Is it time to buy Vocus and TPG?
Since September, shares in Vocus Communications (ASX: VOC) and TPG Telecom (ASX: TPM) have been savaged by the market. Margin pressure coupled by the possible entry of new competitors has led to a wave of selling. The upshot is that these telcos are now trading on seemingly attractive multiples. So, is it time to buy?
Back in August, we outlined our case for Vocus Communications Limited (ASX: VOC). While we believed it to be a quality company, its share price had exceeded our estimate of fair value and the growth assumptions required to justify a share price of near $9 were in our view too optimistic.
Since then, the share price has fallen back to below $4. Over this timeframe there has been a significant amount of talent leaving the business – James Spencely, Tony Grist, Head of Sales Matt Hollis to name just a few. FY17 earnings expectations have also been downgraded and the firm’s future profitability is in question given concerns over the cost of reselling NBN retail services.
However, relative to the firm’s historical financials this telco looks like a bargain. So why don’t we buy more?
The same case could be made for TPG whose share price has fallen from circa $12 to around $7.
A couple of issues come to mind. Firstly, as above, it’s very difficult to get comfortable around the margins that an NBN reseller can earn over the long term. Many market participants have an opinion on what it could/should be – however, there’s no solid evidence as to who’s right.
To illustrate this point, I’ll use an example. Let’s consider an average NBN plan costing about $70 per month with a speed of 25mbps. The retail provider earns $63 after GST and might have to pay about $15 per month for staff/overheads leaving $48 for wholesale costs and its own margin.
If the $70 NBN plan has a speed of 25 mbps, it’ll cost the telco $27 per month to connect to the NBN, so $21 is left. We still have bandwidth charges (known as connectivity virtual circuit charges, or CVC charges, which are paid to NBN) and the retails provider’s profit margin to think about.
Most market estimates peg CVC in the range of $15-$20 for a plan like this meaning an operating profit of $1-$6 per plan per month. Hardly a compelling proposition.
More bullish investors are pointing towards NBN’s intentions to introduce discounts to retail providers who buy capacity in bulk and that because of this, retail provider margins would supposedly rationalise. This might end up being true, but whether the discounts are enough to rationalise margins is uncertain. Further, data demand by retail broadband consumers is growing at circa 30-50 per cent p.a. meaning that any discounts would need to be a greater magnitude to offset this grow as well as rationalise provider margins.
And let’s not forget, what of new entrants? Vodafone is proposing an entry into the market, as is MyRepublic and others. These additional competitors will also present margin pressure.
From a valuation perspective, it’s not difficult to see upside for TPG and Vocus. But as the above demonstrates, that upside is dependent on a fragile set of assumptions that could easily change.
For now, the safety of cash seems like a better option.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Lawrence Prasat
:
Hi Scott, just to echo a previous comment. You mention that your 180 degree change of opinion on this company (VOC) tracks changes in the quarter. Those being (to paraphrase) (1) departure of executives, (2) a reduction in full year earnings expectations and (3) concern about margin on NBN resales. But this is a strange “thesis buster” because reason (1) is a neutral, given the opportunity for new tenant to come in, possibly a slight positive or negative- depending on your experience; reason (2) is a neutral, given that immediate term earning were flagged as subject to challenge by the company itself at the time of the Nextel deal and certainly not unique to this company, after all we are talking “short term” and “expectations” – exactly the kind of thing value investors should not be hanging their hat on; and reason (3) has been a perennial concern for some time now – hardly a new uncertainty, more a structural risk in the sector since the NBN started to gain speed in the last 2 years. So what has ACTUALLY changed in the business over the last 3 months to get to that 180 degree change? What have I missed? Thank you for your opinions.
Scott Shuttleworth
:
Hi Lawrence, thanks for your question.
With regards to (1), it’s our view that the departed executives were a ‘cut above the norm’ and that their departure was a detriment to the company. It’s not a ‘thesis buster’ in itself but their expertise and commercial knowledge helped drive both Vocus Communications and Amcom to high levels of profitability.
With regards to (2), this is not a ‘thesis buster’ either. We had already taken the decision to exit Vocus prior to this event and had a minimal holding by the time the deal was announced.
In fairness, both (1) and (2) were simply the introduction to the article. The real change to our thesis was explained in (3).
Now you’re correct that with regards to (3) it was a risk that had been flagged some time ago. However the view that I formed was that CVC charges would be reduced in order for NBN retail plans to remain reasonable. It’s true that CVC charges have been reduced, the problem is that the reduction has not been enough.
In addition, the industry appears to be moving in an irrational direction with respect to NBN plan pricing – margins are being sacrificed in order to gain market share. So higher costs are not being offset to the extent that they normally would’ve been. This is a very recent development.
So taking all this into account – Yes there was uncertainty prior, however in my view, the uncertainty has now increased since irrational pricing creates an environment where the upside risk for CVC costs cannot be offset.
Norman
:
I am super confused by this one Scott. The and half months ago, margin on NBN revenues was well the same as now, unknown. What facts changed for your opinion to change so dramatically?
Scott Shuttleworth
:
Hi Norman, thanks for your question. I think the answer to your question is in the above article but please let me know if I’ve misunderstood.
John
:
Pretty sure Telco’s will pass additional NBN related costs straight on to customer rather than reduce profit margin. PM has said he’ll be kinder to smaller Telco’s and harder on Telstra, who’ve had a rails run to date.
Scott Shuttleworth
:
Hi John, thanks for your question. In relation to telco pass through, that’s a reasonable expectation however it’s not what’s currently occurring in the market.