In 2005, M2 Group Ltd (ASX: MTU) reported profits of $1.8 million and diluted earnings per share of 3.3 cents. Fast forward 10 years and the telecommunications company reported net profit of $67.1 million and diluted earnings per share of 37 cents. Incidentally, it could be argued that the 2014 figures are understated because they include amortisation charges for acquired customer contracts of $26.3 million. How has M2 Group achieved this exceptional performance?
Growth by acquisition done right
Far too often companies do deals that end up destroying shareholder wealth because acquisitions are tricky to get right and fraught with risks. Some of the reasons for this are listed below.
- The vendor is at an advantage at the negotiating table because they have a much deeper understanding of the business being acquired.
- Theoretical synergies used to justify purchases often never materialise. For example, cross-selling may not work because it turns out that the new products require a completely different sales approach.
- There is the risk that the newly acquired business will be a bad cultural fit which is hard to foresee.
- The finance costs and advisory fees charged to enable a deal are high. The buying firm must be vigilant against being sold a dud by brokers who are often just keen to get a deal done and don't care about the lasting outcome.
- The new owners are not able to run the business effectively as they lack the knowledge of the previous owners.
However, M2 Group is an example of a company that has grown very successfully by acquisition over a number of years.
One reason for this is that customers of utility retailers do not have any special affinity for the people they buy from and are usually locked in to multi-year contracts. Changing suppliers is a hassle and so customers rarely switch.
Contrast this with an accountancy practice where clients have loyalty towards an individual providing them service and are likely to follow that person should they leave the firm in the event of a takeover. Essentially when M2 Group makes an acquisition, it is buying a collection of customers that are unlikely to leave regardless of what personnel changes are made to the company.
Whilst the nature of the business that M2 operates in is well suited to a growth by acquisition strategy, that does not take away the fact that management has executed well. They have consistently improved the profitability of the firms they acquire by cutting duplicate functions. They have also paid sensible prices for the businesses they have acquired, usually less than 5x earnings before interest, tax, depreciation and amortisation.
Another major reason why M2 has had significant success over recent years is that the whole telecommunication sector has done well. Internet service providers earn stable recurring revenues and demand for bigger data allowances and faster connections continues to grow rapidly.
Foolish takeaway
A combination of favourable industry conditions, growth off a small base and able management explains M2 Group's meteoric rise in the last decade. I doubt it can achieve similar performance in the next 10 years for the simple reason that it is now much bigger. Given it is one of the top-five largest internet service providers in Australia and New Zealand today, there are not many potential acquisitions large enough that would have a major impact on the company.
To find out the names of two small companies that are capable of duplicating M2 Group's performance in the next decade just follow the links below…
