Behind NetComm's rocky ride

NetComm Wireless (NTC) has achieved early success in transitioning away from consumer-based communication technologies towards the machine-to-machine (M2M) market. Evidence of this success can be seen from the supply contract with Vodafone, as well as the wireless roll-out for the NBN through Ericsson, and its smart meter contract with SP Ausnet.

Much of NTC's 32 years has been spent selling industry leading data communication or traditional fixed broadband devices through the wireless evolution.

Over the last couple of years, however, management has focused its efforts on setting the business up to benefit from the forecast M2M industry growth. In the recent 2013-14 results, 51% of revenue was from M2M, up from 20% the year before.

Investment opportunity

The M2M industry has forecasts from large telecommunications companies, such as Vodafone, suggesting there will be 50 billion connections by 2020. This provides large opportunities across a wide range of sectors. So far the competitive landscape is fragmented with a number of players expanding without directly competing.    

The growth potential comes with associated risks due to the fast moving technology, large competitors and the start-up phase of the M2M industry.

Currently a majority of NTC earnings are concentrated with a few contracts, and the company will need to continue to win work to justify the market price. The lack of scale and earnings visibility places NTC in the high risk category with a share price that is likely to remain volatile.

If the current weakness in the broader market continues NTC is a stock that is likely to underperform. This is because the stock trades on a very high trailing price-earnings (P/E) multiple and requires a risk-on market that is willing to factor in some of the future potential growth in a globally disruptive industry.  

Having said all this, the volatile nature of the share price means it's best to buy NTC when it is out of favour rather than when it's running hot after positive news. That is obviously assuming you do have a high risk tolerance and believe in the potential of the company to become a major player in the M2M hardware components market. 

It is also best to focus on the longer term opportunity rather than trying to pick the shorter term fluctuations. The timing of contracts is likely to remain a key share price driver, but some of this will be out of management's control. It will also only take one key overseas contract to provide a major uplift to the company's earnings and valuation. Management's investment and expertise in the rural NBN and smart meter roll-outs provides the potential to leverage that experience through multiple large overseas contracts.

Director ownership

Buying on weakness is exactly what the chief executive, chief financial officer and chairman did last week, with all three topping up their holdings at a share price just above 50 cents. The combined director ownership is now at about 23% of NTC, with chief executive David Stewart owning 18%. The $100,000 purchase from Chairman Justin Milne was particularly interesting considering he is also a non-executive director of NBN Co.

NBN Co. is expected to announce in the next month if it will expand the use of fixed wireless broadband (benefiting NTC) as per the recommendations in the independent fixed wireless and satellite review from the Boston Consulting Group in May this year.

Some will argue the smaller purchases from David Stewart and chief financial officer Ken Sheridan are not as meaningful, considering the very healthy cash bonuses they received during the year. While it's true they have benefited from NTC shares rising considerably over the past year, their combined cash bonuses of $750,000 appears excessive when considering the 2013-14 profit before tax was only marginally higher at $826,000.

Azure Healthcare (AZV) is a company with a similar market cap, yet achieved higher earnings and share price growth than NTC during 2013-14. By way of comparison the two key men there, chief executive Robert Grey and chief financial officer Jason D'arcy, received a combined bonus of $141,000. Further, their combined salaries of $407,000 are well below that of the two key NTC management personnel at $692,000.

Share price catalyst

In terms of share price catalysts there are two that will be in focus over the next month or so. Firstly, whether or not NBN Co. acts on the recommendations from Boston Consulting Group. Generally speaking the recommendations called for an expanded and fast-tracked use of fixed wireless in more areas than the previously approved rural and regional towns.

The other is a potential contract extension from SP Ausnet, due to a competitor failing to successfully connect about 300,000 units in the Victorian smart meter roll-out. In 2013-14 NTC received $14 million in revenue at a margin of 25% for the supply of the communication units for 120,000 Victorian smart meters. If the contract is extended, it would appear that there is at least another $30 million of revenue available for NTC over the next two years.   

Management is also working towards contracts in a variety of verticals and locations that could be announced at any time.

M2M industry background

M2M or “the internet of things” is a shift from knowing “what happened” to “what is happening” – all the time and then automatically controlling systems with that knowledge.

Further, this exchange of information between machines using a cellular network enables the capability to

• Monitor the environment
• Report their status
• Automate processes
• Receive instructions
• Take action

M2M has become a viable opportunity due to the reduced cost of implementation. The benefit is that the networked assets allow businesses to be more aware of operational progress, with a faster ability to react – which increases productivity.

Wide range of verticals

The long term objective is to achieve diversity of customers, geography and verticals. If this can be achieved it will dramatically reduce the risk profile of investing in NTC.

The current major industry opportunities are with

• Smart metering – can leverage overseas.
• E-Health – in-home devices.
• Industrial automation.
• Business services – point of sale, vending machines, digital display.
• NBN – Can leverage into other jurisdictions. Same challenges in rural regions occur in many other developed countries.

NBN wireless background

Prior to the report in May it was thought that the NTC opportunity to supply wireless for rural and regional NBN was approximately 250,000 units. This was assuming a 50% take-up rate from the 500,000 homes identified in the rural and regional areas appropriate for wireless. If this occurred then the opportunity for NTC was approximately $100 million in revenue over four years at a 25% margin. In 2013-14 there were 16,000 units, and in 2014-15 there are forecast to be 35,000 units.

However, the recommendations from the May report now suggest the opportunity for NTC is up to 750,000 units. This includes an expansion in recommended areas for wireless rather than fibre optic line. The expanded wireless usage has scenarios for both a temporary and permanent solution – with the assumption that the wireless rollout will be faster and cheaper.

There are no guarantees, but there is also no obvious reason why NBN Co. is not going to accept the recommendations. If this occurs it will be a major share price catalyst for NTC.

The changes would increase our 2015-16 and 2016-17 forecasts, with another part of the recommendation being that the roll-out occurs at a rate of 12,000 to 15,000 units per month compared to the current 4,000 per month.

The earliest the faster rollout could begin is January 2016, but if 150,000 units were rolled-out in a year it would provide NTC with $60 million revenue, which is roughly equal to its entire group revenue in 2013-14.

What NTC provides NBN/Ericsson

NTC provides the 4G device that connects all premises to the NBN's wireless towers. The device is designed to suit Ericsson's unique 4G methodology which guarantees speed for NBN users.

Significantly, the review from May concluded that the NBN was “prudent in terms of making choices around technology, network design and engineering”. This is a strong endorsement for NTC's ability to execute its domestic work as well as opening up opportunities for contracts overseas.

NTC is the sole supplier of the equipment and therefore its revenue is fully leveraged to any expansion in the NBN's wireless rollout.

Telco relationships

Currently NTC has supply agreements with Vodafone, Verizon and Etisalat Group. Management has an objective to win a further three relationships from top 20 M2M global telco players during the 2014-15 year. The relationship with Vodafone has been especially beneficial in enhancing the company's reputation as an innovative device supplier.  

Utility smart meters (electricity and water)

In 2010 there were 100 million smart meters installed around the world, but this is forecast to grow to 1.5 billion by 2020. This is due to the expectation of a more attractive investment return for project owners due to the enhanced ability for consumers to save money on their bills through efficient energy usage.

This represents a clear global opportunity, and NTC's successful job with SP Ausnet in Victoria is a step in the right direction. This produced $14 million of revenue in 2013-14 compared with nothing the year before.

“Coat tails” partnerships

Although NTC has unique engineering capabilities and intellectual property, it doesn't have the marketing reach to win global contracts by itself. As a result the company is focused on a “coat tails” strategy of partnering with larger global companies for supply agreements that will enhance the opportunity to increase scale.

In relation to competitive advantages the company has a relatively fast turnaround for customised solutions to meet specific needs of customers. Larger competitors may not be able to justify the customised solutions, but for NTC it allows for tight relationships and longevity with its customers.

The turnaround time for new customised products is generally 9 to 12 months. All manufacturing is completed offshore in China, providing a clear cost benefit that will only improve with scale.

Currently the most likely global growth opportunities are seen in North America, Europe, Japan, the Middle East, Australia and New Zealand.

Earnings and valuation

Revenue of $64.5 million in 2013-14 consisted of $14 million from SP Ausnet smart meters, $7 million from NBN Co., $12 million from Cubic and $32 million from the traditional fixed communication device business. Cubic is the transportation project with the Opal card in New South Wales.

Earnings before interest, tax, depreciation and amortisation (EBITDA) was $5.22 million from the year and net profit after tax (NPAT) was $1.02 million. Although those earnings margins may appear low, it needs to be highlighted that huge benefits are to be made from increased scale due to the high fixed cost nature of the business.

The 2014-15 revenue forecast of $80.7 million assumes growth from NBN Co. to $15 million, representing work that is already contracted. On top of that, we are factoring in that the SP Ausnet project extension is successful for $29 million, with no other new contract wins assumed. The benefits of scale begin to flow through here with a 25% increase in revenue – producing a substantial lift in NPAT from $1.02 million to $5.16 million.

The 2015-16 and 2016-17 respective revenue growth assumptions of 24% and 15% will most likely turn out to be too conservative. The NBN wireless expansion scenario would force these assumptions to be upgraded, and there is the ongoing potential for many other contract wins.

NTC's general aim is to achieve 35% gross margins for contracts under 100,000 units, and 25% gross margins for contracts over 100,000 units.

We have a $0.90 discounted cash flow (DCF) valuation (13% cost of capital), and a BUY recommendation for Netcomm Wireless (NTC). We have a High risk rating, with expectations of continued high share price volatility.

To see NetComm's forecasts and financial summary, click here.