An Alternative Investment? James Faulkner on Alternative Networks

Recent share price weakness in converged telecoms services provider Alternative Networks (AN.) could be an opportunity for investors looking for growth at a reasonable price. With an enviable track record of consistent profitable growth since its inception in 1994, the company has also become a savvy acquirer of companies that augment its skill set and enhance earnings.

As of 2012, Alternative Networks has delivered an average CAGR (compound annual growth rate) in diluted EPS of c.18.7% per annum and generated an average return on equity of 34.3% since flotation – not bad for a business whose more traditional markets are generally considered to be in decline. The firm has historically been a prolific cash generator, and has rewarded investors through a highly progressive dividend policy.

The business…

Alternative Networks (AN.) is a reseller of fixed, mobile and data services to the corporate SME market (typically 100-500 employees). With a strong focus on the enterprise segment of the market, acquisitions have broadened the product set along with the addressable market, and the firm has become adept at cross-selling its products and services. This might not seem like a particularly exciting or original business model, but the fact that the company is network agnostic (i.e. it does not rely on any particular network or service provider) gives it significant advantages – not least of which is the freedom to choose best-of-breed network and services, tailored to specific customer requirements.

On top of this, the business model does not require heavy capex spend, as there is no need for meaningful investment in network assets on the part of the company. Instead, the firm has cultivated relationships with a selection of major network operators and equipment providers (including BT, Cable & Wireless, Talk Talk, Vodafone, O2, Extreme and Mitel), enabling it to keep pace with the latest industry developments without having to bear the brunt of the related costs.

The group generates all of its revenue in the UK. Headquartered in London, it has national presence through offices in Manchester, Reading, Chatham, and Woodburn Green, Buckinghamshire. The firm is divided into three main business units. In Fixed Line the firm provides a broad range of services, ranging from the installation of analogue and ISDN lines, through the provision of least-cost routing and carrier pre-select services, all resold to clients but provided by network operators.

Mobile is a key segment for the group, with mobile telecoms accounting for around half of all corporate telecoms spending in the UK. the firm has secured licence agreements with two of the major network operators with product offerings that are tailored to the corporate market, ensuring that the company’s product set contains voice and mobile devices that keep pace with technological developments.

Completing the package is Advanced Solutions, which provides its SME customer base with bespoke, complex services aimed at allowing them to manage their communications assets in addition to providing the group’s data service solutions. The group’s customer billing solutions also form part of the division, as do the activities of the recently acquired Scalable Communications, which has added expertise in IP network, IP security and IP telephony to the firm’s offering.

The market: highlighting the benefits of convergence…

Ofcom estimates that the size of the corporate telecoms market in the UK is in the range of £13.5-14 billion, complicated by the fact that the last published data for the market relates to 2009, which was a year of decline as the sector was impacted by the recession. However, the market is characterised by diverging trends – principally the growth in corporate data services and the decline in corporate fixed-line voice revenues. Herein lies the attraction of the business model: the company’s focus on converged services enables it to readily adapt its offering to the changing landscape of the corporate telecoms market, identifying trends along the way and investing selectively to maximise its customer offering and, consequently, growth. Its tailored, converged approach is attractive to SMEs who see the cost advantages this offers and the value of single billing and customer service from one operator. Therefore, although some parts of the corporate telecoms market (i.e. fixed-line voice) are in decline, there is significant scope for the firm to continue to grow these revenues through taking market share from the incumbent network operators who still dominate the market.

In order to broaden its appeal, Alternative has been making strategic acquisitions that have increased the scope of its capabilities into adjacent areas of technology. In January, the firm announced the acquisition of Intercept IT Limited, an established provider of Hosted Desktop solutions to the SME market, as well as desktop and server virtualisation services to Enterprise business customers running on-premise IT infrastructure. For a consideration of £12.95 million in cash, funded from the group’s cash resources, the acquisition of Intercept enables Alternative to offer complete cloud-based solutions to its SME customer base. Given that the UK cloud hosting market is set to grow from £1.4 billion currently to £2.5 billion by 2016 (according to research from cloud hosting firm Parallels), companies like Alternative Networks cannot afford to miss out on such an opportunity. Secondly, the deal will enhance the group’s Managed Services offering to the Enterprise market, which is also forecast to expand at double-digit rates over the next four years (Insight).

Later the same month, managed hosting and cloud-based services provider Control Circle Limited, for £39.4 million in cash, to be funded from new bank facilities of £43 million, which replace the firm’s existing £6 million facility. As with Intercept, the acquisition of Control Circle looks to be a highly strategic move for Alternative, with the size and pace of recent acquisitions an indication of their immediate appeal to the group. Control Circle specialises in the delivery of complex managed hosting, cloud and datacentre services, which management describes as “an increasing requisite for the Company’s existing and targeted UK enterprise clients”. Together with Alternative’s existing services in networking and datacentre and the recently acquired virtualisation skills of Intercept IT, the enlarged group now has a comprehensive and compelling data and IT services portfolio including managed and cloud based services, such as managed hosting, datacentre virtualisation and application management. Furthermore, the enlarged group offering will allow clients to choose private or public hosted cloud services.

Acquisitions bearing fruit…

At the interim stage, the benefits of these acquisitions were beginning to become apparent. Revenue climbed by 14% to £63 million in the half-year to March, with the benefit of the acquisitions of Control Circle and Intercept IT acquisitions adding £6.5 million of revenue. There was still organic growth of 2%, which is reasonable for an industry generally seen as being in decline. Adjusted operating profit increased by 5% to £7.5 million but statutory operating profits before tax decreased by 11% from £5.5 million to £4.9 million as a result of non-recurring charges relating to the acquisitions. Diluted adjusted EPS rose by 14% to 12p and the interim dividend was increased by 11% to 4.9p. Looking ahead, it is intended that annual dividend growth should progress towards 15% in 2015.

Cross selling continues to be a key focus, with the proportion of customers taking more than one product currently at 46%, highlighting the potential for a significant uplift from this quarter. The average spend continues to increase as larger customers have been won and more products cross sold into existing larger customers, growing by 2% from £5,349 in H1 2013 to £5,445 during the first half of the current financial year. The acquisitions of Intercept IT and Control Circle have also significantly enhanced the firm’s ability to cross-sell. Since those acquisitions, 10 new cross-sell contracts have already been signed, including one that involves all three parts of the group. 

The momentum continued into H2, with a particularly strong performance in mobile with the subscriber base up 12% year-on-year for the year to 30th September (and 7% since March 2014). Organically the business is expected to deliver modest like-for-like revenue growth for the year and the acquired businesses are expected to deliver revenue growth above 10% for the period since acquisition. Cross selling progress across the group is said to have been buoyed by both acquisitions (ControlCircle and Intercept IT) and management expects this momentum to continue in the current financial year. In addition, a new headquarters at at 240 Blackfriars Road will accommodate the enlarged business and is expected to allow further integration and cross selling opportunities.

What’s more, Alternative has achieved this strong performance whilst making significant inroads into the debt accumulated to conduct its recent acquisitions. Group net debt at 30th September 2014 was £29.4 million, down from £35.4 million in March and below the £30 million target set by management at the half year. The firm’s “cash cow” credentials have thus been upheld, but at the same time as a major growth element is being injected into the business.

Valuation…

Alternative Networks trades on a prospective current rating of 13.9 times based on consensus estimates, with a prospective yield of 3.8%. While the current valuation reflects the quality of the business and its burgeoning growth prospects, Alternative Networks is positioning itself in several secular growth markets within which it is ideally placed to compete by virtue of its converged business model. We also believe the balance sheet offers room for further acquisitions which could push through further earnings upgrades.