downwards, from 21% in FY15, to 11% in FY16, and now <10% in FY17. Growth capex opportunity is a good thing for shareholders as it promises increasing returns in the future.
FY 17 GUIDANCE
This may have undershot by 6% or so due to unexpected problems with NEXTGEN and a few operational matters, but it still includes around 14% EPS growth. Not bad, considering that $28M of synergies are still to come after the end of FY17.
FY18 EXPECTATIONS
Starting from the FY17 mid-point guidance of $440M EBITDA and $210M underlying NPAT, I expect around $90M to be added to EBITDA in FY18, for a total of $530M:
* $17M from partially fixing the recent NEXTGEN problems (assuming only half the $34M miss is fixed by FY18). It could all be fixed by then.
* $5M from a full year contribution from NWCS (note the $3M this year was not included in the above FY17 guidance)
* $31.5M from increased synergies (note, the figures in the presentation are end of FY run rates, so I have calculated an average for two FYs and taken the difference).
* $15M from fixing the one-off, temporary operational issues.
* $22M from organic growth (I have assumed revenue growth of 4% plus improving margins leading to organic growth of 5%).
MANAGEMENT AND BOARD
* From the last AGM, it is very clear that the board is now past its disharmony stage.
* The Vaughan Bowen / Geoff Horth team have proven themselves since 2009 as COO/CEO/Executive Director for M&A. Over the 6 years between 2009 and 2015, M2’S share price went up more than 10 times from around 80cents to around $10.70 (then to $12.58 just before merging with Vocus in Feb 2016). EPS went up 6 times from around 9cents to around 55 cents in FY15. Dividends went up 5 times from around 6.4 cents to 32 cents in FY15. Having been a shareholder during this whole period, I am confident in saying these guys know what they are doing. They have never made a bad acquisition and they have always overdelivered.
VALUE PROPOSITION
I have not even attempted to cover all the positives associated with VOC, such as New Zealand, having set out to examine the negatives in detail. I leave this for others at this stage. However, the financials still look very bright:
* At $4.10, VOC is at a 33% discount to book value.
* I expect EBITDA to increase by 20% to around $530M in FY18.
* Based on my updated FY18 NPAT estimate of $250M, the forward FY18 P/E is now at 10.3.
* Backed by improving utilisation of its assets, greater share of NBN, corporate growth, synergies and further efficiencies, EPS growth should easily continue at > 10% p.a. for several years to come.
* VOC will be a strong cash generating business, able to pay steadily increasing dividends.
All of the above is my opinion only, and I invite comments from anybody, including those with differing views.
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