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Morningstar | Baking in the Turnaround Before Vocus Delivers?. See Updated Analyst Note from 17 Dec 2018

Shares in Vocus have enjoyed a meteoric rise since the fiscal 2018 result release on Aug. 22, 2018, up 34%, and outperforming the market by 45%. Having endured a tumultuous two-year period of integration angst and execution mishaps (culminating in a series of earnings downgrades), shareholders are understandably pinning their hopes on the new CEO Kevin Russell to bring a new focus and a sense of urgency to the simplification and transformation tasks at hand.

However, investors should not expect any tangible benefits to flow in quick time. Competitive intensity in the fixed-line broadband market remains elevated, with Vocus' combined consumer and small-to-medium business EBITDA down 7% in fiscal 2018 to AUD 172 million (31% of group total before overheads). While costs are being taken out, this earnings stream is likely to remain under pressure, with competition exacerbated by the National Broadband Network's, or NBN's, challenging economics.

To combat this, management has a renewed focus on the enterprise and wholesale business, one that represents 58% of group EBITDA before overheads and was up 15% in fiscal 2018 to AUD 319 million. But all other telecom operators are also looking at this space to counteract the pressure on NBN-dependent units. As such, competitive dynamics in the corporate arena are unlikely to abate, albeit we recognise Vocus' disproportionately low mid-single-digit percentage share of this market relative to its infrastructure footprint.

Consequently, we are cautious on Vocus with the stock trading at 18% above our AUD 2.90 fair value estimate, at fiscal 2019 enterprise value/EBITDA of 8.8 which sits at a premium to the global telecom industry average of 7.5. Investors should bear in mind that fiscal 2019 is a "year of reinvestment" and the first priority is to meet the fiscal 2019 AUD 350 to 370 million EBITDA guidance (versus our forecast of AUD 358 million)--something that has been elusive in recent periods.

It is possible the market is also focusing on Vocus' new management incentive scheme, as a pointer to its long-term prosperity. It is one based on long-term shareholder returns, with equity that has a three- to five-year vesting timeframe. Indeed, there is no vesting unless there is a minimum 50% appreciation in share price in three years time (from a strike price of AUD 2.39 per share). Full vesting requires the share price to double in three years. As such, management is fully incentivised to take a long-term view and their interests are perfectly aligned with shareholders in terms of executing on Vocus' turnaround program.

That is all well and good, but management still needs to deliver at the end of the day. And Vocus does not operate in a vacuum, with all its competitors equally keen to defend and grow their earnings in all the telecom segments that the group operates in. Our AUD 2.90 fair value estimate assumes a five-year EBITDA CAGR of 6% and we maintain these projections at this stage which would see Vocus' EBITDA approaching AUD 500 million in five years' time, up from AUD 366 million in fiscal 2018 or our forecast AUD 358 million in the transition fiscal year 2019. We are confident in our fiscal 2019 forecast being met, despite the recent poor form in earnings delivery, as the new management team has reset earnings expectations at an achievable level and continuing cost-out initiatives should provide some buffer against worse-than-expected top-line pressure during the year. The current net debt/EBITDA of 2.7 is still too high (albeit below the covenant limit of 3.75 times) but we project this to decline to 2.2 by the end of fiscal 2021, providing room for dividends to resume. We expect dividends to start at AUD 0.02 per share in fiscal 2021, rising to AUD 0.10 per share by fiscal 2023.