Vita dials into Telstra's growth plans

The Vita Group (VTG) story began in 1995 when current CEO Maxine Horne and co-founder David McMahon opened the first Fone Zone store on the Gold Coast.

Horne and McMahon jointly own 46.5% of VTG, with McMahon retaining his stake despite no longer having any involvement with the company. He was co-CEO until January 2013, and finished as a director in June last year.

Horne’s background included working for Barclays Bank as a management trainee – but after about six months she determined that her calling was to pursue a more entrepreneurial path. After arriving in Australia from the UK, she identified a telco opportunity benefiting from her knowledge of the UK market. Subsequently the company owned the first mobile phone retailer located in a shopping centre in Australia.

By 2005 the company had grown to 120 Fone Zone stores and become the largest independent mobile and accessories retailer in Australia. In the same year the company acquired One Zero, which included its first five Telstra stores, and also completed its listing on the ASX. The Telstra relationship has become increasingly important for Vita, and today represents the company’s main growth driver.

It has not been all smooth sailing, however. The pre-GFC acquisition of Next Byte – an Apple reseller, has been a failure and resulted in significant goodwill write-downs over recent years. But after impairments of $34.4 million there is no further goodwill to write down. In the company’s defence, at the time of acquisition there were no Apple stores, and unlike now Apple products could not be purchased from multiple sales channels.

With Next Byte’s performance stabilising under new management, it should no longer cause as many headaches as it has in recent times. Management is comfortable with the current amount of stores (15). The latest $19.1 million write-down at the half-year result was taken due to the decision to abandon previous expansion plans to get to 25 stores.

In 2008 Fone Zone Group changed its name to Vita Group; Vita is Latin for “way of life” and reflects the way in which electronics and telecommunications equipment have become an essential part of our everyday lives. The name change was also in recognition of shifting away from being a pure mobile handset retailer to providing a broader range of telecommunications and computing products and services.

This is also around the time that management noted the increasing trend in the UK for telco/computing product producers to own their own stores. This triggered alarm bells that previously successful brands such as Fone Zone and One Zero would be on the decline. In anticipation of the trend moving to Australia, Vita management approached Telstra with a proposal to extend their existing relationship.

In 2009 the Telstra Master Licensee agreement was signed. The agreement has seen the roll-out of approximately 25 Telstra stores per year – through a combination of replacing poorly performing Fone Zone, One Zero and Next Byte stores, building stores from scratch and acquiring existing Telstra stores.

The roll-out of Telstra stores has been extremely successful, with average revenues doubling from the start to the store’s maturity in three to four years’ time. Due to the average age of the Telstra stores being three years the company is well positioned for continued strong growth as more stores move into the maturity range through our forecast period of FY14-FY16.

Focus on people

The company’s history has involved many strategic shifts and hard learnt lessons. It would appear that Horne’s acquired knowledge is paying off, especially in regards to the importance of people management and promoting a customer-focused healthy culture through the business. This focus is without doubt VTG’ number one differentiator and the reason its Telstra branded stores have performed so well.

Whilst the focus is on training and supporting staff, the reality is that it is a strictly performance based culture that doesn’t suit everyone. Employees are highly incentivised to meet performance targets, with bonus payments and average staff earnings significantly higher than equivalent positions in the industry. There also is a large focus on values, and little tolerance for not meeting company expectations.

In the retail environment, where there is constant pressure from the industry shift to online sales, it is increasingly important that customer service is providing value and giving a reason to come into the store rather than buying online. While a shift to online will occur in the telco space, we believe that demand for in-store service will remain at reasonable levels. This is especially true with increased competition and development of new mobile products from Apple, Samsung and other providers.

At a recent results presentation Horne jokingly suggested she had a time limit on how much she spoke about some of the people initiatives that have promoted leadership and increased productivity through the business. Horne is regularly quoted as saying Vita Group is a people business rather than a telco or computing retailer.

She has also been quoted in saying that her biggest mistake was letting go so many staff through the GFC. In a small caps presentation this week, there was a slide titled “The Lessons I’ve Learnt….” Interestingly, four out of the eight key lessons were directly related to people management, including customers.  

The tangible evidence that the focus on people is paying off is the large percentage of new staff hires that are sourced internally – now 60%, up from 45% in FY12. The profit per team member has also increased 21% since last year.

Portfolio optimisation

In regards to the closure of poorly performing Fone Zone, One Zero and Next Byte stores, the worst have been closed, and the Telstra store opportunity will more than compensate the marginal results from the other brands.  

The portfolio optimisation that has seen Telstra stores currently comprising 91 of the 167 sites, plus another 13 Telstra business centres, is setting the company up to focus its attention on its best growth opportunities.

This optimal mix of stores also includes a more profitable revenue mix with connectivity, broadband and other value-added products. The national footprint of stores sets the company up to leverage adjacent categories. An example is the expanding range of Vita-owned accessory brands – Sprout (mobile cases), TewlpTribe (Twitter-based customer service), Finga (electronic SME management tool), Liquipel (water protection for mobile), and Amtel (mobile security application).

The transition process to close Fone Zone stores or transfer them to Telstra stores if applicable is on track to have all Fone Zone stores closed by FY15.

The One Zero brand portfolio is operated by third parties under the VTG master service agreement. One Zero is marginally profitable with approximately 25 stores – likely to continue to decline by 2-3 per year.

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The Telstra agreement

Vita’s Master Licence Agreement with Telstra moved the company’s prior trailing commission agreement to an up-front payment model. Through strong performance and meeting target key performance indicators Vita has had the agreement re-confirmed through to 2018. The contract is on a store-by-store basis, and if Telstra want the stores back it has to pay the market price, which is generally 2-3 times earnings before interest, tax, depreciation and amortisation.

At first it appears that Vita is in a very risky position relying so heavily on Telstra, however a more detailed examination of the agreement eradicates many of the potential risks. For one, with the master licence agreement being re-signed until 2018 this creates an important barrier for competitors as no other Telstra licensee is allowed more than five stores.

The other key factor is that the relationship has been going for 20 years, and VTG now represent a meaningful part of Telstra’s business. While VTG continues to perform and provide strategic value it is hard to see any changes. The other issue is that if Telstra was to try and break the agreement it would be a very costly process.

Vita is approaching ownership of 30% of Telstra’s retail stores, and hence is meaningful in regards to Telstra’s overall retail strategy. In recent Telstra results it has been highlighted that the retail strategy involves an integrated three-part approach, with Telstra owning most of the city stores. VTG focuses on the regional stores, and then the online component is used to complement the stores rather than replace them.

With the more recent small business (SME) focus, Telstra has typically not directly marketed and relied heavily on resellers and licensed stores. The one exception is that Telstra does directly market to larger ASX 200 businesses. With VTG comprising approximately 15% of Telstra licensed business channel revenue, it is becoming increasingly important in this segment.

Financial metrics for Telstra stores

The maturity of a Telstra store is a reliable driver of revenue and margin growth. The average revenue of a store acquired from Telstra is $200,000 per month. After the VTG makeover, stores can achieve $400,000-plus revenue per month in the third to fourth year. This upgrade includes store refurbishment, sales and leadership training programs.

The annual EBITDA store targets are $220,000 after one year, and $440,000-plus after three years. With the average Telstra store age now approaching three years there are many stores in the sweet spot with regards to earnings growth.

Telstra business centres

On top of the Telstra store roll-out the next priority is products and services to small business (SME). This provides a lower capex and higher margin opportunity for VTG. Whilst only comprising 6% of current revenue, there are expectations it will comprise 15% by FY16. There are 13 dedicated Telstra business centres, and 45 (out of 91) of the Telstra stores also service the SME market. These services include a mix of mobile, data, fixed, unified communications, NBN, broadband cloud and managed services solutions. The Camelon IT acquisition in October 2013 has expanded capabilities in the IT services space.

Next Byte – Apple

There is no doubting the Next Byte acquisition has been a disaster. Most Apple resellers have struggled, and Next Byte is no different. The good news is the bleeding has stopped and the company has worn the pain through the goodwill write-downs. There are currently 15 stores, with nine using the new Apple Premium Reseller (APR) model. The new APR stores attempt to exactly replicate the succesful Apple stores, and new management has showed signs of improvement. The first-half result was a $0.8 million EBITDA loss, however with the improved performance of the new stores a slight profit (up to $1 million EBITDA) may be achieved in FY15. Stores numbers are likely to stay flat or slightly decrease in coming years.

Risks

• The Telstra relationship is the obvious major risk. Continual management focus is required to ensure high performance and value creation for Telstra to ensure the longevity of the relationship.
• Limited gross margin upside with the Telstra agreement. Large forecast net margin growth over next few years largely mitigates this concern in the near term.
• The risk of weak performance from non-Telstra stores has largely been resolved through the closure of the weakest Fone Zone, One Zero and Next Byte stores
• Telecommunication stores – A greater-than-expected shift to online.
• Retail sales – Consumer confidence

Valuation, earnings, financials

• Huge franking balance ($40 million), high free cash flow and 65% dividend payout.
• Towards the end of a large expansion capex program. Will be in a position to pay higher dividends, and maybe a special dividend, as well as considering other strategic acquisitions.
• Non-cash write-down at half-year result, has no negative impact going forward and is just recognising the past weakness with Next Byte (Apple). Improves future profit and returns on equity. Also a positive that management has decided not to allocate any more capital.
• Non-cash reported impact from ending VTG warranty and adopted TLS warranty ($6.5 million in FY14; $8.5 million in FY15, and $2.5 million in FY16).
• Continued expectations of high operating cash flow conversion.
• Sub 10 P/E and EV/EBITDA of 3 at large discount to comparables. Discount likely to be removed as the high earnings growth flows through over next 2-3 years.
• We have a discounted cash flow valuation of 95 cents with a 12.8% assumed cost of capital.

Investment opportunity/summary

With a continued focus on optimising the portfolio towards the high-growth Telstra stores, the company is set for 2-3 years of very strong growth.

The new target growth area of servicing small business is in the early stages and presents a higher margin growth opportunity. With a national retail footprint management is also positioning to benefit from an expanded range of products and services via the acquisition of Camelot IT. We have an outperform recommendation with a $0.95 valuation and price target.

To see Vita’s earnings forecasts and financial summary, click here.