I covered AdEPT Telecom in a recent article where I described the company as "Steadily Performing" and where I also noted that AdEPT appeared to offer "solid value". Although I concluded with a No Rating tag on the basis of the company having a wide spread at the time and there potentially being a long wait until the next news was to be released, the value case for AdEPT Telecom appears too strong to dismiss. I therefore provide a short update looking at a couple of other valuation metrics that underscore the value case for the company and why it should form a solid bedrock within the site portfolio.
Since, as you would expect, very little has changed since just one week ago, much of the content of this review will simply bolt on top of the previous review, the link for which can be found above.
The main attraction of AdEPT from an investors point of view is the strong cash generation and given the low CAPEX intensive nature of the business, there is a high conversion rate of operating cash flow to free cash flow; this is derived from taking the net cash generated from operations and subtracting any capital expenditure (or sometimes amortisation) that is capitalised over the period in question. This is a core focus for many investors since the ability for a company to generate cash is paramount.
In terms of AdEPT's position within AIM, the ability of the company to generate £2.2m in free cash flows in H1 alone (or £1.8m if you pro-forma subtract the likely tax charge for the year) is a significant attraction that sets it apart from the bulk of companies on AIM. Indeed, most below a market capitalisation of under £50m are either not profitable, have a highly inconsistent financial performance, or are trading on a profit rating that is fair value or above fair value. Very few generate both high and consistent free cash flows; that is why very few small companies report "Free Cash Flow" as a headline figure, whereas a much higher proportion of larger companies (£200m+) do.
Indeed, a whole sub-£50m company comparison is not required to know that AdEPT is within the very top bands of cash generation. Having looked over the sub-£50m company space numerous times over, the free cash generation of AdEPT likely ranks within the top 10, and probably within the top few when you account for the quality of earnings.
For example, one of the few companies to challenge in terms of free cash flow would be Newmark Security (LSE:NWT). To put Newmark's performance into perspective, AdEPT is forecast to generate circa £3.7m in free cash flows for the current financial year, putting it on an Enterprise Value/Free Cash Flow multiple of circa 8.6. On the other hand, last year Newmark generated free cash flow of circa £1.1m, putting it on a multiple of around 7.2.
Is Newmark's earnings quality superior to AdEPT's? No; AdEPT's earnings quality is currently far greater due to a couple of key points. Firstly, the company has a much better revenue profile with higher levels of recurring revenues and no customer accounting for more than a few percent of total revenues for any particular year. The services offered are largely 'defensive' in the sense that they are not largely prone to sharp demand falls if the economic situation in the UK falters. To the contrary, a significant proportion of Newmark's revenues and profits are derived from 'lumpy' contract orders and there are high levels of customer dependency, so a lower rating is deserved, and AdEPT should really attract an above-average rating to numerous sectors. Certainly in terms of earnings quality, AdEPT's is far superior and the 'challenge' for a lower Market Cap/Free Cash Flow multiple can be dismissed as a comparison trap.
Other companies who challenge for comparably low Market Cap/Free Cash Flow multiples tend to have a similar problem; 32Red for example, has an issue regarding the point of consumption tax (which I have covered extensively) and operates in the high risk, heavily regulated gambling industry. A further set of comparative figures between AdEPT and its peer group is shown below.
Of the metrics above, the EV/FCF of AdEPT stands out as being abnormally low for a full-year. That is partly down to peers owning their own infrastructure therefore having lower free-cash flows, but the most sensible two figures are Daisy Group and Kingston Communications; their average of 12.4 implies a discount of circa 30%.
That difference in business models is shown by the much narrowed discount in the EV/EBITDA figures, where the discount is much smaller at circa 10% (to the average). That said, the last FY EV/Sales figure is considerably lower than peers, and when matched with the free cash flow multiple, reflects highly positively.
Below are a series of questions asked of CEO Ian Fishwick, which assist in giving an overview of AdEPT and its operations.
- For potential investors looking at AdEPT, can you give a short overview of the company and its business activities
AdEPT Telecom plc is listed on the AIM market of the London Stock Exchange (ADT.L) and is one of the UK’s largest independent suppliers of telecommunication and data products in the UK with sales of £22 million per annum and c.20,000 customers across the UK.
AdEPT is widely recognised as one of the leading independent multi-site multi-product specialists in fixed line telecoms with over 700 multi-site customers. AdEPT has around 20,000 fixed line telecoms customers taking a full range of telecoms products including calls, line rental, mobile, broadband, data connectivity cloud-based contact centre solutions and VoIP.
Our carefully selected Carrier partners provide tier-1 services through a variety of access products. Our business is built on a strong financial footing and continues to innovate through our fresh approach to solving communication problems. AdEPT combines the carrier independence and cost effectiveness of a Virtual Network Operator with all of the innate technical and business benefits gained from access to a fully resilient MPLS core platform.
- You have completed 19 small acquisitions to date. Can you outline the process of integrating
the businesses post-acquisition and the resultant realisable benefits?
All fixed line customer base acquisitions to date have been fully integrated into the service centre in Tunbridge Wells. No acquisition has taken longer than 6 weeks to integrate. The AdEPT call centre starts to take calls from acquired customer bases the morning after completion of an acquisition. We do not acquire people, buildings or systems; all we want to buy is customer contracts.
The acquisition target is generally valued on a margin multiple as we do not take over the indirect cost base. The AdEPT systems were established to be fully scalable and therefore acquisition margin of a fixed line telecom base is a direct bolt-on with the margin virtually all dropping through to EBITDA.
Revenue per customer is not used by AdEPT as a KPI or measurement tool. This is because we have a wide range of customers from very small customers spending as little as £10 per month to very large corporate and public sector customers spending up to £50,000 per month. AdEPT has a wide spread customer base with no single customer accounting for more than 2.5% of total revenue. The organic sales drive for AdEPT is to win higher spending customers through leveraging the public sector frameworks and direct marketing.
- Where does AdEPT currently sit within the market in terms of market share of each segment?
Depending how you define the Telecoms market in the UK the size of the market is up to £10 Billion. It is unwise of us to talk about market share when we represent such a small proportion of the market [but] the opportunity is huge.
- From a customer perspective, what are the key differentiating factors that sets AdEPT apart?
AdEPT has approved status on 3 government frameworks:
* Janet: approved to sell data connectivity to UK colleges and universities. This framework was renewed for a further 4 years in July 2014.
* Eastern Shires Purchasing Organisation: sole supplier of calls, lines, broadband, fibre broadband, super-fast internet access and SIP to local government, public sector and registered charities nationwide. This framework was renewed in October 2014 for a further 2 years.
* Crown Commercial Service: AdEPT is one of 10 companies recommended on the central government telephony services framework.
AdEPT offers dedicated account management for customer spending as little as £5,000 per annum on any telecommunications product or service (a Premier Customer). Premier Customers have a named dedicated account manager. The Premier Service account managers are our highest qualified staff and are trained to answer any problem. They act as a single point of contact for all issues and would personally handle all faults, orders, billing queries etc. This means that AdEPT is ideally positioned to deal with multi-site or more complex customers.
AdEPT offers a single bill solution, which means that we can knit together best of breed services from different underlying networks and offer the customer a single invoice solution and a single point of contact for any issue.
- One of the more significant points is that AdEPT is transitioning towards the provision of next-generation services and there is excellent revenue growth within that segment. Are you seeing that growth being derived from the existing customer base switching into the next-generation services, or from new customers?
We have existing customers who take voice services adding or upgrading their existing data connectivity services through AdEPT. AdEPT can offer the full range of next generation services to meet the requirements of a wide cross section of customers. AdEPT has a team of data specialists who can develop a complex network solution to meet customers bespoke requirements.
We also have a number of new customers coming on board who are taking only data connectivity solutions from AdEPT. For example AdEPT was one of the first suppliers in the industry to offer 10Gb Optical Spectrum Access services and this has attracted several new university customers.
The majority of revenue growth in data connectivity has been driven by new customer acquisition rather than cross-sell into existing customers.
- Can you summarise the operational and financial progress that has been made over the past few years, and also the ongoing investment opportunity that AdEPT offers to investors
Our business model is based on recurring revenues and minimal capital expenditure as we rent network capacity rather than build our own. AdEPT therefore has excellent free cash flow generation, typically between 85-110% of EBITDA. AdEPT has used debt finance to fund its acquisition strategy as the free cash flow can be used to meet debt repayment.
AdEPT went through a period of de-leveraging from 2008 to 2012 repaying more than £9m of debt finance. In 2012 AdEPT went back on the acquisition trail and we have completed 3 acquisitions within 24 months. The last set of interim results (to 30 September 2014) showed that net debt to EBITDA ratio was 0.7x giving plenty of scope to use debt funding to finance transactions without driving gearing.
AdEPT announced in September 2014 an interim dividend of 2.25p (an increase of 50% over the comparative period), which on a full year basis equates to a dividend yield of around 4%. Given the current rate of interest on savings a dividend yield of 4% should prove attractive.
As an AIM quoted stock an investment in AdEPT qualifies for both IHT and ISA, giving investors a tax efficient investment. AdEPT is highly cash generative, profitable and paying a dividend.
Having re-considered the investment case, the positive elements identified within the initial review remain, but with the technical breakout, it makes complete sense to reverse the previous tag of No Rating and to instate a buy tag on AdEPT. Broker targets remain at 175p and 185p respectively, implying attractive upside of between 30% and 40% for what is a seemingly low risk play. An initial target in line with that at 185p (implying over 40% upside) would put the shares on a 2015 PE ratio of between 12 and 13, which is not at all reasonable given the excellent free cash flows and earnings quality. That would correspond to a Mcap/FCF multiple of around 10.6 for 2015, which still places the company comfortably towards the best Mcap/FCF on offer amongst sub-£50m AIM stocks given the earnings quality.
Broker targets have been conservative in the past and with the cash generation and ability to secure further debt, there is strong potential for those EPS figures to be revised upwards in the future. Admittedly, AdEPT is not a short-term play (rather a medium-long term play), but the risk-reward is highly attractive with little obvious downside from current levels given the defensive attributes. A rare high quality AIM company with an excellent track record and potential for low-risk share price appreciation, along with the benefit of a significant technical breakout. I have put a Buy tag on AdEPT Telecom at 128.50p.