Hull-based telecommunications provider KCOM Group today issued a double whammy for investors: a trading update which forecasts weaker than expected earnings, and a revised dividend projection, which halves the potential return for investors. This was not particularly expected: the share price has traded in a relatively broad range for a couple of years, which tells the story that underling performance has been rather solid, if unspectacular. The share price responded this morning with an almost immediate 40% drop, although it has recovered somewhat:
These are bad months for news releases, owing to the heightened uncertainty about the details of Brexit, or even which political party will be in power by the time March 2019 swings around. This has fed down into share prices. Easyjet released a fairly decent set of results today and its price still declined by another 2%, despite the price being not far off its year low and indeed, the level that it crashed down to when Brexit was originally announced.
KCOM may not be familiar to those outside of the region. It provides internet services to consumers, but also enterprise services such as cloud products, support services as well as connectivity services for larger organisations and government. This is an area where there is plenty of growth to be had (after all, technology is still evolving) but also sees increasing competition on all its segments. Geographical advantage has much been eroded in these days of instant communications.
The RNS gets straight into it:
The Board now believes that the Group’s trading performance for the current financial year ending 31 March 2019, on a pre-IFRS 15 basis, will be weaker than originally expected. This is principally the result of flat revenue (driven by lower than expected order intake) in the Group’s Enterprise segment and continued customer churn in the Group’s National Network Services segment (“NNS”). It is the Board’s view that these trends will continue into the following financial year.
This is helpfully quantified, but it looks as though the profit warning will continue for at least another year:
As a result, the Board now expects EBITDA (pre-IFRS 15) for the current financial year ending 31 March 2019 to be c.5% below current market expectations. However, as a result of the factors outlined above, it is also the Board’s expectation that EBITDA (pre-IFRS 15) for the financial year ending 31 March 2020 will be significantly below current market expectations.
Holders attracted by the high yield will also be disappointed:
As such, the Board has decided to review the Group’s ongoing dividend policy, resolving to pay a dividend of not less than 3 pence per share for the current financial year ending 31 March 2019, rather than the previously stated commitment to pay 6 pence per share.
The basic metrics here do not initially point to a good business. Revenues have been declining, as has EPS. The anomalous year of profit (2016) was explained by a £44.5m profit on the sale of its national telecommunications network, the £90m payment allowing it to repay debt. Taking this into account it does square with the comment of paying uncovered dividends as the dividend cover ratio has been less than 1 for the past 4 years.
Because of the rather stable share price, the yield has been generous, ranging between 4.5% and 7% roughly depending on the purchase price. That seems set to tumble, and net debt has increased from zero in 2016 to over £100m today, and that isn’t the end of the bad news as detailed in the warning:
The Group’s net debt at 30 September 2018 is £108.5 million (30 September 2017: £67.8 million, 31 March 2018: £62.6 million). This includes a material permanent one-off working capital outflow, which is principally the cash impact of the decision, in order to drive down costs, to insource a managed service arrangement with a key partner, alongside the unwind of certain deferred revenue balances in the Group’s Enterprise segment. The Board expects the Group’s net debt at 31 March 2019 to be c.10% higher than current market expectations.
Arguably, the warning signs were here already: if we know that a dividend is uncovered, and the company has a fair level of debt, short of producing great performance, the dividend will end up being cut. The two risks are related.
Despite the profit warning today, the market cap is still around £300m, so the share could still be said to be quite expensive on conventional metrics. Projected profits this year were £22.8m according to Stockopedia, so allowing for a 5% hit that puts us on a rough earnings ratio of 15, with a further decline to come.
The balance sheet is not great. Total equity is almost equal to the level of intangibles, giving a rather slim NTAV. Better news exists with regard to the debt: their facilities were refinanced in 2016, and there is a £180m ceiling, of which we are under, even if the debt is higher next year. Financial and non-financial covenants exist, although obviously raising debt and declining EBITDA would be a danger. The last figure for EBITDA was £67.6m, so not an alarming ratio.
The question would be whether the profit warning is due to one-off factors or something more structural within the company? Why was Enterprise revenue flat, and why are customers churning in the networks?
My suspicion is that this might have a bit further to fall and the dividend will end up disappearing. At this stage, using those funds to pay down some of the debt and leave some headroom for contingencies might be a better idea. But the other aspect of ownership is that the shares look unappealing from a growth point of view. The current trend is that of decline, and that is set to continue into the next year as detailed by the profit statement.
The reasons cited don’t seem to be one-offs to me. Customer churn in telecoms is something that has been around since the start. People are largely not bothered about who supplies broadband or their phone services after a threshold level of service has been reached. After that it’s all about price. Switching has become much easier over the years, so competitors wanting a bit of action can simply put out incentives to acquire customers, who might end up not being that loyal. Structurally I don’t see how one firm could dominate the broadband or telephone market, which is the nature of competition.
The Enterprise part of the business has more potential, but flat revenues to me reflect increased competition or reduced spending, and may deliver lumpy contracts, with big organisations contributing disproportionately to revenues.
I don’t think this is a real basket-case, and there is a strong local identity here although from the point of view of the share I think there will be a re-rating; as such I go 2/5.