More Research

Forwarded by a mate who deals with lodge

Update: Spirit Telecom (ASX:ST1)
Capital H December 9, 2016

Disclaimer: The information contained in this report is solely the view of Capital H and should not be interpreted as advice or reason to invest. Conduct your own research and seek professional guidance before making any investment decision. Capital H holds shares in Spirit Telecom.

In the initial report on Spirit Telecom it was outlined that acquisitions would form an integral part of the company’s strategy. The thesis held that the first acquisition and how it was structured would be a significant milestone for the company, despite the fact it was always going to be smaller than the acquisitions that may follow.

Yesterday Spirit announced the acquisition of Phone Name Marketing Australia, trading as Phone Names. Encouragingly, the company also told the market that one of the most highly regarded individuals in the telco industry has joined the register.

Phone Names

Phone Names, which is based in St Leonards, owns, markets and leases out inbound 13/1300/1800‘smart numbers’. Smart numbers, which are similar to domain names, have become a common marketing tool for businesses.

As an example of how it works, one of the smart numbers Phone Names owns is 1300 DOMINOS, which is then leased out to Domino’s Pizza. Other major customers include Harvey Norman, Bendigo Bank and Vodafone.





Phone Names Overview

Phone Names generates $1.5m revenue and $800k of normalised EBITDA with very strong cashflow conversion. Spirit are paying $4.2m in cash funded evenly by debt and a $2.25m placement at 2.7c to institutions and sophisticated investors. Net debt will rise to ~$2m, which remains comfortable.





Acquisition Details

There is no CAPEX associated with this business and the ability to increase asset utilisation at no incremental cost provides operating leverage. Given just 20% of the 2200 smart numbers are currently being leased out there is plenty of opportunity to drive utilisation (and thus earnings) higher. While the quality of those numbers would vary management believe there are some that would command a respectable yield, e.g 1300 FITNESS, and given it all drops down to the bottom line even a slight increase in utilisation will see leveraged profit growth. The customers are also very sticky given changing their phone number would cause a disruption to their business.

The Phone names customer base consists of over 400 businesses of all sizes, providing Spirit the opportunity to cross sell services such as voice, data and hosted PBX. Spirit’s management team have extensive experience in running businesses like Phone Names and it appears as though there is an opportunity to push the business a little harder through increased marketing and the improved utilisation of the asset base noted above.

When you call a smart number there is a tolling fee that is currently not being collected by Phone Names. Under Spirit’s ownership the call can be hosted on the Spirit network generating an additional revenue stream and opportunity for growth.

This acquisition should be a quick and easy bolt on for Spirit and it wouldn’t be surprising to see them make another acquisition in the next few months given the pipeline of opportunities to do so remains enticing.

Note: Spirit expects the acquisition to complete in the next 10 days.

MHOR Asset Management & James Spenceley

The cornerstone investor for the $2.25m placement was a boutique fund manager called MHOR Asset Management. If you haven’t heard of its co-founder, James Spenceley, then you have certainly heard of the telco giant he founded and built in Vocus Communications (ASX:VOC).

James is without doubt one of the most highly respected figures in the telco industry. For a small and growing telco like Spirit there is no bigger endorsement than to have someone of his stature back the company financially.

In the acquisition announcement James was quoted as saying:

“Spirit is an exciting company that has proven its ability to deliver a superfast Internet service on it’s own wireless infrastructure with resulting expanding margins. The acquisition of Phone Names while providing solid cross sell opportunities for the core business and is incredibly EPS accretive. At 20% utilisation of the numbers, there is real leveraged upside as they increase that utilisation and resulting cash flow benefits.”

One of the most obvious benefits of receiving an endorsement from James and MHOR is the improved market sentiment around the stock. If the market starts to view Spirit as a potential winner in the NBN environment then it will likely price it at a premium. It also means Spirit shouldn’t have any issue raising further capital as many investors will feel comforted following James into the stock.

But more importantly Spirit management now have access to someone with extensive experience in building and running a listed telco from a micro cap to a multi billion dollar company. When Vocus listed it was capped at just $24m and James built it into one of the largest telcos in Australia. That is invaluable experience and insight for Spirit which is at the start of its growth story as a public company.

Impact On Earnings and Valuation

In the previous report the Capital H thesis outlined a valuation range of 3.7c-4c that was based purely on organic growth of the core business. The reasoning being that while an acquisition strategy had enormous potential upside the conservative approach was to wait until management demonstrated some traction before pricing any of that upside into the valuation. With the first acquisition now under their belt and James Spenceley backing the management team that valuation range now moves significantly higher.

On a pro forma basis the Phone Names acquisition will add $0.8m of EBITDA. Thats a ~44% increase to FY17 and 26% increase to FY18 based on previous broker forecasts, so it is meaningful. The ability to increase asset utilisation, collect tolling fees and (most significantly) cross sell core business services to the Phone Names customer base should ensure this business generates decent growth moving forward.

The updated numbers are provided below, noting that the figures for FY17 are underlying (removing acquisition costs) with Phone Names only contributing for six months.



ST1 Financials Post Acquisition

The initial report outlined the view that Spirit deserved to trade on a forward EV/EBITDA andP/E of 10x and 16x, respectively. This was based on the conservative end of the range of multiples that the listed telcos are trading on. For more on that thinking please view the original report. As the Spirit story plays out it may prove too conservative to use the lower end of this range given Spirit should register growth rates well beyond what most of the other telcos will be capable of. OTW for example trades on EV/EBITDA of ~14x and a P/E in the mid 20’s. When these multiples are used the valuation that results is between 2-3x that of Spirit’s current share price. However, using the lower end of the range should simply create a greater margin of safety while the prospect of multiple expansion towards comparable listed peers leaves some very attractive upside potential as Spirit continues to execute and thus justify a higher multiple.

Based on the forecast numbers above, and assuming the conservative multiples previously mentioned, Spirit is now worth between 4.3c-4.5c. If Spirit were to trade on similar multiples to comparable listed telcos the valuation range would move to 5.5c-7c.

The Capital H thesis assumes Spirit is very likely to trade at least on the lower multiples outlined above, but with recognition that the market may well start to price Spirit in line with the other telcos with similar growth prospects. The endorsement of James Spenceley only serves to increase that likelihood.

Capital H Thesis

This acquisition is more a quick bolt on than a strategic play but the way it is structured means it is highly accretive and provides a nice source of cashflow to fund the core business. It is also a tick for management in that they have now begun to execute the strategy they have communicated to shareholders.

Having James Spenceley join the register is a vote of confidence. His endorsement is a powerful recognition of the business model and the opportunity in front of the company, while also potentially being a source of guidance for the management team. As a small listed telco employing an M&A strategy having James backing you is about as good as it gets.

With regards to the core business, which management have indicated continues to perform well, the main challenge for Spirit will be in convincing the market of its superiority to the NBN. The Spirit product and technology is already faster than what the NBN can offer and at competitive rates. But what NBN has in its favour is widespread brand awareness and some level of trust with consumers. It is up to Spirit, as a relatively new market entrant at least in NSW and QLD, to be able to convince a broad market that their product is a better option than the NBN. If it can do this then the upside from current prices is significant just from organic growth alone, and this acquisition demonstrates the type of earnings accretion the M&A strategy can create. Acting in the company’s favour is the widespread and growing issues with the NBN and given the organic revenue growth being generated from the core business, and a handful of very large buildings currently in the installation process, it appears they continue to make good progress.

The market is likely to start pricing the stock on FY18 earnings as we progress towards the end of FY17. With the first acquisition under its belt and the endorsement from James Spenceley the prospect of the market starting to wake up to the Spirit story and price it as a growth stock has become more likely. And with management noting an exciting pipeline of potential further acquisitions (which are likely to be both larger and strategic rather than a bolt on like Phone Names) it feels as though the Spirit growth story is only just getting started.

Given that even on a conservative basis Spirit is worth well north of 4c, and potentially 5.5c-7c in the event it traded in line with comparable listed peers, it becomes likely that over the next 12 months the options held by management (~3.9c exercise price) go in the money. As a result its worth discussing the impact these options may have on the business and the investment thesis.

In the event of all options being exercised the two founders, Geoff Neate and Joe Tigel, will end up tipping in roughly $2m each at a price significantly above the current share price, with the funds likely to be utilised to pursue acquisitions. So long as it is well executed that is likely to result in 1) a big confidence booster for the market given the two individuals who shareholders want to see most incentivised will have even greater ownership in the business beyond the 20% of the stock they each own currently, 2) it basically puts a floor at the next capital raising given management will not want to do a large raising at a price below 4c as it would only serve to dilute the value of both their shareholding and their options, and 3) it helps to ensures that Spirit will have plenty of demand in the event they require further equity capital given those new investors will be entering at the same time as Spirit management tip in more of their own cash.

The telco M&A strategy is not without its risks particularly surrounding integration but it is a model the market likes and knows well having watched numerous successful growth stories play out in recent years. Spirit now has the same opportunity in front of it and with ongoing execution it is likely the market will latch on to the story and price it accordingly.

The compelling valuation, endorsement from MHOR and prospect of further acquisitions justified Capital H increasing its investment in Spirit Telecom. With management indicating that the acquisition pipeline remains exciting we continue to look forward to seeing how this growth story plays out.