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Vocus Outlook Deepens Broker Concerns

Australia | Nov 30 2016

This story features VOCUS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: VOC

The AGM update from telco Vocus Communications has weighed heavily on estimates and several brokers urge caution be applied to the stock.

-Heightened competition compounds earnings issues specific to Vocus
-Is the stock a target for private equity?
-UBS questions long-term sustainability of NBN economics


By Eva Brocklehurst

Telecommunications provider Vocus Communications ((VOC)) has been marked down in recent months as the sector has de-rated and the company's AGM update has now weighed heavily on estimates. Several brokers urge caution be applied to the stock.

The company has provided specific guidance for FY17 for the first time, which includes earnings of $430-450m, underlying cash profit of $205-210m and capital expenditure of $186m. The guidance is generally below expectations and attributed to weakness in the recent acquisition of Nextgen, because of slowing sales following the announcement of the transaction.

CLSA questions the quality of the earnings base, with 50% of underlying net profit made up of cost items that are recognised below the line. The guidance is also considered low quality. The broker notes capital expenditure may increase going forward if the company decides to go ahead with the new undersea cable. CLSA is also concerned about the changes to ARPU (average revenue per unit) disclosure, delivered, in its view, without a supporting explanation.

The broker also estimates that around 20% of Nextgen revenue is not contracted. Churn also remains a risk, as disgruntled ADSL customers, affected by outages which appear to be specifically related to Vocus-based services, may choose to go elsewhere. CLSA, not one of the eight brokers monitored daily on the FNArena database, moves to Underperform from Sell. Target is $4.55.

Morgan Stanley believes the stock offers the highest risk/return characteristics in the sector, as a heightened competition is compounded by some specifics relating to Vocus. The broker remains a believer in the revenue growth opportunities that are ahead to the company as a vertically integrated telecommunications business in the NBN (National Broadband Network) infrastructure.

Yet there are changes stemming from the AGM which require the broker to revisit its fundamental view. Increased competition and consumer/retail broadband are negative for margins, returns and the future growth trajectory, in the broker's opinion. The acquisition of Nextgen has also meant several key management and board departures. This adds volatility to equity holder returns, Morgan Stanley asserts.

The broker downgrades earnings expectations sharply, reducing its target to $5.00 from $9.55 and downgrading to Equal-weight from Overweight. The broker believes investors should adjust their valuation framework to apply either lower target multiples and/or a higher weighted average cost of capital for discounted cash flow-based valuations.

Shaw and Partners believes management is not on top of the business. The broker takes the company's suggestion that earnings will be skewed to the second half to mean that there is some risk to the numbers, and now assumes the low end of guidance.

This broker also finds it hard to reconcile the monthly recurring revenue for the corporate business in the first quarter compared with the preceding quarter. Sales growth is suspected to have slowed and some issues with staffing and culture are evident. Shaw and Partners, not one of the eight monitored daily on the database, has a Hold rating and $4.65 target.

So, what is there to like? Citi already assumed market expectations were too high and the sell-off in the stock has pulled it further into Buy territory. The broker acknowledges confusion regarding where growth is being achieved and the gap between reported and core earnings.

Credit Suisse believes the stocks price/earnings multiple of 12.7x for FY17 forecasts does not reflect the growth opportunity in the core corporate business. The main risks to operations relates to voice exposure in the former M2 business. The broker envisages potential for the company to become a target of private equity if the share price remains at depressed levels for an extended period and retains a Outperform rating.

While the Nextgen weakness was disappointing, in the company's defence the broker notes it has been going through a period of extended transition in ownership and the performance is expected to improve now the Vocus sales force can start selling the Nextgen network.

While consumer broadband subscriber growth had slipped, it was impacted by a Telstra ((TLS)) wholesale provisioning issue, which the company says has now been resolved. Credit Suisse also defends the company's accounting, noting disclosure has improved, with reported consumer broadband ARPU revised lower because of an error with the prior calculation.

Deutsche Bank retains a Buy rating on valuation grounds. The broker acknowledges that while the issues facing Vocus in isolation are not that significant, combined they suggest a level of caution should prevail regarding the operational performance.

The broker reduces revenue forecasts for the Australian consumer business, Nextgen, and the corporate and wholesale businesses. Additional costs are now forecast for migrating existing customers to the NBN. Capital expenditure assumptions are also increased FY17. The net impact is a reduction to Deutsche Bank's earnings per share estimates of 12-35%.

UBS, disappointed with the Nextgen performance, and the loss of a $17m fibre build contract, questions the long-term sustainability of NBN economics. The broker welcomes the additional disclosures by Vocus but envisages risks to both broadband profitability per subscriber during the NBN transition and gross costs.

The broker also notes declines in legacy voice could also be accelerating, as voice revenues are set to fall by another $30m in FY17. The broker considers the stock cheap when taking account of FY17 price/earnings and enterprise value/EBITDA metrics. Yet these ignore capital expenditure growth, maintenance costs and other cash impacts. However, longer term, the stock's free cash flow yield is more appealing although this also assumes the capital expenditure profile eventually normalises.

In this company's defence, UBS notes heightened NBN concerns may have meant the sector has lost its lustre but as Vocus is largely a re-seller it should not suffer the same degree of adverse impacts as other platforms, although there remains some risk to customer economics post NBN. Additionally, the second order impacts of the NBN are a concern for the broker, such as increased competition and accelerated declines in legacy products.

It is not entirely clear why some of the acquired business of Nextgen appears to be struggling while internally the company's sales continue to improve, but Morgans suggests a bottleneck in customer provisioning and, hence, the organic growth profile has slowed.

The company has taken a number of steps to address its sales problems and remains confident it can re-build momentum. Nevertheless, the broker believes it will take time for the earnings trajectory to stabilise and investor confidence to return. The business is complex and the broker suspects the investment market struggles with all the moving parts.

FNArena's database shows four Buy ratings and two Hold. The consensus target is $6.08, suggesting 39.2% upside to the last share price. This compares with $8.08 ahead of the AGM. Targets range from $4.46 (Morgans) to $6.85 (Citi).

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