Australia | May 09 2016
-Merger synergies of $40m identified
-Potential to gain market share
-Weakness in mobile infrastructure
By Eva Brocklehurst
Vocus Communications ((VOC)) is consolidating its merger with M2 Telecom, joining its infrastructure with M2's sales and marketing force to form a vertically integrated, full service operator of fixed line telecommunications.
The earnings potential is high, as the merger synergies entail an ability to pursue new opportunities in the small-medium enterprise (SME) market. Vocus has historically targeted corporate and government customers, while M2 has pursued the SME market.
Now, in concert, Deutsche Bank envisages significant potential to take a further 10% share of the the $2.9bn CBD SME market in the next four years. Management has identified $40m in cost synergies associated with both network and non-network savings, which is expected to improve margins by 250 basis points.
Deutsche Bank also alludes to the potential for margin expansion through on-net buildings and cross selling, forecasting earnings margins should improve by 580 basis points between FY16 and FY20.
The company has been building out its fibre network and is now undertaking more in-building marketing to sell additional services inside its footprint. Further penetration within its existing fibre would incur minimal costs. Deutsche Bank estimates an additional customer would have a gross margin of 90-95%.
Management acknowledges it has a gross churn ratio for its consumer division of 36%, which appears higher than its competitors. The reason suggested is because of a younger customer demographic and sales-centred model. Still, with the merger comes faster broadband speeds and Deutsche Bank suspects, as a result, a reduction in churn.
The broker forecasts a compound earnings growth rate of 34% for FY17-20. Deutsche Bank values the stock from an equally weighted average of several methodologies, initiating coverage with a Buy rating and $10.38 target. The main downside risk relates to merger synergies not being realised.
Morgans rates the company's management highly, noting an enviable track record of delivering shareholder value, but believes at current levels the share price is factoring a lot of upside and would prefer to accumulate the stock at lower prices. Hence, the broker kicks off coverage with a Hold rating and $8.50 target.
Vocus is the only one of the big four telcos which does not have to defend consumer margins under a National Broadband Network (NBN) and is well placed to gain market share.
How Morgans envisages this advantage will play out is in the fact competitors are all currently selling their services on the internet and need to sell NBN product at a higher price to protect their profits. Vocus has a consumer brand, Dodo, that is already a re-seller and therefore enjoys pricing flexibility and the ability to substitute, if necessary, margin uplift for market share.
The main weakness, the broker contends, is that there is a lack of mobile infrastructure within the merged group and limited control, therefore, over the mobile product. Still, a recently re-signed re-seller agreement with Optus should strengthen the offering. The broker also notes the time to realise cost synergies in telecoms is typically longer than expected as supplier contracts of two to fifteen years need to roll off.
Other brokers also laud the merger rationale. Credit Suisse considers the business will be transformed, with the company growing into a major telco over time, while execution on potential synergies remains the key factor in determining success.
Morgan Stanley has previously suggested the company needs to fill a hole by increasing its Australian backhaul assets. These assets are the links from a core network to the perimeter networks, or the “edge” of the network where applications are made.
This should mean further market share and a possible re-rating. Based on in-house analysis the broker calculates that an acquisition of NextGen, owned by the Ontario Teachers Pension Plan and Cimic ((CIM)), could be beneficial to both.
There are four Buy ratings and one Hold on FNArena's database. The consensus target is $9.10, suggesting 2.9% in upside to the last share price. Targets range from $8.50 (Morgans) to $10.38 (Deutsche Bank).
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