Is Vocus poised to become Australia’s stellar performing telco?

Having merged with the recently delisted phone/Internet provider M2 Group(ASX: MTU), owner of the Dodo, Commander and iPrimus brands late February, Vocus Communications Limited’s (ASX: VOC) has become Australia’s fourth largest telco with a market cap of $4.36 billion, and is now a serious alternative to ‘big-end of town’ internet services providers.

For shareholders who’ve been with Vocus from the beginning, it’s been an exciting journey, with the share price growing three and a half times from $2.39 early in 2010 to $8.14.

But given that the company wants a market cap of $10 billion within five years, Vocus’s biggest growth trajectory still lies ahead of it.

Regardless of whether it takes an infrastructure-led route or a more consumer-focused growth path, Vocus also has the capacity to become the strongest performing telco stock in Australia, with better returns and share price growth than either of its two bigger rivals Telstra (ASX: TLS) and TPG (ASX: TPM).

However, whether it does or not depends on how well it chooses the right parts of its business to investment in, and how well it integrates its old core business with that of M2 Group.

Vocus has focused on selling data carriage capacity to telcos such as iiNet, plus internet services to large corporates, while M2 – which has 411,000 fixed-voice customers, 471,000 internet users, 173,000 mobile customers based on the Optus network and 126,000 electricity subscribers – has aggressively targeted the low-cost home and internet market.

In an attempt to net around $40 million in merger-related savings and synergies by the end of financial year 2018, M2’s broadband users are expected to be moved in part onto Vocus‘ network of fibre-optic cables and wholesale supply deals.

While total shareholder equity is still under review, the combined Vocus/M2 entity will have sufficient earnings to raise around $500 million in debt – before hitting 3x EBITDA – and market support for a similar amount from capital raising should pose no difficulties at all.

Both companies reported rising profits and revenues in their last financial results as independent companies, with M2’s underlying net profits in the six months ending December 2015 increasing to $55.1 million, while Vocus reached $27.4 million.

Given the investment grade quality of Vocus’s balance sheet – which includes low net-debt to equity of 22.47%, a cash flow ratio of 2.02% and exceptional earnings per share (EPS) growth from $0.31 in 2016 to $0.49 in 2018 – the company is well positioned to continue its growth-by-acquisition strategy.

Future acquisitions likely to be on radar include, corporate telco Macquarie Telecom Group (ASX: MAQ) in which it already owns 16%, 2degrees a NZ-based mobile network with future bundling opportunities, and NextGen Group, which builds and operates inter-city fibre-optic networks and  a data centre business.

Vocus may also take its cue from M2 – which made an unsuccessful bid for discount reseller Lumo Energy in 2014 – and contemplate buying up an insurance energy retailer.

This would help to turn Dodo into a one-stop shop for Australian consumers by bundling credit cards, insurance products and electricity services in with telecommunications.

Given the need for size and scale by major players within the sector, it’s possible that Vocus could again be a future takeover target. However, the decision by larger rival TPG Telecom to sell most of its stock earlier this year, suggests Vocus is becoming harder for its rivals to digest.

Based on 2016 price to earnings (P/E) multiple of 26.04, a 60% premium to its intrinsic value, and an all-time share price high – up 40% since 31 august last year – Vocus looks anything but cheap.

However, it’s very early days into its merger with M2, and the future growth-by-acquisition upside, plus ongoing cost-saving synergies, and continued rollout of bundled services are likely to re-rate the stock in the not too distant future.

But given the stock’s recent run-up, and outperformance of the S&P500 by 48.07%, the stock’s share price momentum may run out of steam in the short-term.

True believers in the stock’s long-term fortunes should look to buy on market weakness, and watch closely for revised earnings upgrades and news of ongoing acquisitions.