A tough call on M2

PORTFOLIO POINT: A combination of balance-sheet factors, including the sell-down of shares by the company’s founders, has lessened the appeal of M2 Telecommunications.

It takes courage to found a business, it takes strategic excellence to successfully execute, and it takes great intelligence to monetise the opportunity with sustainability.

One of the great stories of the Australian entrepreneurial landscape is M2 Telecommunications (MTU). Founded by Vaughan Bowen in November 1999, MTU was floated on the ASX at $0.25 per share on October 28, 2004. At the time Vaughan and his father and chairman, Max Bowen, owned 19.33 million shares in MTU.

The table below details the company’s revenue, net profit after tax, equity, return on equity, and dividends per share, together with consensus forecasts for the year to June 2012 and 2013.

Over the period under review Vaughan Bowen has shown enormous discipline in acquiring and integrating 12 separate businesses, purchased mostly at miserly multiples.

Together with organic growth, these acquisitions have helped drive a spectacular boost to the Company’s revenue, profitability and dividends per share.

Shareholders lucky enough to join the float at $0.25 per share have received approximately double that in aggregate dividends. And the icing on the cake is the price of MTU exceeding $3.50 on a several occasions in the past 15 months.

Chart 1. Skaffold value line chart of MTU

As any company develops there are personnel changes, especially when staff numbers jump from 35 to 750 over the period under review. In November 2011, 12 years after founding M2 Telecommunications, Vaughan Bowen stood down as CEO to concentrate on mergers and acquisitions, but since that move he has sold a meaningful portion of his shares.

Industry veteran Geoff Horth was promoted to CEO. At the same time Max Bowen retired from his directorship of the company. In itself, this should not be overly concerning.

What is concerning however, is the share ownership changes by Vaughan and Max Bowen. This has declined from 19.33 million shares at the time of the float to the current 6.05 million shares, or less than 4% of the company’s issued capital. The vast bulk of the 13 million shares sold was done in four tranches. Net of option exercises and purchases of rights, 5.5 million shares were sold in fiscal 2008, 2.5 million shares were sold in fiscal 2010, 2.6 million shares were sold in fiscal 2011 and around 2.4 million shares were sold in fiscal 2012.

We only invest in high-quality companies that are available at a discount to our estimate of their intrinsic value. There’s a bit of science to that. What we cannot predict, for example, is the selling of shares by a director (M2), or the price of iron ore (BHP), or the loss of contracts (mining services). We spend a great deal of time looking at the science, but if we don’t try to anticipate these other factors we are like a man driving at 200 km/h while staring at the calculator in his lap.

With the 70% decline in the Bowen’s shareholding, we wonder whether the founder, mastermind and strategic genius behind M2 Telecommunications growth is monetising 12 years of hard work? We think, yes.

Should other shareholders be wary of this significant change on the M2 Telecommunications share register? Yes. Is it something that can be quantified? No.

Will their biggest acquisition yet, Primus Group, be the success shareholders hope for? One wonders what the founder Vaughan Bowen must think about this if he selling so many shares.

In summary, M2 Telecommunications has paid $185 million, net of cash, for approximately $300 million of revenue and a forecast $46 million of EBITDA, or a prospective Enterprise Value to EBITDA multiple of 4.0x. On the surface this looks cheap. The concern I have largely surrounds the deterioration in M2 Telecommunication’s balance sheet. This is detailed as follows:

We are not saying M2 Telecommunication is an outright sell. As seen in Chart 1, Skaffold now has a valuation of $3.45/share. But I have recently followed Vaughan’s lead and reduced our MTU shareholding above $3.50. This move is based on the indigestion that accrues from the very large and unproven Primus acquisition combined with the deterioration in the company’s balance sheet.

Roger Montgomery is an analyst at Montgomery Investment Management and author of Value.able, available exclusively at rogermontgomery.com.