M2 Group: Interim result 2015
Recommendation
M2 Group is quite a conundrum. It operates in a highly competitive sector, with little in the way of hard assets and no obvious competitive advantages, yet it's been able to increase earnings per share tenfold since listing in 2004. And because it doesn't bother with such trifles as assets, most of that profit has appeared as cash – funding a string of acquisitions to support the growth, even while half the profits have been paid out as dividends.
So what's the secret sauce? Many put it down to those acquisitions which, in an industry offering considerable economies of scale, have offered plenty of scope for cost-cutting. But the company's latest interim result proves it can grow quite happily on its own, with revenue increasing 8% and underlying net profit rising 16% to $51m despite no significant business purchases.
Key Points
Company enjoying strong growth even without acquisitions
Increasing proportion of electricity, and entering gas
Raising Sell price to $11; Hold
While acquisitions have no doubt helped build scale, the true secret to M2's success is that the flexibility allowed by its lack of hard assets, combined with astute management, have kept revenues rising, while operational leverage due to economies of scale have kept earnings rising quicker.
The trouble for investors is that such advantages as flexibility and astute management can be fleeting and operational leverage can work in reverse; the good news is that there's an obvious solution to it all – you give yourself a big margin of safety when you buy and take profits on the way up.
Six months to Dec | 2015 | 2014 | /(–) (%) |
---|---|---|---|
Revenue ($m) | 546.2 | 506.0 | 8 |
EBIT ($m) | 62.9 | 53.2 | 18 |
U'lying net profit ($m) | 50.6 | 43.8 | 16 |
U'lying EPS (c) | 27.8 | 24.5 | 13 |
Interim dividend | 15c (up 30%), fully franked, ex date 24 Mar |
When we first recommended M2 in M2 finds life in Dodo on 18 Oct 13 (Buy – $6.02), the market could only see the negatives, putting the stock on a forward price-earnings ratio of less than 12. Now investors are focused on the positives, pushing that multiple up to about 17 times the 57 cents of pre-amortisation earnings per share expected for 2015.
Energy firing up
The company has certainly done well over the past six months. Total services in operation increased 4% between June and December, with growth of 3% and 5%, respectively, in fixed voice and broadband on flat average revenue per user (ARPU). Energy grew 15% alongside a 4% fall in ARPU, while 'post-paid' mobile services fell 1% alongside a 21% rise ARPU.
Importantly, the balance between the various sources of revenue has shifted away from fixed voice, which is particularly threatened by voice over IP telephony and the NBN, and towards Energy, which has the highest ARPU at $111 per month and is the least technologically threatened.
The company's energy product for business customers, Commander Electricity which was soft-launched in March 2014, had 1,200 subscribers at 31 December paying an average of $314 per month. The product got its full launch in February, so it will be interesting to see how it's going in the full-year results. The company is also moving into gas, with a Dodo offering a combined electricity and gas bundle in NSW from this month.
All of this plays to the company's strength of selling bundled products and services to its large customer base.
Take profits and let it run
Cash flow showed another solid performance following the shock of deferred commissions introduced with the acquisition of Dodo (see M2: Interim result 2014 on 20 Mar 14 (Buy – $5.99)). Free cash flow of $38m represented 75% of the underlying net profit of $50m, after capital expenditure of $14m. Following the payment of $20m of dividends, net debt fell by $20m to $235m, which is higher than we'd like, although the interest bill is covered about eight times by operating profit.
Management maintained full-year guidance of a 15-20% rise in net profit, which translates into underlying earnings per share growth of about 12% to 57 cents. With the stock up 40% since M2: Result 2014 on 26 Aug 14 (Hold – $7.11), that puts it on a forward PER of 17 and a free cash flow yield of around 4.4%.
As already mentioned, it's hard to know whether or when M2's excellent run of growth will come to an end, so we recommend taking profits along the way and keeping your portfolio weighting below 4%. With that proviso, we're raising our Sell price to $11 and our Buy price to $7. HOLD.