After my intial analysis of the three growth Telcos I decided to dig deeper into M2 Telecommunications and am now a part owner. The following are my notes and as always are for entertainment purposes only. While I endeavour to provide correct figures and facts, some or all of them may be wrong.

From the Horses Mouth

The MD Vaughan Bowen kindly replied to my email about his share sales and difference between NPAT and EPS FY10 forecasts. I’ll publish his reply, despite the second point being a tad embarrassing for me.

Firstly, re my sale of shares; After nearly 10 years of progressively growing my MTU stockholding (including most recently my exercise of 500,000 options in June) my wife and I had agreed some time ago that for personal reasons we would sell down approx 20% of our holding at a point in time that MTU share price passed the $1 mark, which is what we did. Notwithstanding the sale I remain the largest individual (non-institutional) shareholder with 10% of the company, am fully committed to the business and am very optimistic that the best for M2 lays ahead.

Secondly, re the delta between our NPAT forecast growth and EPS forecast growth, this is in large part due to the fact that in late April 2009 we issued approximately 35% new MTU shares as consideration for the acquisition of People Telecom.

This second point is embarrassing as I both knew about and mentioned the People Telcom acquisition, but never engaged my brain on how EPS is calculated. EPS is calculated using weighted average number of shares. Usually this has negligible impact on EPS, but when the share count is greatly increased near the end of the reporting period it does have a large impact. M2’s 2009 results are a great example of that.

M2 acquired People Telecom in April 2009, the bulk of the payment was 28.6M MTU shares. Therefore, the weighted average shares was over 20M less than the actual shares outstanding at the end of the period, thus creating the difference in NPAT and EPS growth forecasts for next year. The above table shows that calculating EPS on actual shares outstanding at period end results in EPS growth of 100%, just like NPAT.

The Elephant in The Room

Readers of this blog may be aware that I’m not a fan of serial acquirers. As M2 is a serial acquirer you may be surprised to read that I purchased a starting position in the company. Coupled with my Neptune Marine Services purchase, you may wonder if I talk and walk different paths. Let me put it this way, I’m nominally a Collingwood supporter, but if someone offered me a ticket to the AFL Grand Final I wouldn’t care who was playing, I’d want a seat in that crowd. I prefer to find great companies growing organically, but will invest in great companies at good prices despite them being serial acquirers.

I don’t like serial acquirers as it makes analysis and valuation harder and more importantly increases risk of a loss. Acquisitions are difficult to integrate and a string of acquisitions even harder. Each acquisition carries risk of overpayment and that risk accumulates on the balance sheet. M2’s accumulated risk accounts for 48.5% of their assets, up from 46.9% in 2008. That $68.6M may or may not represent a good investment. If at some future time management decide the investments are impaired then that asset will be written down or off. Hence the risk. Risk that the investment was a waste of money and the even more ominous risk of debt covenants being broken.

I get nervous whenever goodwill in over 20% of assets, consequently I had to pop a couple Inderal (beta blocker for anxiety) before placing my buy order. Yeah OK that’s a slight exaggeration, a cup of herbal tea and a cursory look at the acquisitions was enough to calm me down.

I’m going to go into some detail on the acquisitions now, so if you get bored easily I suggest you skip ahead to the juicy valuation section.

Commander was purchased in June 2009 out of receivership for $19M, excluding inventories. Commander had annual sales of $100M and M2 expect it to be earnings accretive, delivering incremental EPS in excess of 50% in FY10. I’m going to call that 3.5 cents, NPAT of $3.8M. The ratios look excellent P/S of 0.19, P/E of 5. The provisional goodwill was booked at $22.117M so let’s check the completion filing, no new information there. This looks like a great deal for M2. BRR interview on the deal. Compelling transaction.

The People Telecom acquisition was completed in April 2009 for $2M + 28.6M shares.  Goodwill of $17.177M booked. Original announcement of deal. Commentary on integration progress at Business Spectator. While this doesn’t look like as good a deal as Commander, it does look like a good deal. Unfortunately when a public company is taken over the likes of the ASX make it difficult to retrieve their history. Thus far I’ve only been able to retrieve People Telecom’s 2007 Annual Report. The benefits to M2 listed are the standard type of fare; synergies and increased scale. Synergies seldom realise the anticipated value and as for scale, I’ll paraphrase Buffett and say I’d prefer to own a $10M company making 15% than a $100M company making 5%. I do see value in the third benefit, buying People Telecom expanded M2’s presence in both medium enterprises and other states while providing the opportunity to cross sell products.

Acquires Unitel from Commander in February 2008 for $10M minimum price tag with further $2.5M performance based consideration. The majority,$2M, of the performance consideration was later forgiven. Strategic addition to wholesale network services business. Forecasted to increase eps by 50% (2.9c) and annualised revenue by 35% to $140M+ ($37M increase). This acqusition marked the introduction of debt on to M2’s balance sheet and the associated risk of loan covenants. Interestingly, to me at least, the reseller rights to an old favourite of mine, Polycom, came with the deal.

Going back further:

• Orion Telecommunications (October 2007) and the final annoucnement Total cost of $22M, $15.1M in shares (18.2M shares at $0.83) remainder in cash.
• Tenex Communications (June 2007) $510,000 at forward P/E of 1.75
• Wholesale Communications Group (May 2007) $1.525M. In FY08 it contributed $705,000 to net profit and $10.0 million to revenue. That deal sure gets a gold star!

Had enough? I sure have, here’s a summary table of Capex and Acquisitions since 2007. It appears M2 have been doing a wonderful job of acquiring complementary and accretive companies. I’d now prefer to see M2 manage this business and show organic growth.

I just came across an analysis by Intersuisse. Here’s a snip:

The combined group is amongst the largest customers of both Telstra and Optus. It has excellent relationships with both. Commander’s long-term landline-focused Telstra connections beef up those of MTU and balance the latter’s mobile wholesaler role with Optus. The nationwide exclusive dealership network of Commander is a great asset alongside the national channels which deliver the service-oriented People Telecom offering, M2 Telecom, Southern Cross and Simply Mobiles (via online). MTU has a full product range and well-established nationwide coverage. It now plans to work it!

Valuation

I was going to work through a few valuations ranging from simple to head scratching (for me at least), but I’ve already banged on for too long, so I’ll probably only give the output of my valuations. In summary the valuations point to MTU being undervalued by up to 50%.

Discounted Dividend Model

• Forward yield of 7.6% (Est EPS* Payout ratio/Price. =$0.138 * 70%/$1.27)
• Basic DDM Price Target: $2.4 I also ran two and three stage dividend models. Both derived slightly higher targets, but are more prone to garbage in.

Earnings Based Valuation Targets

• Discounted Earnings based: $2.9 This is similar to a discounted cash flow analysis, but based on blended earnings estimates and book value.
• EPS * P/E Weighted Target: $2.4. I apply a probability (WAG) to each of the below possibilities and sum the products.

Part Three: It’s Earning’s That Count Analysis – Defensive and Enterprising Profits, Finanical Statement Notes and the five minute checklist.

Part One: Orginal Analysis of M2 Telecommunications

Disclosure: I now have a long position in MTU.

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