Australia | Jun 15 2017
In highlighting its opportunities Vocus Communications has also exposed the challenges and brokers believe it will take some time for the company to achieve on expectations.
-Cash conversion expected to normalise in FY18 and improve over time
-More rational level of pricing intended and increased share of government
-Short term outlook dependent on the outcome of the bid by KKR
By Eva Brocklehurst
In highlighting its opportunities, Vocus Communications ((VOC)) has also exposed challenges and brokers believe it will take some time for the company to achieve on expectations. The opportunities are significant but none of them are easy, Citi asserts. The company needs to fix cash flow, churn and provisioning issues, automate processes and boost its cross-sell rates. If all this can be achieved, then there is significant upside.
There are also multiple projects underway to deliver on the expected synergies from acquisitions but the scale of this task should not be underestimated, the broker contends. If project time lines push out this is likely to put downward pressure on earnings forecasts.
In the broker's opinion assets are significantly underperforming, and the enterprise & wholesale segment can start to boost monthly recurring revenue by fixing poor provisioning and better managing its accounts post sale. The business has recently been leading on price more than necessary, Citi believes, especially given its scale. Now Vocus intends to retain a more rational level of pricing and aims to increase it share of the government sector.
Meanwhile, consumer business needs to address high churn and the company will re-launch iPrimus and look to boost Dodo cross-sell rates. Citi assumes Vocus takes two years to get back on track.
The issues surrounding cash conversion have been better explained, Macquarie ascertains. Cash flow is expected to normalise in FY18 and improve further over time, as deferred revenue recognition winds down and assuming operating earnings grow.
The most significant opportunity for the company, in the broker's opinion, is the enterprise & wholesale segment, surrounding government and wholesale solutions to carriers. Macquarie notes some headwinds as legacy carrier deals roll off but the opportunity more than offsets this, assuming the company can execute on its plans.
The business is being managed with a stretched balance sheet and this is being addressed by increased discipline over discretionary expenditure, while consideration will also be given to dividend policy and asset sales.
Morgans concurs there is a substantial amount of work required to fully integrate and simplify the Australian business but delivering on these outcomes should crystallise the company's market position and improve the quality of earnings.
Assuming all goes to plan the company should be able to de-gear in FY18. Going forward, assuming capital expenditure is kept under control, the broker expects the company will deliver that all-important free cash flow, which can then be used to pay down debt to what is considered a more comfortable level.
KKR
In the short term, the investment outlook relies on the potential for the conditional proposal from KKR, or any other offer, to progress, or the possibility of no further bid materialising. As such, Morgans considers buying the stock to be speculative at this stage and retains a Hold rating. In the medium term the broker believes there is upside around delivering on the strategies.
Shaw and Partners deduces from the briefing that the board, which is independently reviewing the KKR bid, will reject the proposal. The bid price is then expected to be lifted, or another player will enter the fray.
Shaw and Partners, not one of the eight monitored daily on the FNArena database, suggests risk centres on management rejecting the bid amid claims it can turn the business around. This has happened to other companies and, the broker warns, often management and the share price fail to deliver. A Hold rating and $2.79 target are maintained.
Even with better conversion of free cash flow, UBS believes aggressive business case assumptions are required to hit private equity hurdles for internal rates of return (IRR) which typically range around 15-20%. This could include higher gearing, a reduction in the capital expenditure profile and aggressive organic earnings growth.
Under the upside scenario the broker believes around a 19% equity IRR is theoretically achievable based on KKR's current $3.50 proposal. On base case forecasts, which factor in just minimal growth, UBS only envisages an equity IRR of under 10%.
ASC
With a large capital commitment to the Australia-Singapore Cable project, Ord Minnett expects the company to preserve cash by suspending its dividend and reducing non-ASC capital expenditure. This should not affect its ability to grow the top line.
While the transformation plan is encouraging, the broker believes it could take up to three years for the company to realise its full potential. Ord Minnett now models the dividend suspended in the second half and FY18 and a pay-out of 8c in FY19.
While management insists the ASC will proceed, with the cost of building largely funded by foundation customers, Macquarie suspects that, if the process takes longer than hoped, it may be cancelled.
Citi believes there is still risk that a capital raising or asset sales may be needed to fund the ASC and clarity on this issue is required before becoming more positive. If foundation customers cannot be signed up to offset the cost of the ASC construction, the broker expects the company will need to raise capital.
New Zealand
In New Zealand the key to the business is productivity, in Citi's opinion, particularly given the extremely competitive consumer market. The integration of NZ business is effectively complete and the focus is now on leveraging the assets to pursue growth opportunities.
Vocus will use the recent acquisition of Switch to enter the NZ energy market, which is highly concentrated, and bundling energy with broadband will be key to its strategy. The company has streamlined its NZ consumer offering and will lead with Orcon and Slingshot after dropping the Flip brand.
FNArena's database has eight Hold ratings for Vocus. The consensus target is $3.29, suggesting -9.2% in downside to the last share price. This compares with $3.14 ahead of the update. Targets range from $2.55 (Morgan Stanley, yet to update on the briefing) to $3.65 (UBS).
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