Vocus: A Growing Force In Dark Fibre

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-Difficult to emulate Vocus' growth rate
-Demand for dark fibre substantial
 

By Eva Brocklehurst

The future is dark. Fibre that is. Vocus Communications ((VOC)) has garnered attention from several brokers as it expands a dark fibre offering with a substantial growth opportunity. CLSA thinks the stock is one of the few telecoms that can generate double digit organic growth over the next few years, expecting a 27% compound annual rate for earnings in FY14-17. Bell Potter expects 31% for the same period.

The company's network has reached a point where capital efficiency and operating leverage has started to show. CLSA has initiated coverage with a Buy rating and $5.65 target. The broker notes Vocus is trading at a 15% premium to its closest rival, Amcom ((AMM)), which shares the Western Australian metro duopoly with Vocus. According to CLSA, Vocus has the stronger growth profile. Compared with TPG Telecom ((TPM)), the main competitor in dark fibre on the eastern seaboard, Vocus is cheaper. There are high barriers to entry in this market, because of the high capital intensity needed to roll out fibre and access rights to land and the three companies are considered the main incumbents.

Dark fibre is the most profitable product for Vocus, being high margin. Moreover, dark fibre requires little ongoing support as the customer is responsible for running the transmission devices. The company is therefore primed to benefit from growth in cloud computing, data consumption and demand for super-fast connectivity with plenty of capacity to meet this need, in CLSA's view. CLSA expects returns on invested capital to improve to 17% in FY16 from 9% in FY13.

Credit Suisse thinks the company has an attractive structural growth story, as Vocus intends to accelerate growth plans via bolt-on acquisitions, leveraging success from the past three years of acquisitions. As corporates move their IT functions to a data centre, this could be the catalyst for seeking alternatives to their existing data networks provider. Credit Suisse has an Outperform rating and $5.40 target. Bell Potter is a little more subdued in its views. The broker revisited forecasts but left them unchanged after Vocus acquired iBOSS International and One Telecom recently. These are tiny acquisitions and it is unclear how many customers will be reconnected with Vocus. These are also the first acquisitions since Vocus undertook its $48m capital raising. Bell Potter retains a Hold rating and $4.50 target, believing that on a FY15 price/earnings ratio of 20 times the forecast earnings are already reflected in the share price.

What are the threats? In CLSA's opinion the threats could come from TPG's Pipe Networks, which may enter a price war to gain market share, and/or Megaport, Australia's first network as a service, which may pose a longer-term threat if its on-demand fibre connectivity becomes a viable substitute for Vocus dark fibre. What are the other risks going forward? The biggest for CLSA is price deflation. Dark fibre prices have fallen by 15% per annum. There is the risk that assumptions may be too optimistic if competitors were to behave irrationally by undercutting prices.

Vocus was established in 2008 to provide an international telecom network and wholesale services to ISPs (internet service providers). It has since diversified into data centre and dark fibre, operating 12 data centres across wight sites in Australia and New Zealand. CLSA highlights the cross selling opportunities that front the company, and the fact that Vocus is on the hunt for further acquisitions – second tier data centres in a fragmented market. The company has a right to use the Southern Cross cable which provides a connection between Australia and the US west coast via New Zealand and Hawaii. Earnings growth has impressed brokers since Vocus listed in 2010, although that took a knock from a significant capital raising in FY13. Dark fibre and ethernet represent around 30% of revenue at present. CLSA expects this to rise to 50% in FY16.

What is dark fibre? Dark fibre refers to optical fibre that has not been connected to any transmission equipment – which when switched on provides the "light". Each strand of dark fibre leased is used exclusively by the customer. The company's ethernet management services use different communication media to link office locations and connect to a data centre, mainly fibre but not necessarily so. This feature of the business is used by smaller companies without the IT resources to manage a dark fibre connection. CLSA notes there is a lot of pent-up demand for dark fibre, given its superior characteristics such as high bandwidth, security and reliability. Telstra ((TLS)) and Optus ((SGT)) may operate the most extensive network of fibre between cities and in metro areas but they are not specifically selling dark fibre.
 

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