When Speedcast International Ltd (ASX: SDA) released its half-year 2016 results to the market earlier this week, shares rose 10%. Now, the group appears to be trading on a full-year Price to Earnings (P/E) ratio of around 35 times in Australian dollar terms, depending on the exchange rate and impact of the latest acquisition.
Is this too much?
Two big things I would keep an eye on are whether the company can:
- Make good acquisitions, and
- Generate operating leverage
So far, Speedcast has been growing rapidly both organically and through acquisition. The acquisitions have led it into a number of new markets, and its growing capabilities have themselves lead to new customers in places as diverse as Kiribati and Afghanistan. I feel that it is too early to tell if all of the recent acquisitions have been positive – indeed, the recent weakness in the Oil & Gas sector may prove to be a poor allocation of investment capital if that sector deteriorates further. Yet the rapid growth in the company's revenues and profits can't be overlooked, nor can the new opportunities its acquisitions have generated for the business.
In this, Speedcast is partly protected by the nature of its customers – cruise ships, oil rigs, Kiribati. The big theme is remote access and potentially less competition. Also, communications are an essential service and not something that can be done without. Indeed, in the modern era, communications often lift productivity more than the cost of communications themselves, so they're the last thing to be cut when times get tough.
That's not to say Speedcast is the only provider of those communications, however. Indeed it noted at its recent WINS acquisition announcement that the market was 'characterised by strong supply'. However it appears to be a more defensive sector than consumer discretionary spending, for example.
Operating leverage?
The second question is whether costs are relatively fixed, or if they scale up in line with the company's sales. Unfortunately, Speedcast's costs scale up quite well alongside revenue. Here's an overview of the last few years:
| Costs as a percentage of revenue | First half 2016 | Full year 2015 | Full year 2014 | Full Year 2013** |
| Equipment and bandwidth services | 61.8% | 61.9% | 61.3% | 61.1% |
| Staff costs | 14.7% | 14.0% | 14.8% | 14.7% |
| Finance costs | 2.4% | 2.1% | 5.3% | 15.4% |
| Shares on issue* | 0.6% | 1.1% | N/A | N/A |
*represents an increase in the shares on issue compared to the previous year. I.e., there were 0.6% more total shares in the first half of 2016 compared to 2015. 2015 had 1.1% more shares than 2014, etc.
**Due to technical issues with Speedcast's site I was unable to source full data for 2014 and 2013.
After nearly four years of data, readers can see that Speedcast's costs look to be essentially fixed, despite a significant increase in the size of the business. So far the company has always had to pay around 61% of its revenue on equipment and bandwidth services. An additional 15% of revenue has typically gone to staff costs, and finance costs are a modest 2% despite the company's higher levels of debt. With ongoing acquisitions, this will remain an important cost to keep an eye on.
Investors should also remember the hidden impact of share issues, nibbling away in the background. Although their impact has been modest so far, over the long term they could start to bite. Shares on issue are expected to jump by 17 million in the full year 2016 thanks to the recent WINS Limited acquisition and subsequent raising.
Not building economies of scale
With Speedcast so far not demonstrating economies of scale (where costs become a smaller percentage of revenue as the company grows) so far, I'm not convinced it will begin to generate them in the future. Even though management has touted significant synergies from recent acquisitions, that hasn't had an impact on costs as a percentage of revenue – which have remained remarkably fixed despite rapid growth.
The company is profitable enough after operating costs are accounted for, and investing in further expansion makes a lot of sense. Today's price probably isn't too much to pay for Speedcast, but I'm conscious that as the company gets larger, the increasing number of shares on issue and a declining number of opportunities might come home to roost. This is especially important since Speedcast's operating sectors are competitive, as hinted at by management's comments on capacity, and it's uncertain if Speedcast will have much ability to pass on price increases to customers.
I'm still fence-sitting on Speedcast, but at least for the time being I have decided not to buy shares.
