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Service Stream: Margin Pressure Versus NBN Upside

Australia | Mar 03 2021

This story features SERVICE STREAM LIMITED, and other companies. For more info SHARE ANALYSIS: SSM

While Service Stream has indicated its second half would continue to be weak, material wins under NBN Co’s upgrade program could be an important swing factor.

-Views on Service Stream dominated by uncertainty over margins
-High margin telco division has client concentration risk
-Comdain is the stand-out performer
-Brokers acknowledge upside potential exists from NBN Co’s upgrades

By Mark Story

After warnings by Service Stream ((SSM)) that the second half could be just as rocky as the first, Bell Potter questions whether there could be further earnings downgrade in the current cycle for the network service provider.

Fuelling Bell Potter’s concerns are ongoing issues surrounding the margin outlook for FY22 and beyond, when scale in the telecommunications business is set to decline further.

From a margin perspective, the transition to new contracting arrangements is also viewed by Bell Potter as a potential risk.

Management at the services provider has made it clear covid-related disruptions to work programs and shortages across client supplied materials, plus the likelihood of further restrictions on movement and interstate travel bans, will continue to hamper the company for the reminder for the year.

After an arduous six months, Service Stream delivered a first half FY21 -17.7% reduction in revenue to $409.9m, which was below Bell Potter’s already low expectations.

But while covid certainly didn’t help, it was the end of the NBN construction program last year, on top of lower activation volumes, that saw the company post a -30% decline in Telecommunications revenue to $209.9m. This led to a -40.5% drop in first half net profit after tax to $16.2m.

Bell Potter notes additional material contract wins under NBN Co’s upgrade program could be a key potential positive for Service Stream in coming months.

But while the broker has greater confidence there should be no further downgrades in the current cycle for Service Stream, significant uncertainty remains as to where margins ultimately land in FY22.

Client Concentration risk

Service Stream is extra-vulnerable because its revenues in the Telecommunication division are derived from two customers only.

Thus, the loss of a large contract or material reduction in demand from either NBN Co or Telstra ((TLS)) would have a material impact on revenue and earnings.

Given what is still expected to be a material FY22 earnings decline, the broker does not see a reason to upgrade from its Hold recommendation at current levels.

Post the February interim report release, Bell Potter’s revenue estimates have been lowered by -4.1%, -7.7% and -4.9% across FY21, FY22, and FY23 respectively.

In addition, the broker has made more aggressive cuts to its forecast earnings (EBITDA) margins, which it expects to be impacted materially by the anticipated loss of scale in the telecommunications business in FY22.

Earnings rebase is in motion

Given that the major drop-off in the telco segment was largely expected, especially given the run-off in historical contracts and timing of workflows around major contract transitions, Ord Minnett has a more optimistic outlook on the fortunes of Service Stream.

Given the productivity disruptions experienced in most states were far from unexpected, Ord Minnett regards the fact divisional earnings (EBITDA) margins reduced only to 7.3% from 7.8% as a solid outcome.

With first half earnings of $40.2m beating Ord Minnett’s expectations by 10%, the broker is encouraged by the continued strong performance of Comdain and the broader utilities business, backed by contract wins and national expansion.

Re-based to reflect the covid and contract disrupted year, group guidance of a similar first/second half earnings skew equates to a -11% revision to Ord Minnett’s FY21 forecasts.

Underpinning the broker’s improving sentiment towards Service Stream is the company’s progress in extending three major telco contracts onto longer term arrangements through (a) improved forward visibility, and (b) the opportunity to participate in the $4.5b NBN Co network upgrade, with outcome for this commercial process expected late in the second half FY21.

What also can’t be overlooked, adds Ord Minnett, is growth in the Comdain utilities business. While recent contract wins with SE Queensland Water and Sydney Water are contributing positively to the outlook, Ord Minnett believes Comdain to be the stand-out performer within FY21, with expected sales growth of 15%-plus.

With the net cash position providing balance sheet headroom, Ord Minnett notes Service Stream has the capacity to add to the service mix via M&A activity. Overall, the broker believes Service Stream is well positioned for the upcoming major program of work upgrading the NBN Co’s FTTN (fibre to the node) and HFC (hybrid fibre-coaxial) networks, and retains its Buy recommendation.

Swing factor

Broadly in line with its expectations, there was little within Service Stream’s first half result to get Macquarie overly excited, or alter the broker's Neutral rating on the stock.

However, given lacklustre results in other areas of telecommunications expected to persist into FY22, it agrees with other brokers that the ability to secure additional work from $4.5b NBN spend could be an important swing factor.

Despite the benefits of diversification evident within Comdain’s performance, which is on track to deliver around 15% revenue growth in FY21 (second half growth of around 25% versus the previous corresponding period), Macquarie notes that utilities, particularly Comdain, is a lower margin business relative to the Telecommunications segment.

The broker has dropped its FY21-23 earnings forecasts by around -30%. While Macquarie assumes Service Stream will a beneficiary of NBN works being awarded in the $4.5bn Federal Budget, the broker still expects subdued activity across Utilities (ex-Comdain) and Wireless and continues to capture the well understood step-down in NBN Activations & Assurance revenues to $70m in FY22.

On the back of ongoing weakness in Wireless and Utilities, Macquarie has downgraded second half forecasts to be approximately in line with the first. Underscoring Macquarie’s downgrade were Service Stream’s ongoing concerns around covid impacts, current trading conditions and caution on the transition to the new NBN Unify Networks model.

Equally concerning to Macquarie is activation and assurance revenue, with the outlook for activations expected to remain weak, following a revenue decline after peaking in FY20.

On a more positive note, Macquarie recognises the pipeline of new gas and water utility project opportunities is robust and growing on the back of expanding urban development and upgrade/replacement of aging infrastructure.

Equally encouraging, the broker also notes Service Stream’s working capital at 1.3% of revenue, $50.4m cash balance, and upsized debt facilities of $275m, which complement the company’s appetite for future M&A and organic growth.

FNArena’s consensus forecasts, in this case based on projections by Ord Minnett and Macquarie, and not including non-database broker Bell Potter, imply the shares offer a dividend yield of 4.7% and 5.8% on FY21 and FY22 forecasts respectively. Ords has a Buy rating with a $2.06 target and Macquarie is on Neutral with $1.40.

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