Service Stream Limited (ASX:SSM) release their FY18 results on 14 February 2019. The share price is now hitting all time highs. Should investors lock in their profits prior to the results? We look at the fundamentals and technicals.
About Service Stream Limited
Service Stream is a provider of essential network services to the telecommunications, energy and water industries. The main revenue driver of the business being the rollout of the National Broadband Network (NBN). The Company operates in three segments namely Fixed Communications, Network Construction and Energy & Water.
The Fixed Communications segment is the main contributor to group revenue and earnings. This division, which accounts for 47% of group revenue and 53% of group earnings, provides a wide range of operations, maintenance and minor works services to the owners of fixed-line telecommunication networks in Australia. Principal customers include NBN Co and Telstra.
NBN Activations Declining In Current Financial Year
The Company has benefited from the NBN exceeding its total ready for service, activations and revenue targets for three years to FY17. According to the NBN Co’s latest Corporate Plan for 2019-2022, the NBN expects that 1.5m premises (i.e. homes) will be activated in FY19. While this is lower than the 1.6m delivered in FY18, a large portion of activations have been pushed out to FY20. In the latter year, an additional 2.0m premises are expected to be activated on the NBN network. By June 2020, NBN Co expect that 7.5m premises will be activated on the NBN network.
The main reason for the dip in activations in FY19 is that NBN Co paused new orders on its Hybrid Fibre Coaxial (HFC) network in November 2017. This was in order to improve end-user experience. According to the Corporate Plan for 2019-2022, a full recovery is planned in FY20. Because of this, the forecast is for an additional 2.0m premises in FY20.
While the level of activations is declining in FY19, there is potential for SSM to offset the resultant revenue shortfall. This would be from increased remediation, network testing and maintenance work required to improve the reliability of the NBN. In particular, maintenance work is now scaling strongly as the network is activated.
Concentrated Customer Exposure
A significant investment risk is that SSM’s revenue base has a high exposure to a small number of clients. This means that it is exposed to disruptions/delays from its major customers and changes to the level of customer demand. That is, many customer contracts do not contain minimum volume commitments. Further, the Company has retained a high exposure to its two major customers. These account for ~92% of the combined revenue for the Fixed Communications and Network Construction segments. This is despite the Company’s strategy to diversify the overall revenue stream in FY18 by making acquisitions. That is, TechSafe – a domestic independent electrical inspection and auditing business. Also, winning new (albeit relatively small) contracts in the “disruptive energy” space (i.e. the Energy & Water segment).
While the acquisition of Comdain in January this year lowers the level of exposure to the two major customers from FY19, further acquisitions are needed to further reduce this investment risk. This is because the exposure, in % terms will still remain high. The challenge for SSM is that the acquisition multiples for potential targets have recently increased. This is evidenced by the acquisition of Comdain on an EBITDA multiple of ~7.4x, compared to the 6.4x paid for SSM’s previous acquisition of TechSafe (completed in April 2017).
Fundamental View of Service Stream
We consider that the main risk to the near-term earnings growth profile is a further delay in the activations profile outlined by NBN co. This is in light of media reports that NBN customer are continuing to experience connection speeds that are slower than what has been represented by the Retail Service Providers (RSPs)
Consensus forecasts imply 20% EPS growth in FY19. Approximately 11% is organic growth with the balance derived from a ~6-month contribution from the Comdain acquisition. This then declines to ~10% growth in FY20. In context, it is worth noting that only one broker covers SSM.
Although the shares are currently trading on a 1-year forward P/E multiple of around 14x, which appears undemanding in the context of the above-mentioned earnings growth profile, we take a cautious view on SSM. This is in light of the risks from a potential slowdown in the growth profile of NBN activations and the concentrated customer profile.
Charting View of Service Stream
Service Stream has been in an uptrend for a few years now. It spent the back half of 2018 forming an ascending triangle, holding up well against the broader market. In mid January it broke beyond that triangle and is now heading higher again. It is looking overbought on the daily chart, but it has not provided us with a sell signal yet. However, price action in the last few days is showing a bit of rejection at these higher levels. We may be now reaching a short term top. Given the fundamental concerns within the company, investors may consider taking some risk off the table and wait for the FY results which are due shortly.
Michael Gable is managing director of Fairmont Equities.
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