NetComm: Better than it seems

NetComm Wireless (NTC) reported a solid half year result with revenue up 53.7 per cent to $A46.4 million and EBITDA up 123.5 per cent to $5.1m.

The positive from the result was a greater than expected contribution from the Australian NBN/Ericsson fixed wireless contract. Approximately 40,000 units were delivered in the half compared with 33k units in the full FY15 year.

The company has aggressively capitalised $A2.1m of costs associated with winning contracts. Although this potentially over-states the result, it is all dependent on management's assessment of its likelihood in winning the relevant contracts. Additionally, there was a $2m increase in operating expenditure.

At the divisional level, the broadband business had a decline in revenue of 9.2 per cent to $A15.2m following an above expected 2H15 contribution. The M2M division was above expectations, up 131.6 per cent to $A31.2m, supported by domestic NBN fixed wireless volumes.

Operating cash flow

One of the potential reasons the share price initially sold off after the result is related to a weak operating cash flow. But after going into more detail, it can be seen that it is a one-off working capital adjustment due to holding inventory for longer. The reason for this is now that the delivery of NBN fixed wireless units has ramped up, there is a worthwhile cost saving from shifting from air freight to sea freight. Management has estimated that this saving is $14 per unit, and had a one-off $7m working capital impact. If you remove this working capital impact, then cash flow conversion was as expected. Moving forward the cost saving is expected to continue, and as such provides the opportunity to increase gross margins.

US rural broadband contract

The company is yet to provide sufficient details to accurately forecast earnings for the large US Rural Broadband Contract. We have previously assumed it could be up to 13 million units. Although this assumption was not confirmed, management did confirm that the volumes will be much larger than the Australian NBN fixed wireless contract.

Multiple free options

Although forecasting earnings is currently difficult, there are a number of free options that have not been priced in. The magnitude of some of these opportunities is large enough, that even if for example there was a delay to the rollout of the US NBN broadband contract, there are enough other opportunities to provide significant share price upside from these levels.

For example, company chief executive David Stewart is currently in Barcelona for a large global mobile conference. All the big players are in attendance, and it would not surprise if he came back with further contract wins. There are multiple NBN contracts that could be awarded, for examples in Ireland, Germany, France and Mexico. There are also other M2M opportunities, and as we approach 2020 the rollout rate of M2M work will continue to increase.

Domestically, there is a politically sensitive issue regarding the drop-off in internet speed for some planned HFC and FTTN work. Netcomm (NTC) has a solution that is more expensive, but less expensive than reverting back to higher speed FTTP. Given this is a politically sensitive issue for the NBN, there is potential for NTC to win this work in the near-term. During the analyst conference call, management was very bullish in regards to the potential size of this work.

Australian NBN rates lifting substantially

With the overall project behind schedule, we expect the fixed wireless activations to remain at a very healthy rate for the next 2-3 years. This reduces earnings risks for NTC, especially as in the past the activation rates have been inconsistent.

Management increases costs for future gains

When looking at short term earnings, it needs to be remembered that NTC is taking on additional costs to build capabilities for future potential large contracts. Given the magnitude of M2M connection opportunities available in the next five years, we view this short term impact of additional costs as a positive step by management to increase the chances of creating longer term shareholder value. Most analyst valuations don't adequately consider that current earnings include some costs, without future matching revenues.

This dynamic is especially true in the global fixed wireless space, with NTC building an early mover advantage in gaining valuable experience from winning both the Australian and only US contract awarded to date. If NTC were to win one of European rural broadband contracts, it would only further enhance this competitive advantage.

Although it is true that there are multiple competitors who can provide similar devices, evidenced by the fact there were initially 12 competitors bidding for the US contract. But if these competitors don't get the opportunity to rollout their devices, then their service offering is likely to fall behind Netcomm's (NTC).

Balance Sheet

The working capital build resulted in a material increase in net debt to $9.8m. Additionally there was the $2.1m expenditure for new contracts, and a $2.2m expenditure on PP&E (vs $A0.2m for 1H15A). $11m of the $15m bank facility was drawn down, though this is likely to reduce in the second half. However, if required NTC can increase its debt capabilities with the sale of some customer receivables (and receive cash within 15 days).

Management were stating in the analyst conference call that they expected gearing to reduce going forward. The uncertainty with this would be capital requirement due to winning additional contracts. However, any such announcements would be likely to get a positive response from the market and enabling cheaper capital management initiatives if required.

Outlook

Management has guided towards a further increase in domestic NBN volumes in FY17. This assumption is supported by public commentary from the NBN. They also expect revenues to flow in FY17 from the recently signed US contract.

Although not specific enough to accurately forecast earnings, as previously stated management did confirm that the US opportunity is much larger than the domestic NBN contract.

In relation to the broadband business it is expected to continue generating around $30m in annual revenues. However, there is opportunity from a potential 8.5 million ADSL devices that will become obsolete during the rollout of NBN and will be replaced by VDSL devices, fibre or cable devices.

Valuation / Summary

We have an increased $3.60 valuation, with increased assumptions for the US broadband contract. We are comfortable with the relatively aggressive US assumptions, because if they are delayed or not what we expect, then there are multiple other opportunities that will likely pick up the slack.

As Netcomm (NTC) continues to win contracts, the risk profile of the business is declining through diversification. At current levels we believe the market, and particularly institutions investors are not adequately supporting the stock and are underestimating the significant earnings growth momentum.

As such, we are upgrading to a buy recommendation with a $3.60 target price / valuation.