M2 Telecom Acquires Businesses And Risk

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-Acquisitions ahead of wholesale renewal
-Gains more bargaining power
-Risks heightened
-Is there too much debt involved?
 

By Eva Brocklehurst

In a previous story (Doubts over M2 Telecom's Growth Rate) we noted broker views that M2 Telecommunications ((MTU)) needed to deliver better organic growth or pursue more acquisitions. Well, the company has obliged. M2 has acquired Dodo Australia and made an offer for Eftel ((EFT)). Eftel is a telecommunications reseller as is Dodo. Dodo also resells other services, such as gas and electricity.

CIMB finds the new acquisitions a bit of a mouthful, coming just nine months after Primus was acquired. The broker's key concern is whether the amount being paid for Dodo ($204m) and Eftel ($44m) will adequately add value. The company expects the acquisitions to be 20% accretive to earnings in FY14. The acquisitions will take net debt to around $302m in June 2013, nearing three times the broker's earnings forecasts for FY13. The company expects to pay this down to 1.8 times in FY14 and still maintain a dividend payout of 70% of net profit after acquisition.

As an aside, the FNArena database shows consensus dividend yield based on FY13 forecasts of 4.5% with 5.4% for FY14. For CIMB, reducing debt, improving earnings and maintaining payout is the risky bit and means M2 has to rely on a good relationship and wholesale agreement with Telstra ((TLS)). The broker pointedly remarks that these acquisitions could make or break the company.

The company's growth projections from the acquisition would take FY14 earnings to around $165 million. To CIMB this appears unrealistic, given organic growth has been flat. The broker believes it would require about 6% organic revenue growth post-acquisition and about 30% incremental earnings margin, supported by acquisition synergies. To achieve this would require a smooth transition in operations and high customer retention rates as well as a lift in bundled sales. Despite the acquisitions, Macquarie believes that share price outperformance in the longer-term will be reliant on the company's ability to achieve better organic growth.

Macquarie was surprised by the acquisition of a consumer business, given the company's focus on the small-medium enterprise market and the intense competition for the consumer dollar. The broker notes that, unlike M2's iPrimus consumer business, which is positioned at the top end of the market, Dodo is low cost and only differentiates from competitors on price. The business has posted very strong organic revenue and earnings growth over the past few years but does not provide any infrastructure and has established wholesale agreements with Telstra and Optus ((SGT)). So there's little prospect to move customers to the Primus network. The positive for Macquarie is the enhanced buying power that may be possible once wholesale agreements come up for renewal in 2014.

For Citi, the diversification in the business model should lower risk, but then it also dilutes the focus on the higher margin business. Citi noted that peak debt was 2.1 times FY12 earnings following the Primus acquisition, so paying that down to 1.8 times in FY14 takes it off the peak in historical terms. The broker just wants to see more of what Dodo and Eftel are about before judging the merits of the acquisitions. Citi currently rates M2 a Buy, the only Buy of the three rating the stock on the FNArena database. Macquarie has a Hold rating and CIMB has a Sell. CIMB believes the stock is overpriced, given the aforementioned risks. The consensus price target is $4.73, revealing 4.7% downside to the last traded share price.

It's just that the debt is being loaded up at a time when the company is vulnerable to negotiations with Telstra, CIMB maintains. In mobile, M2 resells Optus and the broker understands that arrangement is also under review. M2 may be planning to switch this customer base to Telstra, CIMB surmises. Regardless, the additional customers and traffic should give the company more bargaining power. Maybe Telstra will value the arrangement enough to consider offering good terms. Time will tell.

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