Update No. 179 – 05/09/14

Our FY2014 performance letter mentioned that we had begun acquiring some stock of businesses listed on Australia’s second tier exchange the National Stock Exchange of Australia.

Late August or September was the commitment and I prefer to keep my commitments, so a brief outline of the first such stock is set out below.

I figured we should outline the stock for two reasons. Firstly, we are now the 5^th largest shareholder (.pdf) in Bendigo Community Telco (BCT.NSX). This achievement required only the purchase of less than 100,000 shares, although we owned 127,000 by 30 June, so that information is in the public domain in any case via the reports. Furthermore, I declared in our most recent investor letter that I had been buying some NSX stocks, the exchange is small and there are only a handful of stocks on it that are of a sufficient quality that we would invest, so the curious mind could probably narrow the group down to include BCT as it is probably the best on the exchange. Rather than let investors speculate, simpler to lay it out.

The investment proposition is pretty simple for BCT. Based on the June 30 2014 balance date, FY14 P/E is 5.9x. When the substantial cash on balance sheet is backed out, the ex-cash P/E is 3.9x. EV/EBITDA is 1.9x At the recent trading price of $1.65, based on the 20c dividend for FY14, yield is 12.12% and given the dividend is fully franked, to the Australian taxpayer the effective (grossed up) yield is 17.32%. Since listing, when factoring full franking of the substantial dividends that have been paid, investors in the IPO of BCT have generated an IRR of 20%, and yet based on most common metrics, BCT stock is probably cheaper now than when it listed.

The most commonly used valuation technique in the telecommunications industry is EV/EBITDA. An Ernst & Young report (.pdf – see page 5) indicates the global median EV/EBITDA for a ‘Multiline Telecom Service Provider’ is 5.1x. Median P/E is 12.0x and median ex-cash P/E is 17.0x (the ex-cash P/E goes up because you’re adding in debt, whereas with BCT you are subtracting cash). Obviously, comparing BCT to Vodafone, Deutsche Telekom or Verizon is manifestly unwise, but the idea with valuation is to find some unit of comparison and these were available.

So BCT trades at a 63% discount to the global EV/EBITDA median. The P/E is less than half the global median and when the cash (or debt) is factored out, the P/E valuation for BCT is less than a quarter of the examined ‘peers’.

The cheapest in the group on an EV/EBITDA basis is Nippon Telegraph and Telephone Corporation (NPP) at 2.8x. EBITDA has declined by 18% for NPP over the last 10 years. NPP’s earnings per share exceeded 2005 levels for the first time in the period ended March 2014, unfortunately over those 10 years, the company repurchased about 25% of its shares, so net income is actually much reduced. Per share earnings over the last 5 years for NPP exceeded by only 2.5% the EPS over the five years prior to that. NPP is a profitable company with limited growth, there is a good reason it trades at the lowest multiple of the examined group. By way of contrast, per share earnings for BCT over the last 5 years have exceeded by over 58% the five years prior to that, EBITDA has tripled over the last 10 years. There has been growth in the business that would indicate higher multiples should be applied (than those applied to NPP for example). What we need to examine as investors is whether there are any prospects of growth into the future.

To be sure, BCT faces some issues that come with being very small. Topline revenue growth has been non-existent (in fact total revenue has declined since 2010). The roll out of the NBN offers some excellent opportunities for BCT in this regard, in the areas surrounding Bendigo (BCT are expanding the sales of NBN to encompass a much wider area beyond Bendigo also), as the network is switched on, BCT do not need to capture a lot of the new connections for it to have a meaningful impact on their results. The decline in revenue has been dealt with so far by massive improvements in gross profit, that is, by reducing costs of products sold. In simple terms, BCT have restricted themselves steadily to the most profitable areas of the market. GP has risen from the 30% range to nearly 50% and appears to be plateauing.

Furthermore, BCT has some ‘major customer risk’ around the provision of services to Bendigo Bank, however I view this as being nicely offset by the fact Bendigo Bank is also the largest shareholder, so they would be reluctant to torpedo the business just for squeezing a little extra profit from their telco provider. Recent 5 year contract extensions give some medium-term relief from major customer risk. It would be nice to see the current contract period used to add revenue streams outside of this important customer.

Our average purchase price is a little below the last traded price of $1.65, so without any capital appreciation, if the dividend remains constant (bear in mind it has double over the last 5 years), we will generate a pleasing grossed up return of 17.45% annually on our holding of BCT. We really don’t need any meaningful capital appreciation for that to make a sound investment, but the stock since listing has managed to generate capital growth of a little over 5% annually, I would be surprised if it couldn’t generate something similar over the next 5 years as I said above, the stock is priced more cheaply on virtually every common valuation metric than it ever has been.

To any BCT holders who might find themselves reading this, I will be attending the AGM in Bendigo on October 1^st. If you have any interest in selling your holding, come along and find me, we can make a deal. I would point out to you (as I have to the others from whom I’ve purchased stock) that at current prices, I expect EGP to make out very well out of the deal – we would not be interested otherwise. But if the cash is of more interest to you than the shareholding, we stand available to turn your holding into cash – Tony Hansen 05/09/2014

EGP Fund No. 1 Pty Ltd. Up by %, leading the benchmark by % since July 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by %, leading the benchmark by % all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1.000 cent per share Franking Credit & 31 May 2014 Dividend of 7.000 cents per share plus 3.000 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}