An opportunity 150 years in the making
It's not easy to put an investment opportunity of this magnitude into perspective. So allow me to start at the beginning… all the way back in 1858 to be precise.
By today's standards, it was a no-tech era. Samuel Morse had only patented the telegraph 20 years earlier, and telecommunications were just beginning in Australia, with the first inter-colony telegraphs being built between Sydney, Melbourne and Adelaide.
In 1901, the newly federated Commonwealth Government rolled them into Telstra's precursor, the Postmaster-General's Department (PMG), which had been established to manage all domestic telephone, telegraph and postal services.
Telecommunications come of age
While none of us were alive in 1858, many will remember when telecommunications was deemed important enough to stand on its own two feet. The year was 1975 and the Telecommunications Act separated Telecom Australia from Australia Post.
Telecom was rebadged as Telstra internationally in 1993 and domestically in 1995 and remained a state owned monopoly until 1997.
1993 and 1995 are key dates in this story for another reason. But first, let's jump back a few years.
One small step for the internet
The year was 1969, and it was still a relatively low-tech time in our history.
Although mankind had just landed on the moon, the more important event for our purposes was the birth of the internet – or at least its early precursor, known as Arpanet.
Everything moved slower back then, especially internet speeds and growth. By 1990 there were only 5-10 million worldwide users of the internet. That was pretty slow over the 31 years since Arpanet's humble beginnings in 1969 when the first network spluttered to life with the message "lo". They were trying to spell log-in, but the system crashed!
One giant leap into the World Wide Web
The internet as we now know it came to life in 1990 when Tim Berners-Lee created the World Wide Web. The first real browser, Mosaic, launched in 1993. Microsoft Windows 95 launched in 1995 – no prize for guessing that year correctly – with a web browser included. At that point there were 30-40 million internet users globally.
While computers, the internet and browsers of that period were painfully slow, it was an age of unprecedented technological advance. Suddenly the world became much smaller. Conversations spanned thousands of miles and information could be shared instantly! The world was starting to speed up.
Privatisation and Competition arrive
Two years later, in 1997, the burgeoning Australian telecommunications sector was opened up to full competition. That was huge news at the time, especially for nimble young entrepreneurs. The same year, Telstra was partly privatised when the Commonwealth sold 33% of its shares to the public.
Things were starting to heat up in the telecommunications market. The birth of our top stock was then only two years away.
A game changer – the National Broadband Network
Let's be clear – the NBN is unlikely to be good value for money. However, putting the price, politics and stupid decisions behind us, the NBN will be of tremendous value to Australia. It is the essential infrastructure of the 21st century. Paul Keating might call it the infrastructure we have to have.
Not only will the NBN create value for the country, it will also create tremendous value for the best positioned telecommunication companies.
Customers are king
The NBN will create a level playing field. That will give smaller companies with the best service, the best products and the best brands a massive leg up.
OK, let's get down to brass tacks. You've been patient while I've laid out the scope of this opportunity, and now it's time to reveal how you can make some money from it.
As I said, the NBN will dramatically change the telecommunications playing field in Australia. Brand, efficiency and customer service will matter more than ever. There is one company in Australia which has made those three key elements its priority over the last five years.
From a standing start in 1999 this fast growing business now generates around $430 million in annual revenue. Whether by vision or good fortune, this company's 'reseller' business model gives it a massive head start in the NBN world.
Our Top Stock for 2012: M2 Telecommunications
M2 Telecommunications Group (ASX: MTU) started life in 1999 with a vision to create value in the newly deregulated telecommunications sector. Since then, M2 has delivered amazing performance and growth. In 11 years it has become the largest 'network independent' telco in Australia, with 2011 marking M2's tenth consecutive year of growth in earnings and earnings per share.
M2 is a supplier of telecommunication services to small to medium businesses (SMBs) via wholesale and retail channels in Australia and New Zealand. Listed in on the ASX in 2004, M2 operates a multi-brand reseller business model, best known for the the Commander, People Telecom, Southern Cross and M2 Wholesale brands.
M2's high level of customer service is one of the company's competitive advantages. The SMB market seeks a higher level of service than they can get easily from major Australian telcos. M2 ensures SMBs get the service they require. It's perhaps no surprise that 8 out of 10 of M2's new customers come from Telstra.
M2's revenues have grown 59% per year for the last five years, with 70% of that revenue from fixed line services, while mobile and broadband each contribute around 15%. Despite falls in the number of fixed line services in Australia, fixed lines remain an essential service to SMBs.
Impressively, 70% of the company's revenue growth in the December half was organic. While acquisitions have been a core competency and growth driver, it was pleasing to see M2 can still grow revenues within its current business.
Earnings growth has been outstripping revenue growth over the last three years, with profit up 50% per year compared to 37% compounded revenue growth. Naturally we love that! This stellar performance is due to margin expansion as M2's scale delivers efficiency and pricing improvements.
M2's low capital requirements allow for both 70% of profits to be paid as dividends and still grow faster growth than the capital intensive telco sector. While growth is good, being paid handsomely to wait for that growth to translate into capital gains is even better.
M2 has a high return on equity business model. At the 2010 AGM, CEO Vaughan Bowen promised margins would expand and return on equity (ROE) would continue to improve. M2 certainly delivered on that promise in 2011 and has provided guidance for further margin expansion in 2012. With an ROE over 35%, M2 is one of the best performing businesses in Australia.
Those high returns on an asset light, service-focused business model mean M2 is well positioned to prosper from Australia's NBN. I believe shareholders will also be well rewarded.
While I like growth, I love a share market sale even more. The combination of the two gets me excited. When this report was originally written M2 was a growth company on sale. Although its share price has risen strongly since the end of 2011, M2 remains a compelling investment opportunity for long-term investors.
M2's 2011 full year results were a mixed bag. The company reported towards the upper end of its guidance on most key numbers. The notable exception was revenue, which the market has focused on, while giving little regard to the underlying business strength.
In that myopia lays our opportunity. While the market focuses on M2 missing revenue guidance, I see a company that is improving efficiency, expanding net margins and delivering higher returns to shareholders.
In March 2011, M2 increased its earnings guidance by around 20%. That was on the back of better wholesale rates lowering M2's cost of business. The market celebrated and sent M2 to an all-time high of $4.08.
As I mentioned, M2 met the upper range of its increased earnings guidance. M2's scale, operational efficiencies and improved wholesale rates allowed more money to flow to the bottom line.
Here are the key figures.
% Change FY10-11
380 – 420
58 – 62
30 – 34
24 – 28
|EPS (cents underlying)||
27 – 31
|Final Dividend (cents fully franked)||
|FY Dividend (cents)||
Importantly for shareholders the largest growth was in M2's dividend. The final dividend increased a massive 80%. At around $3.40 M2 has a trailing twelve month dividend yield of 5.4%.
Looking ahead, with a payout ratio of 70%, the fully franked forward yield should be close to 6%, that's better than the highest paying cash account.
Growth is good, a discounted price is fantastic, but those two combined with a superb cash return is better yet.
Valuation and Key Metrics
I value M2 at $3.80 – 4.20, with upside potential dependent on good acquisitions and market sentiment. Downside should be limited – GFC mark II aside – giving M2 an attractive risk/return profile.
A price around $3.40 gives a price to current earnings of just over 12.5. The forward P/E is 11 based on my estimate of $0.30 underlying earnings per share in the 2012 financial year. M2 reaffirmed its guidance 27-31 cps underlying earnings in February. They are attractive price multiples to earnings for a company with plenty of opportunities to grow.
M2 is currently trading at around 8 times EBITDA (earnings before interest, tax, depreciation and amortisation – effectively operating cash profit), which is close to the lowest multiple since 2009.
Cash from operations increased significantly in 2011, leaping from $13 million to $40 million. That was enough to almost cover M2's major acquisitions and capital expenditure.
M2 has a strong balance sheet. Despite the $24.5m acquisition of Clear Telecom earlier this year, M2 has a lowly geared balance sheet, with only $10 million of net debt. 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.
While the growth in cash flow was excellent, I'd like to see M2 reduce its need to borrow.
M2 has undertaken eight major acquisitions since April 2009, all bought at multiples of between 1.5 – 3 times EBITDA. That's cheap, damn cheap.
The best of its acquisitions were undertaken at the height of the GFC. Those purchases of People Telecom and Commander highlighted the quality of M2's management. As every investor knows, buying good assets at the darkest hour is incredibly difficult to do. In doing so, M2 clearly signalled that its board and management are clearly focused on creating value for shareholders.
M2 has announced that Vaughan Bowen, the founder and current CEO, is transitioning to a non-executive role. After expertly driving the business for 12 years, Bowen will now concentrate on what he loves – acquisitions.
He leaves the business in the capable hands of Geoff Horth, the current Chief Operating Officer. Horth is well respected in the telecommunications industry and has been credited with driving much of M2's operational efficiency.
Key shareholders include one of Australia's best performing fund managers, Hunter Hall, which has a 10% stake. More recently the experienced telco investor John Cornish had built an 8.3% holding via his Cornish Group, but sold that down to 6.6% in December 2011. CEO Vaughan Bowen holds 5.7% having sold down from over 12% two years ago.
Risks and when we'd sell
The share market graveyard is littered with once promising telecommunication companies. In fact, M2 has prospered by picking over several carcasses. Investors must remain alert to any deterioration in M2's key metrics.
Telecommunications remains a fast-moving industry. New telecommunication may solutions marginalise M2's predominantly fixed line strategy, NBN costs and access may hurt margins (with details on both still unknown), and incumbent providers may actively target M2's core SMB segment of the market. Telstra is currently concentrating on mobile and broadband, but did flag a growing interest in the SMB market during its 2011 results presentation.
Lastly, if M2's service standards slip or one of its key brands is tarnished, or if the business overpays for an acquisition, we would reconsider the business case. Thus far M2 has cherry picked bargains, but investors should be alert to any lowering of M2's standards.
Foolish bottom line
M2 is built around a reseller business model and excellent customer service – two traits which give them a massive head start in the new NBN world. M2 have also acquired and built strong brands.
The recent market malaise and M2's revenue miss give us an opportunity to buy the best positioned telco in Australia at a discount.
At around $3.40, M2 is trading at significant discount to my calculated intrinsic value. I'm attracted by M2's strong balance sheet, capital-light business model, great customer service and customer retention, proven management, strong recurring revenues and excellent ROE.
The 5.4% dividend yield is icing on the cake.
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Last updated 2nd April 2012
This report has been written by Dean Morel. Employees and contractors of The Motley Fool, including Dean Morel and Bruce Jackson, may have an interest in any shares mentioned in this free report. At the time of writing, Dean Morel had an interest in M2 Telecommunications and Telstra. Bruce Jackson had an interest in Telstra. These interests can change at any time. The Motley Fool has a clear and concise disclosure policy.