AdEPT Telecom - Steadily Performing

http://www.adept-telecom.co.uk/

Adept Telecom Logo
Companies capitalised under £30m that are profitable, pay dividends, have strong recurring revenue streams and that are growing are something of a rarity on AIM; fixed line telecommunications provider AdEPT Telecom fits the bill on each of those criteria. AdEPT's management have also proven themselves to be successful through a buy-to-build strategy - which is a hurdle that many companies fall at - having acquired a total of 19 bolt-on companies since 2003. However, the market capitalisation is circa £29.2m compared to the circa £29.5m valuation it achieved during its IPO in 2006; that perhaps does not reflect the progress made over the past eight years, as the company has and should continue to be a steady performer.

Technicals


The technical outlook for AdEPT is seemingly becoming increasingly bullish with a recent breakout through a medium-term descending triangle pattern that started to form in late 2013. That is a material breakout too as it usually suggests a medium-term bullish pattern may form (fundamentals allowing). Importantly, the breakout was on above average volumes and was linked with AdEPT delivering H1 results comfortably above expectations. The longer-term pattern is highly bullish with a swift and continuing recovery in share price from lows of 10p in 2008; that suggests excellent operational management of the company, especially given the scale of the move.

Liquidity does remain an issue for AdEPT although the current spread around 130p is abnormally narrow; usually the spread spans 3p -> 4p, which can be an issue. The liquidity issue arises from circa 40% of shares being owned by directors, so although they are heavily incentivised to see the share price perform well, that is higher than is optimal in my opinion. The issue with large (high level)director shareholdings is that they are difficult to dispose of should a director leave the company; the flip side of the equation is that it can lead to the company looking to sell itself should the management wish to exit and realise their investment.

Deputy Chairman Chris Fishwick holds around 29.2% of the shares in issue with Greenwood Investments holding a further 13.2% of shares, and Fiske Private Clients holding 10%. Notably, an Octopus VCT and Hargreave Hale have 'significant' holdings in AdEPT, which is testament to the business model and performance over the past few years.

There are several director holdings changes to note. In April the Chief Operating Officer increased their stake by a net 30,000 shares following the exercise of options, although in July CEO Ian Fishwick sold 290,000 shares at 120p with the reasons being to settle a tax demand and to improve stock liquidity. In my opinion, a director sale is usually a negative regardless of the reason. To properly assess the reasons for the sale, it's usually important to look at the credibility of the management team, and also to look at the quantity of shares sold. In this case the management team has performed well in growing the business, and Ian Fishwick still retained a holding of around 1.2m shares so it's not a particularly concerning share sale, especially given the recent outperformance of the company. Lastly, in November around 350,000 shares were exercised under options packages, with 170,000 of those sold back into the market.

Operations

As the name suggests, AdEPT is a UK provider of telecommunications services for mobile, fixed line, VoIP and data connectivity. The company covers two separate markets; residential (where there are 5 - 10 core competitors) and businesses where there are over 700 competitors. The latter market is particularly fragmented with a large number of low revenue companies; AdEPT has used this to its advantage through pursuing a mixture of organic and acquisitive growth over the past few years.

Indeed, the latest acquisition pursued was of BlueCherry Telecom for £2.025m (plus £0.2m -> £0.75m deferred dependent upon performance). BlueCherry was acquisition 19 for the group, which has demonstrated considerable success in its acquisition method of growth. The acquisition was highly complementary, and as with the other acquisitions the management of BlueCherry's operations was shifted to AdEPT's sole core headquarters in Tunbridge Wells. BlueCherry alone added annualised revenues of £1.2m and £0.45m in EBITDA.

Impressively, AdEPT is a highly efficient operator within the sector, with industry leading sales per employee just short of £500,000. That compared to an industry average of circa £160,000, and proves the tight focus on costs within the business and extracting the highest value of sales per head possible. There is a rough 47:53 split in terms of revenue derivation between lines, and network solutions/calls.

AdEPT is a member of the ESPO framework
An increasing focus for the company over the past 12 months has been to diversify into revenues derived from the public sector. This sits alongside AdEPT's wider ambition to drive next generation service revenues - such as high speed data connectivity - to replace the industry-wide structural decline of the fixed line business. There has been excellent progress on the former objective to date with over 20 council contracts won over the past 18 months, with AdEPT also winning its first NHS trust contract yesterday; the contract has an initial 12 month term and carries a value of around £0.2m. It could prove to be an invaluable reference deal for future NHS trust negotiations That contract also fits with AdEPT's increasing focus on what it calls 'Premier Customers'; these are customers who spend over £5,000 per annum and this bracket of customers contributes circa 50% of total revenues. The other 50% is derived from around 19,000 other smaller customers. Other commercial customers include Halfords, Rexel and RM Education

Reporting on the NHS trust contract win, Ian Fishwick, Chief Executive, said: "This contract award is significant as it is AdEPT's first NHS Trust customer contract to be awarded under one of AdEPT's public sector frameworks and forms part of the continuing focus of the Company on public sector business."

AdEPT's strong market position has been bolstered through its involvement in three main frameworks that it is involved in, although it's critical to first make clear that the company does not own any major telecoms infrastructure. Rather it has deals with major UK network operators such as BT and Vodafone. The three frameworks are below.

- ESPO = Adept is the sole recommended supplied of calls, lines (and other services) to local governments, the wider public sector and registered charities. Savings to local councils are typically around 33%
- Crown Commercial Services (CCS) = Adept is a recommended supplier to supply central government
- JANET = Adept is one of a few companies who can sell to UK colleges and universities. Existing clients through this include the Universities of Oxford, Warwick and Southampton

In November, against the backdrop of continuing customer onboarding, AdEPT renewed a contract with their unnamed largest customer for a further three years, taking the total relationship time between AdEPT and the customer to nine years. The contract has a £2.2m value over its life and is a further demonstration of the company's market position and reputation.

Ian Fishwick, Chief Executive, said: "This is the third time that our largest customer has renewed their contract and it will extend our relationship to 9 years. Our largest customer has over 400 sites across the UK and this renewal is great testament to the fantastic level of service that we offer our multiple site customers."

Financials

As commented upon in the introduction, it is rare to find an AIM company of this size that is highly profitable, pays a dividend, has strong recurring revenues, and that is growing. What's more is that it's even harder to find a company that matches those criteria plus one that generates strong and consistent free cash flow; all too often the highly profitable firms of this size do not generate appreciably positive cash flows. Yet AdEPT also fits that criterion, so that is an encouraging start.

Interim results for this financial year were released recently with the headline figures as follows, with many demonstrating progress considerably above market expectations.
-   Revenues up 11.3% to £11.3m
-   EBITDA up 12.7% to £2.36m with an EBITDA margin of 20.8%
-   Adjusted profits up 13.9% to £2.2m generating basic EPS of 8.38p
-   Interim dividend up 50% to 2.25p
-   Free cash flow up 29.1% to £2.2m. Circa 92% of adjusted EBITDA was converted into cash
-   Gearing down to 29% vs. 38% at the same point in 2013
-   Net debt £0.2m higher than year-end at £3.2m as a result of initial and deferred acquisition payments. Net debt was as high as £11m in 2008
-   Public sector revenue achieved a run-rate of 13.3% and is expected to track higher

The reason for the outperformance was largely down to margins exceeding broker expectations with margin attrition far slower than previously anticipated. The result was that brokers Northland Capital and WH Ireland were prompted to upgrade their targets prices to 175p and 185p respectively, suggesting possible upside of ~35% and ~42% respectively; the question is whether those price targets are realistic. Whilst margin attrition continues to be expected, the forecasts for the next couple of years are assuming static top-line growth of around £22.5m and adjusted EPS tracking around the 14p - 15p mark or EBITDA of around £4.5m.

The reality is that these figures are probably conservative as the company has firepower to undertake earnings-enhancing acquisitions; the £3.2m in net debt is not a material burden given the excellent free cash flow, so I would note that the forward forecasts continue to be on the conservative side; there remains latent upselling capability. Alongside the earnings forecasts are forecast dividends of 3.5% in 2015 and 4.2% in 2016. That dividend growth is encouraging given that dividends have already grown from just 0.5p in 2012.

Also included in the interim results was the fact that next generation services revenues jumped 29% to £3.0m. In addition, the gross margin remained strong at circa 37.2% - albeit down on the 37.9% comparator - with the operating margin slipping slightly to 11.0%. That was partly down to a slip in the fixed line gross margin to 38.8% from 40.3%, albeit that was partly compensated by a rise in next generation services revenues by almost 3 percent to 32.6%. The one aspect of the financials that does not meet my usual standards is the balance sheet where I normally look for current assets being at least 1x current liabilities. In AdEPT's case current assets are only 77.9% of current liabilities, but that condition can be waived given the highly cash generative nature of the business and given that the current borrowings should be capable of being rolled over. Almost all the non-current assets are intangibles so tangible assets/total liabilities is still weak at around 0.4x.

What is crucial to the investment case is that the earnings quality is incredibly high. Not only are the revenues strongly recurring, but the sheer number of customers means that there is no real customer dependency risk. The largest customer only accounts for around 3% of total revenues, hence the earnings profile is very attractive and barring a major operational failure there is unlikely to be a sudden profit warning from a mass customer exodus.

The last point to check is how AdEPT compares to industry peers. A selection of seven other companies are shown below.

Excludes Colt Group given a lack of suitable comparator figures
There are a number of points to draw out from the table. The first is Daisy Group (LSE:DAY), which is the centre of a potential management buyout at 185p, which is what those financials are based off. A takeover forward PE of 13 is a circa 47% premium to AdEPT's 2015 forward PE, which is the lowest amongst peers at circa 8.8. The forward dividend yield is also superior to that of Daisy, although the current assets/current liabilities figure is significantly lower. However, the current assets/total liabilities figure is very similar, as is the gross margin. AdEPT does boast a far lower level of net debt versus the market cap compared to not only Daisy, but the rest of its peers. That does support the viewpoint that there is still room for funding acquisitive growth out of the balance sheet if necessary.

Compared to the other peers, AdEPT carries a lower gross margin, but that is related to its business model. The balance sheet strength at the purely current level is in-line with peers, but the current assets/total liabilities figure is above the average value of the other peers, which was 0.35. As mentioned above, the company has a lower net debt/market cap figure compared to those peers, and combined with the strong free cash flow, the discount seems unjustifiably high. The forward dividend yield is lower than the mean value of circa 4.5%, but remains fairly attractive at 3.5%.

The outlook in the recent results stated, "This has been an excellent 6 months with improved results in all key areas. We continue to be highly cash generative and there is considerable scope for a progressive dividend policy whilst continuing to identify and integrate earnings-enhancing acquisitions."

Highly Free Cash Flow Generative

The strength of AdEPT's free cash flow, combined with the low valuation relative to peers, gives reason to suggest that further upside exists within AdEPT's share price. The technical outlook has turned positive following the breakout on the back of the encouraging interim results, and the forecast figures for 2016 onwards appear conservative and are likely to be upgraded as AdEPT continues to execute its acquisition strategy; indeed, £4m of firepower could appreciably increase future EPS whilst the net debt/EBITDA multiple would remain reasonable at 1.6x. The company is steadily performing and is attractive from an earnings quality point of view. The detractors from the investment case are the liquidity of the stock, and also the lengthy periods whereby there is a lack of news flow. In fact, there were no news releases between November 2013 and April 2014 and the share price unsurprisingly consolidated over that period. In light of that, although AdEPT appears to offer solid value, it makes sense to track the company over the New Year period with a view to re-consider closer to mid-Q1. No Rating. 

8 comments:

  1. Interesting company this one. I always say that cash is sanity, profit is part sanity and revenues are vanity. I see so many companies that make profits but the profits do not turn into cash! Look at trakm8 for an example.

    CraigJ

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    Replies
    1. Yes. Let Quindell shareholders tell you about that. Price to earnings multiple of less than one but no cash. all the money is shafted into receivables and the revenue is reported even though it is not being earned. Crazy revenue recognition policies.

      lol

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  2. Another shareholder perk company!!! If you hold £325 in shares...

    "SAVE £154.20 PER YEAR with FREE line rental

    A 24 month contract for both calls and line rental applies. Billing is by email and payment is by Direct Debit. Available for residential lines only."

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  3. Thanks for the research piece on this cash creating machine. Watchlisted

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  4. Excellent research.
    One remark from me. The company's net tangible book value is negative. Not consequential in the bigger positive picture... unless they hit the buffers,
    It appears that this is common in this sector - just checked if this is the case with the companies in your tabulation. Curious to know why. There must be other capital intensive sectors where this is not prelevant.

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    1. Most of the other peers used have their own infrastructure to some degree, so they do have a lot more in Property, plant & equipment (PPE) on their balance sheet. The reality is that most of the work AdEPT does deals with intangibles, which are around £16m or 98.7% of the non-current assets on the balance sheet. That's also commonly the case with software companies; for example, Advanced Computer Software had just tangible assets/total liabilities of just 0.47 when it had a takeover offer earlier this week.

      As you note, in AdEPT's case the balance sheet is reflective of the industry operated in and more specifically AdEPT's position whereby it doesn't have its own network infrastructure. Tthe strong underlying cash flows and general irrelevance of the tangible book value in this case explains why AdEPT is likely to have continued access to debt facilities.

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    2. Thanks El1te.
      When I was looking up the TBV position of companies listed in your tabulation, I was taken aback by BT's position. Looking at FY2014 accounts, not only is the book value negative around -£592m, but it also has a total of £3bn in goodwill and intangibles, making a net tangible worth of -£3.6bn.

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