The Motley Fool

The one company I bought last week

Peter Lynch said anyone could pick a winner, but the sign of a great investor was the ability to add to their winners, writes Dean Morel of The Motley Fool

Water your flowers and pull your weeds.

Last week I put that adage to the test.

I bought M2 Telecommunications (ASX: MTU) last week at close to $2.40. It was my only purchase.

Here’s why I simply couldn’t resist topping up one of my largest positions.

M2 is a supplier of telecommunication services to small to medium businesses via wholesale and retail channels in Australia and NZ. Founded in 1999 and listed in 2004, M2 is now the largest network independent telco in Australia. M2 operates a multi-brand reseller approach. Their leading brands are Commander, People Telecom, Southern Cross and M2 Wholesale.

M2’s low capital requirements allows for a 70% dividend payout policy and faster growth than the capital intensive telco sector. While growth is good, getting paid a growing 5% dividend yield while you let your growth compound is even better. At under $3, M2 represents that kind of opportunity.

Earnings growth has been outstripping revenue growth. This is, of course, what we love. It’s due to margin expansion from M2’s scale, bringing efficiency and pricing gains.

Earnings out soon

As I’m writing this, full year earnings are over a week away. I expect earnings to be excellent and for the market to re-awake to the opportunity of M2. A lot will hinge on guidance. Based on management’s track record I expect owners should get good news on the integration of Clear and Edirect.

Rear view

Looking in the rear view mirror, M2’s recent results have been excellent. The December half saw revenue up 15% to $216m and profit up a whopping 40% to $12.5m. Earnings per share rose a very healthy 25%. Revenues are now tracking at A$500m per annum.

Impressively, 70% of M2 revenue’s growth in the December half was organic. While acquisitions have been a core competency of the business, it was pleasing to see they can still grow revenues within their business.

Expectations

Full year earnings will be out on August 29th. Underlying earnings per share guidance is for 24.7-26.1c. I prefer to track the underlying earnings which excludes non cash costs. This gives a cleaner picture of M2’s earning potential.

M2 traditionally hits or beats to the upside. A price under $3 gives a price to underlying earnings ratio of under 12 with a forward P/E of 10 based on my estimate of 30c underlying eps in FY12.

M2 has a strong balance sheet. Despite the $24.5m acquisition of Clear Telecom and $5m they forked out on buying Edirect earlier this year, M2 will be close to positive net cash when they report. While that is in part due to the structuring of the Clear Telecom deal into three payments, it is also testament to M2’s strong cash flow generation.

Based on discount rate of 12%, return on equity (ROE) and discounted cash flow (DCF) valuations suggest the market is expecting 10% growth going forward. For a company that has grown at 75% a year for the last five years, and grew around 20% this year, I think the market has got it wrong.

Therein, lies the opportunity.

I value M2 at $3.80 – 4.00, with upside potential dependent on growth and market sentiment. Downside should be limited, giving M2 an attractive risk/return profile.

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Dean Morel is The Motley Fool’s Investment Analyst. Not surprisingly, Dean Morel owns shares in M2. The Motley Fool has an upstanding disclosure policy.

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