Service Stream: Move over NBN, Comdain has arrived

Service Stream (SSM) has developed into a core small-cap industrial poised to capitalise on servicing Australia’s essential networks including electricity, gas, telco and water.

SSM has delivered a solid FY19 result, maintaining its enviable track record of execution with the second half of FY19 delivering a 12^th consecutive half of EBITDA, EBIT, NPAT and EPS growth, and with positive earnings revisions expected from consensus estimates.

Key take-outs from the result

Operating Revenue (+35%), EBITDA (+41%) and NPATA (+39%) growth beat market expectations, even after accounting for the strategic acquisition of Comdain Infrastructure (acquired January 2019), with organic revenue and EBITDA growth of approximately +10% and +24% respectively.

Operating cash flow positively surprised with 89% Gross Operating Cash Flow (GOCF) conversion and 103% for the 2H19, above expectations even with the unwind of working capital in relation to prepayments for design and construction work. Stronger than expected earnings and cash flow conversion resulted in the balance sheet finishing with net cash of $10.5m, despite the significant cash outlay for the Comdain acquisition.

The highly strategic value of Comdain Infrastructure is evident through the combination of complementary capabilities and service offerings, diversifying revenue into a growing utilities market and increasingly annuity style revenues for the group. Further evidence of growing annuity style revenue was evident through the +23% increase in NBN maintenance tickets within SSM’s telecommunications operations. Comdain is integrating well and ahead of plan, delivering solid 2H19 revenue and EBITDA of $160m and $11m as expected.

FY19 was a transformational year for Service Stream with the successful acquisition and integration of Comdain. Management have demonstrated precision-like execution to deliver another outstanding result and could be considered even more reliable than Steve Smith’s recent run for the Australian Cricket team.

Over the last 6-months, SSM’s share price has experienced an earnings multiple rerate from approximately 13x PE to 17x PE on FY20 forward earnings, roughly in line with the S&P/ASX Small Industrials Index. We believe this valuation is justified as outlined in our previous Livewire commentary on the 1H19 result.

While Service Stream arguably traded around fair value prior to the result, successful listed small-cap companies can remain at fair value (or elevated above fair value) for sustained periods of time. Given SSM’s history of delivering reliable revenue, earnings and cash flow, we believe the valuation is justified, albeit with a reduced margin of safety.

For some time, prior to the Comdain acquisition, management flagged their intentions to diversify the business away from predominantly telecommunications in a disciplined and shareholder-friendly manner. The plan is well on track.

What is the market overlooking?

On our estimates, NBN maintenance revenue now exceeds activations revenue within the telecommunications division. This is significant as it demonstrates a successful transition to increasingly annuity-style revenue is occuring. 

We also believe the market may be overlooking the latent potential in further accretive acquisitions that can further enhance (not supplement) SSM’s growth, some of which may have been previous targets where vendor expectations were too high. Vendors now have a case study in Comdain with a well-structured, mutually beneficial transaction that can be replicated for the right opportunities.

Comdain’s vendor script component has appreciated +62% from approximately $68m to $110m, and Service Stream’s market capitalisation has appreciated +71% from $643 to $1,100m, all in just over 8 months!

We believe previous acquisition targets may return to the negotiating table over the short to medium term and provide opportunities and catalysts for further accretive earnings growth.

What is the outlook for Service Stream?

For a capital light, cash flow generative business with disciplined and proven management, the future is bright. Key points of focus going forward include:

1. Acquisitions: We expect SSM to continue to maintain a disciplined approach to assessing acquisition opportunities that are both strategic and value accretive for shareholders.
2. Technology: NBN Co analysts and industry research suggests that Australia’s consumer demand for data is expected to grow by 20-30 per cent annually through 2025. SSM is positioned to capture this not just through the NBN, but also the roll out of 5G, for which it has secured contracts.
3. Comdain Infrastructure: following the integration of Comdain, synergies and margin expansion are opportunities over the medium term.

A further catalyst in the coming year could come through increased analyst coverage. SSM is now an S&P/ASX 200 company, yet has no bulge bracket coverage, with only four small-cap brokers currently covering the stock. We believe expansion in coverage is inevitable, and this will serve to further support capturing the attention of domestic and international investors.

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