Vocus Group Ltd (ASX: VOC) is a vertically integrated telecommunications provider, operating in Australia and New Zealand. Vocus has built a world-class telecommunications infrastructure network across many capital cities in these two countries. At present, VOC has more than 30,000 km of fibre optic cable lays and more than 5,000 on-net buildings connected to the network.
VOC is the fourth largest telecommunication services provider in Australia with an 8% market share and like the wider telecommunications industry in Australia, has underperformed the wider market in the past few years.
Has the Telecommunication industry peaked in Australia?
The telecommunication sector index has fallen dramatically in the past two years, down more than 50% and has underperformed the market. VOC has underperformed the index as well, falling 70% compared to the index.
Telstra (ASX TLS) and TPG (ASX TPM) are the two largest telecommunication operators in the industry with 51% and 24% market share respectively. However, these two companies have underperformed in the past two years as well, down by 50% and 55% respectively while the S&P200 index grew from about 5200 to 6400 today by 23%.
The share price of the top 3 ASX listed telecommunications providers, Telstra (ASX TLS), TPG (ASX TPM) and Vocus (ASX VOC) have all fallen on hard times, victims of the NBN rollout in Australia.
Competition and high capital expenditure in the industry result in lower profit
Including Optus, four companies have approximately 97 % of the market share, which leads to a closed monopolistic market but with drastic competition within these four companies. Being connected is becoming cheaper and cheaper for families and communities as price competition is strong, forcing margins to squeeze. The competition between companies to win the market is a threat to growth in this industry at this point in time.
The price of NBN on average has fallen by 5.1% in the past three years. At the same time, the price of internet delivered by mobile services dropped by 7.1%, which means the cost advantage of fixed internet (including NBN and non-NBN) is being weakened.
However, on 22 August, TPG telecommunication confirmed that it is in talks with Vodafone regarding a potential merger of equals of these two companies. The merger could potentially make TPG group less aggressive and may slacken its competitive price strategies in order not to cannibalise Vodaphone’s customers. A major threat recently has being TPG’s starting a price war with its new mobile network, but now the potential merger makes it potentially less likely.
The news was positive for the telecommunication industry including VOC whose share price rose 17% from 2.38 to 2.8. However, a merger between TPG and Vodafone means an even stronger competitor, which could potentially weaken Vocus’ market position.
5G could be a threat to VOCUS and companies in the telecommunications industry
5G networks are the next generation of mobile internet technology, with faster speed and more stable connection. 5G is in its final stages of design and is expected to launch worldwide in 2020. 5G networks will theoretically be able to reach speed as fast as 10 to 20 Gbps which is much faster than 4G and fixed based internet which currently run at 12Mbps to 100Mbps. This poses a large threat to VOC, other telco’s and the NBN as it could render their fixed network obsolete.
At this point in time, the price of unlimited data on the NBN starts at 59 dollars per month at the lowest tier, but it costs $60 to get 30Gb for both Telstra and Optus on mobile broadband services which is far more expensive.
However, the improved efficiency of 5G will reduce the traffic costs dramatically for telecommunications and lead to a drastic fall in the price of the data. Vocus is particularly affected by the threat from 5G and the uptake of NBN services as it is a wholesaler of broadband. Not only has NBN put pressure on Vocus and its broadband network, 5G will add additional pressure on the company.
If 5G is able to provide higher speeds than fixed lines at a lower price, customers will naturally migrate to the 5G network over fixed-line broadband and the NBN network.
The Australian Singapore Cable Project (ASC)
Vocus expects to finish the construction of a new submarine cable system linking Australia to Singapore in August 2018. The cable system is over 4,600 kilometres in length with approximately 50 repeaters as well as 4 fibre pairs. The company believe that the network will deliver a minimum of 40 Tbps of capacity and will offer a 30% reduction on latency.
The ASC project is forecasted to capture a minimum of 15.5Tpbs of capacity sales by year-end 2029, resulting in revenues of at least US$550 million during that ten years period. However, the project has only just been completed and will not be ready for service until 2019, the income and the potential sales may not live up to its forecasts, which increase further uncertainty with the company.
According to Vocus, the capital expenditure of the ASC project is estimated to be US$170 million, which was paid in FY 2018 by existing debt capacity, operating cash flow and expected customer pre-payment. This means VOC will see high capital expenditures in FY 2018.
1.5 billion loss in impairment of goodwill
In FY 2017, Vocus posted a full-year loss of nearly 1.5 billion. The full-year loss is the result of an impairment charge due to the write-down of goodwill. Vocus shares had 1.3 billion in non-cash impairment on its Australian business and 200 million on New Zealand business. This resulted in a 1.5 billion full-year loss which is much higher than the 47 million net profit after tax.
The CEO of Vocus group Geoff Horth admire that the result does not look good for the company, saying “We recognise that this write off does not reflect well on the prices paid in M&A transactions in recent years”. In 2016, Vocus acquired M2 Group with a 2.26 billion bid which many analysts considered to be overpriced. The impairment loss also lead to negative free cash flow in 2017. After the 1.5 billion loss posted last year, the chairman of Vocus David Spence, stepped down.
Vocus shares’ poor financial indicators compared to its peers
|Comparison between companies|
In the financial FY 2018 report released on 22nd August, Vocus is back in the black after the massive loss last year. The revenue of the company has increased by 2% and the EBITDA increased by 7%. Conversely, the NPAT decrease by 16% because of higher depreciation and amortization expense because of increased capital expenditure. The company looks to be in a much better shape without impairment loss compared to last year.
Price to earnings ratio (P/E) of VOC comes in at 28.84 which is much higher than the P/E ratio of its peers TPM and TLS, at 14 and 10 respectively. EPS has risen to 10 cents from a negative EPS last year, which is lower than 2016 which was at 29 cents and ROE is only 2.62 compared to 19.85 and 24.1 for TPM and TLS respectively. However, it does look like VOC is quite cheap on a price to book ratio as it is currently at 0.61versus a P/B ratio of TPM and TLS at around 2.1. This is exceptionally low and either the company is well undervalued right now or the market doesn’t feel Vocus shares can sustain their EPS into the future and is heavily discounting the stock.
In addition to the losses in 2017, the growth rates of sales are low in the past two years, which shows a low potential for the company to increase their revenue. Telstra and TPG telecom also have a close-to-zero growth rate compared to Vocus shares. The lack of growth indicates saturation which is not surprising considering the Australian telecommunications industry is well developed.
The similar situation for three companies including the low growth rate of revenue and high capital expenditure implies that the main operators in the telecommunication industry are facing challenges and trying to find ways to grow their business in a saturated market.
Weak telecommunications industry and low growth makes Vocus an unattractive stock
Large communication projects such as ASC project and bespoke fibre connections for high demand business customers could keep Vocus going. In additional, Vocus shares seem to be heavily discounted on a P/B basis at 0.61 compared to its peers of 2+, so there is an argument for value investors here to pick up a stock which is priced relatively cheap to its peers.
However, the telecommunication industry as a whole is likely to be weak because of its limited customer growth and move towards wireless. At this point, telco’s such as VOC, TPG and Telstra are fighting over existing market share and killing their margins at the same time. Future growth in the telecommunications will likely come from the new 5G network which could potentially kill the fibre networks such as the one Vocus owns and NBN. Telecommunication companies which are moving with the times and focus more on wireless such as with TPG’s new mobile network will be the way of the future and potentially a better investment at this time.
Henry Fung is a Partner Managing Director and co-founder of MF & Co. Asset Management. He is a highly experienced equities, derivatives and financial markets professional with over 12 years of experience. Henry specialises in building trading algorithms & systems, quantitative & qualitative analytics across macroeconomic, fundamental and technical disciplines and currently runs the MFAM VPAC AU/US models portfolios. The management Partners and Adviser team have decades of experience between them, with experience from major Investment Banks and Brokers. Their Advisers are highly experienced, having dealt with some of the wealthiest clients in Australia.