Fish Carefully Among Telco Minnows

The telecommunications landscape is littered with the carcases of small (and some not so small) failed companies '” OneTel, Flowcom, Eisa, NewTel '¦ the list goes on. Dozens more were bought out at tiny fractions of their former prices after the technology bubble burst, while others were forced into shotgun weddings. But why, six years after the bubble burst, is the fallout continuing?

The industry is in a state of flux, perhaps even turmoil. It shouldn’t be a great surprise, because technology is changing the way communications are delivered '” and quickly. On top of this, telecom networks are expensive to build, barriers to entry are low, at least for resellers (see below) and competition is cut-throat.

Surveying the landscape from above sits former monopoly provider Telstra, which isn’t keen on surrendering market share and is not afraid to price its products aggressively. Add to this an uncertain regulatory regime, and the telecom sector doesn’t seem like very hospitable territory for the investor.

Infrastructure advantage

But uncertainty can create opportunities, and we think there’s some value here, although it will pay to be picky. In researching these companies, it became clear that the ones with their own infrastructure have an advantage over resellers, the telcos that simply resell the services of wholesalers such as Telstra and Optus. With Telstra, in particular, keen on jacking up its wholesale charges, resellers have been doing it tough.

So we’ve concentrated on the companies that own at least some network infrastructure. As we see in a moment, though, even this isn’t enough '” customers are vital too.

At the height of the technology boom in 2000, PowerTel was capitalised at $1.8 billion. It’s a testament to just how far out of whack everything was back then that the market capitalisation of this company today is about $150 million.

Like many companies during the technology boom, PowerTel spent a vast sum, about $500 million, building infrastructure '” fibre-optic cable within and between Brisbane, Melbourne and Sydney. Its strategy then, as now, was to sign up business and wholesale customers, such as internet service providers, who want voice and data services but who don’t want to use Telstra.

The problem is that there are only so many business customers to go around and competition is intense. But PowerTel has done a good job of acquiring customers in recent years, as you can see from the revenue growth in Table 2. In fact, the company is likely to report a net profit for the first time in 2006 (its financial year ends on December 31), and it recently turned cash flow positive.

As an aside, it’s free cash flow, defined as operating cash flow less capital expenditure, that matters in this industry. Be wary of capital-intensive businesses, such as telcos, claiming they are “EBITDA positive”. EBITDA does not tell you how much cash a company produces after spending to develop and maintain its network. Free cash flow does.

PowerTel’s improving performance has been helped by some smart alliances with other small telcos. For example, in 2001 it signed a deal to allow reseller Macquarie Telecom access to its network, taking a 10% shareholding. It has been so successful '” for PowerTel at least '” that the company is trying it again. PowerTel recently took a 15% placement in beleaguered internet service provider (ISP) iiNet, forming an alliance to move the latter’s traffic on to its network.

To us, PowerTel’s relatively new management, installed after Hong Kong-based private equity firm TVG took a majority stake, looks very sensible. It treats shareholders as partners, and its alliance-driven revenue strategy is working. It’s relatively early days but the company is clearly making progress. We’re also reassured by the fact that TVG and directors have been buying shares. So if you’re an existing shareholder, there’s enough reason to hold.

iiNet buys a lemon

Without PowerTel’s placement, the West Australian-based iiNet would have been in trouble, and it’s not out of the woods yet. While the company was highly regarded for its management and technological prowess, it bit off more than it could chew by acquiring OzEmail in early 2005, which made it the third-largest ISP in Australia.

iiNet’s systems and financial resources have been stretched by the acquisition at a time when its profit margins and free cash flow have also been under pressure (see Table 3). Following several profit downgrades, iiNet’s market capitalisation has collapsed from more than $350 million to about $80 million. Although iiNet might represent a turnaround situation eventually, the risks remain too great for us at the moment. Avoid.

Three’s a crowd for Amcom

Amcom, also a West Australian company, is a bit like a miniature PowerTel, having spent about $50 million building fibre-optic cable networks in Perth and Adelaide. Backed by industrial conglomerate and 30% shareholder Futuris Corporation, Amcom has also been seeking customers for its network.

In fact, Amcom’s determination not to miss out seems to have been behind it buying a 20% stake in iiNet after the latter recently agreed its deal with PowerTel. The $18.3 million stake, financed with a convertible loan from Futuris, is a big bite for a company with a market capitalisation of $55 million.

Amcom argues that it has superior infrastructure to PowerTel in Perth and Adelaide, which is undoubtedly true. But, following iiNet’s acquisition of OzEmail, most of its traffic is east coast-based, which is exactly where PowerTel’s network is located. So while Amcom’s network complements PowerTel’s, the former has paid a big price to potentially acquire a relatively small amount of iiNet traffic.

All in all, while the Futuris relationship is worth something, we’re not convinced Amcom has sufficient scale to succeed. We might be accused of having a set against West Australian companies, but we recommend you avoid Amcom as well.

SP Telemedia finds its soul

The largest of the four stocks we looked at in this review, and the most diverse, is SP Telemedia, which owns the “Soul” brand you may have seen advertised (rather irritatingly, it must be said). The company has a market capitalisation of $312 million and is part of the Washington H Soul Pattinson empire, with the conglomerate owning 45%. As you can see from Table 4, the company has been growing quickly, mainly by acquisition, but free cash flow has been surprisingly strong, largely because it has built or acquired high-quality infrastructure.

SP Telemedia is a somewhat unusual collection of three businesses, ranging from excellent to mediocre. Its best division is the NBN television network, the Nine Network affiliate for northern New South Wales and south-east Queensland. SP Telemedia acquired NBN from Soul Pattinson for $145 million in mid-2004, with the affiliate generating a net profit of about $8.5 million annually.

At the other end of the quality scale, it owns a 46% stake in B Digital, which provides internet, voice and mobile services to residential customers under brands such as B, Kooee, and Digiplus. B Digital is suffering from margin pressures and losses in several of its divisions, which will be largely responsible for the poor performance of SP Telemedia this financial year.

Somewhere in the middle of the quality spectrum is SP Telemedia’s third division, SPTCom, which is a very extensive broadband infrastructure network jointly owned with B Digital. SP Telemedia bought Comindico, as SPTCom was then known, from the receivers in late 2004, paying $28 million for a network that cost almost $400 million to build.

While SPTCom has suffered from pricing pressures of late, SP Telemedia has reined in losses significantly and we expect it to become profitable soon, particularly as B Digital’s traffic is moved over to its network and it wins other customers.

Regional focus

There are plenty of reasons to like SP Telemedia. The company is well managed, with a culture of cost control and financial discipline that harks back to its Soul Pattinson pedigree. Perhaps most advantageous of all, though, is the company’s focus on regional markets. Not only are they less competitive than metropolitan markets, but state and federal governments are encouraging regional telcos to develop infrastructure in those markets, so there’s a financial tailwind.

SP Telemedia is also likely to be one of the leaders of any sector consolidation. The company was interested in buying Telecom NZ’s Australian reseller subsidiary AAPT last year. Although the price was too high, we would not be surprised to see Telecom NZ eventually sell AAPT to SP Telemedia, with its traffic then being moved over to the SPTCom network. In this industry, a reseller’s dud business can be an infrastructure owner’s gold mine.

Like any small telco, though, SP Telemedia has plenty of risk. B Digital isn’t a great business, although its 500,000-strong customer base has some value. SP Telemedia also has a complex corporate structure, although we expect some simplification over time, most likely by buying out the minorities in B Digital.

On top of this, as we saw with iiNet, acquisitive companies can come unstuck if they become too big for their boots. Add to that the ever-present threat of competition, and this company is certainly not for widows and orphans.

But the stock is trading at its lowest level for three years due to concerns about the industry and B Digital’s performance, and we think investors are ignoring the company’s other strengths. There’s also some “blue-sky” potential from moving resellers’ less profitable traffic on to its own network, as described above. We’re commencing coverage on SP Telemedia with a long-term buy recommendation.

This article first appeared in The Intelligent Investor. Share prices have been updated. On July 27, Amcon, a 20% shareholder in iinet, announced its chairman Tony Grist would become a director of iiNet.