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Morningstar | Vocus' Earnings Turnaround Lagging Stock Price Turnaround

The 7% fall in Vocus' fiscal 2019 first-half underlying EBITDA to AUD 176 million was a reality check on the transformation progress under the revamped management team. While building blocks are being put in place (strategic focus, culture, cost discipline), there is no denying the tough market dynamics. The core network services unit saw just a 3% lift in EBITDA to AUD 167 million, a slowdown from the 15% achieved in fiscal 2018. The combined Australian consumer and business EBITDA fell 17% to AUD 79 million, hurt by the challenging NBN economics and structural headwinds on legacy revenues.

None of this was a shock and we retain our AUD 358 million underlying EBITDA estimate for fiscal 2019, down 2% on fiscal 2018, and within management's reaffirmed guidance of AUD 350 to 370 million. Indeed, all our forecasts are intact, albeit our fair value estimate for Vocus has nudged up 3% to AUD 3.00, adjusted for time value of money.

However, market enthusiasm for the three-year turnaround program has driven shares in the narrow moat-rated group to more than 20% above our intrinsic assessment. We were guilty of such exuberant expectations with respect to previous management regime's recovery aspirations, but we have learnt our lesson. Over 40% of Vocus' revenue (consumer, business) remains hostage to adverse external factors, and only so much costs can be taken out. While the Network Services division is the crown jewel, it does not operate in a competitive vacuum as evidenced by continuing industry price erosion. Steady growth in New Zealand (first half EBITDA up 10% to NZD 31 million) is encouraging but it accounts for just 10% of group EBITDA before unallocated costs.

In any case, we expect Vocus' group EBITDA to reach AUD 412 million in fiscal 2021, up 15% from our forecast fiscal 2019 base of AUD 358 million (effectively flat over three years). We believe this adequately factors in the recovery potential under the rejuvenated senior management team.

Fiscal 2019 first half reported net profit after tax, or NPAT, fell 56% year-on-year to AUD 17 million. On a normalised basis excluding significant items, NPAT dropped 29% to AUD 49 million. This was dragged down by the 7% decline in underlying EBITDA (or 10% inclusive of long-term incentive employee expense of AUD 6 million), and higher depreciation and amortisation and net finance costs, mostly the impact of the commencement of Australia Singapore Cable project during the half. The board did not declare a dividend, and we do not expect a resumption until fiscal 2021 when net debt/EBITDA is forecast to drop to 2.2, down from the onerous 3.1 as at the end of December 2018.

In terms of segmental results, the 3% drop in Network Services EBITDA reflected industry price erosion on re-sign activities, and growth in revenue from lower-margin National Broadband Network, or NBN, wholesale and Coral Sea cable revenue. Trends in underlying margins, excluding the impact of these lower-margin businesses, are difficult to ascertain but we sense they are also under some pressure. Thankfully, revenue momentum is positive, and initiatives are being implemented to improve service delivery.

The Australian consumer division's EBITDA fell 5% to AUD 46 million. Revenue felt the full brunt of the structural headwinds buffeting the legacy revenue such as voice, down 12% to AUD 350 million. Thankfully, improved cost efficiency (digitisation, automation) helped limit the revenue damage and the challenging NBN economics, with EBITDA down just 5% to AUD 46 million. Still, the tough NBN dynamics appear to have claimed another scalp, with Vocus now declaring it is no longer interested in chasing market share in the space, but instead will run the Australian consumer division for cash and look to gradually reduce its reliance on the fixed-line broadband industry. We see the possibility of this unit being divested longer term is increasing.

The Australian business division's EBITDA fell 29% to AUD 33 million, as the NBN rollout decimated copper-related legacy revenue. Coupled with perennial under-investment in recent times, earnings in this unit are unlikely to recover for perhaps at least another twelve months.

Finally, the New Zealand unit delivered a 10% EBITDA increase to NZD 31 million. This was a business recently put up for sale, but to no avail. If earnings growth continues at the current consistent trajectory and re-ignite outside interest, here too we would not rule out a sale, especially given the current highly-leveraged balance sheet.