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My top 2 telecommunications stocks

The telecommunications sector has enjoyed a strong run this year, and some analysts believe it is becoming overvalued. In the last 12 months Telstra (ASX: TLS) is up 25%, and TPG Telecom (ASX: TPM) is up over 80%. However, this may be justified. The industry is benefitting from long-term tailwinds, as the internet and telecommunications continue to pervade our lives.

Vocus Communications (ASX: VOC) is already up 80% in the last year. Vocus is an internet wholesaler, but its most important business is selling ‘dark fibre’ and data centre space to big corporations. The CEO of Vocus, James Spenceley, is an experienced player within the industry, and owns a significant share of the company.

Dark fibre describes the service where a customer has the exclusive use of a single strand of fibre (which they ‘light’). This kind of connection is both extremely fast and extremely secure, and Vocus is arguably the company best positioned to offer it (along the east coast of Australia, at least). It makes sense for companies using Vocus fibre to also use Vocus data centres, and this partially explains why Vocus has been able to fill its data centres so quickly. A new data centre has recently opened in Melbourne, and will contribute to FY 2014 profits.

Vocus has an Indefeasible Right of Use of an undersea cable that connects Australia to Singapore, Honk Hong, New Zealand and the United States. While reselling this capacity is a stable (even growing) source of revenue, the cost is in US dollar, so Vocus benefits from a strong Australian dollar. This is perhaps one reason it has taken so long for the share price to react to the positive results released in August.

What Vocus showed in its most recent results is that it is gaining customers for its fibre network at a rapid rate. Revenues from fibre and data centres now make up 46% of the total revenue of the company. With a market capitalisation now over $250 million, Vocus is sure to be attracting the attention of larger institutions, and may soon join the S&P/ASX 200 Index (ASX: XJO).

One of only seven Australia-wide IP networks, My Net Fone (ASX: MNF) is up 90% in the last year (making it one of the biggest gainers in the sector). My Net Fone is transitioning from selling VOIP services to residential clients, to wholesaling VOIP and serving larger clients (for example, the Tasmanian government). Skype is one well-known customer. The acquisition of the wholesale business, Symbio, fundamentally changed the company (for the better, it would appear).

My Net Fone is growing organically and by acquisition. The company has the existing capacity to add new customers to its network, so it doesn’t need to acquire to grow profits. Dilution has impacted investors in the past, and I hope the company will consider using the new service On-Market BookBuilds to ensure that existing shareholders get the best possible deal. This would be preferable to the opaque process by which shares have been allocated in the past.

Dilution aside, there is little to be critical of. The management of My Net Fone, led by Rene Sugo, is both honest and competent and they own a significant stake in the business. Their acquisitions have been earnings-per-share accretive, and further synergies will be extracted from past purchases over FY 2014. The company remains on the lookout for new acquisitions, but will probably continue to see organic growth of the wholesale business, in any event.

Foolish takeaway

The telecommunications sector is arguably somewhat overheated at the moment, with all companies experiencing strong share price gains in the past year. At current prices, I prefer My Net Fone to Vocus. However, investors should be aware that the small telcos are often riskier to invest in than the large ones.

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Motley Fool contributor Claude Walker (@claudedwalker) owns shares in Vocus and My Net Fone.

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