The Business

My Net Fone (ASX:MNF, Financial) is in the business of providing Voice over Internet Phone (VoIP) services, predominantly in Australia. VoIP effectively replaces the need for a traditional telephone connection. It uses the internet to connect and maintain the call rather than a telephone exchange. The user experience is the same as a traditional land line phone, enabling users to dial other landlines, mobiles etc. The traditional hook for customers to switch to VoIP is to reduce cost per minute of phone calls, particularly long distance. My Net Fone provides additional levels of service over and above this and have five key sales channels:

Retail – Residential: This is the business of providing a VoIP phone and connection to residential customers. The service is effectively “plug and play” with an existing internet connection. MNF can also provide broadband internet connections to residential customers as a bundle. They have over 100,000 customers in this segment, 13,500 of which also purchase broadband internet. They are seeing strong growth in the broadband internet services.

This is a fairly low margin segment and is also difficult due to low revenue per customer and high support demand. VoIP is commonly a technically difficult thing to set up, MNF have made it easy which sets them apart from many customers. They are also recognized for reliability and good value.

The brands operating in this segment are MyNetFone and PennyTel.

Retail – Business: In this segment, as well providing VoIP services, they also couple this with virtual PBX service. They provide 13, 1-300 and 1-800 numbers to this segment, as well as business broadband services.

This is their highest margin segment. They have 2,800 virtual PBX deployments, 8,900 business voice services and 3,200 business broadband services.

The brands operating in this segment are My Net Fone, Call Stream and Connexus

Retail – Enterprise: Essentially the same services but provided to larger customers across multiple sites. The brand operating in this segment is Connexus

Wholesale – VoIP Managed Services: The wholesale market enables other retail brands to utilize MNF’s network and software to re-sell their own services. This acts as a sales channel for their VoIP network.

The brands operating in this segment are Symbio Networks and iBoss.

Wholesale – Carriage Services: Wholesale selling of capacity on their network.

My Net Fone is a relatively new business, founded in 2004 and listed in 2006. They have the largest VoIP network in Australia by billed minutes, with over 3 billion billed minutes per annum.

They see themselves as software providers rather than VoIP retailers. In this regard, they regard their IP as far more important than their marketing or sales ability. Their focus is delivering the best technology solutions to this market. They are unique in Australia in this regard. There are many VoIP retailers, but very few also wholesaling with network and customer management software solutions.

They have won many awards for their innovation, business success and service provision.

The business is relatively small with a market cap of just $197M this business is pretty small which bodes well for future growth prospects (plenty of headroom). It is also off the radar for most analysts and funds managers, perfect for small investors.

Economic Moats

My Net Fone has a number of moats. In approximate order of strength, these are:

The interconnected VoIP network

MNF has an VoIP network that spans Australia and also reaches to Singapore and New Zealand. Setting up the network (leasing or purchasing fiber and establishing hardware at nodes) is relatively easy and is not a significant moat. The interconnectivity is, however, very difficult to achieve. To interconnect, MNF had to negotiate with every incumbent phone service and establish agreements, mesh networking technologies, etc. This allows porting of phone numbers. In practice, this means that customers can switch retailers without needing to change their phone number. It also allows a business with a My Net Fone service to change premises without changing their phone number.

Negotiating and setting up the connectivity with existing networks is a very time consuming and costly process, a large barrier to entry for both Australian and international businesses.

Virtual PBX

A traditional PBX (Private Branch Exchange) system is a locally networked phone service enabling employees within a business to dial each other on an “extension” without requiring the external telephone network. They can also make and receive calls externally (but there are usually reduced number of external lines that employees share). My Net Fone have effectively moved the PBX to the cloud, which enables much greater flexibility and remote management and switching. This makes a change of premises or workspace management much easier. The virtual PBX system is also less expensive to establish and maintain. This offering is a particularly strong moat when linked to the interconnected network. So in order for a competitor to really duplicate this, they have to establish the network and the virtual PBX technology — a tough undertaking.

Other Software

My Net Fone developed a number of software solutions in the VoIP space to enable superior management of their network and customers. These are offered to other retailers to manage VoIP customers. Coupled with their own network this is a significant moat, it is very hard for other VoIP providers to justify the expense of developing their own software when they can purchase the MNF system off the shelf far cheaper. This also brings more customers to their VoIP network at no cost, a good sales channel for them to better leverage their fixed costs.

Brands

The My Net Fone brand itself has a reputation amongst business and residential customers for quality of service and support, in the VoIP space this is probably unrivaled in Australia. Their other brands also have some value, however generally the brands only offer a weak moat.

Management

The board of My Net Fone have all been in place since it listed in 2006, so continuity is excellent. I personally don’t buy into the necessity for ‘independent directors’ as studies have shown that since their introduction, shareholder value has actually declined. I prefer to see buy-in to the business from senior management. MNF ticks this box for me.

Combined, the directors own just under half of the company. In particular, the founders Andy Fung (Non-executive director) and Rene Sugo (CEO) own large stakes with 23% and 21%, respectively.

The board is relatively lean, as would be expected for a company of this size. The remuneration of the board and senior management is significant for such a small company, and represents approximately 25% of net profit. That said, the company is punching well above its weight and performing very well, so the remuneration probably reflects this quite reasonably.

In 2013 and 2014, most of the remuneration was by way of cash salaries. There is a short term incentive bonus system for senior managers based on an NPAT target decided by the board. The target itself is not disclosed in the annual report, however in 2014 (which reflected the STI bonus for 2013) only 13% of the CEO’s total package related to the STI bonus, and no other STI bonuses were awarded. This suggests the NPAT target is quite high, and/or the bonus available is low.

In terms of competency, the CEO and board have demonstrated very good performance throughout the history of the company. The founders (Andy Fung and Rene Sugo) both have a history in the Telco industry. They obviously recognized a real need and met that with MNF very successfully. The company continues to perform very well. They have also demonstrated some competence at capital allocation with a number of successful acquisitions performed to date, all of which have benefited earnings and justified the expense.

The CFO is relatively new, having only been appointed in 2013.

Financials

With zero debt, the balance sheet is very healthy. The company has great cashflow and margins are quite healthy (9.7% in 2014 and growing). The operating history is very short with only 9.5 years of data available since listing, and only the last 6.5 being profitable. Having said that, the earnings and sales figures are a textbook example of a good start up business:

Sales growth sits at around 50% (compound over 10 years), and earnings at about 70% (compound over 6 years). They are growing margins which is consistent with their message that states they are now leveraging more and more sales through a largely fixed cost base.

Risks

The business is not without its risks, this is certain. In order of perceived important these are discussed below.

Bad Acquisition

My Net Fone are open about using acquisitions to help grow the business. There is a real risk that they will fall into the trap that so many companies do, and make a bad acquisition that damages earnings at some point.

Senior management claim they have a strict acquisition policy. When queried about this, they conceded that it wasn’t a written document; however, they were able to describe the qualities they require in acquisitions.

Principally they are looking for IP. The target business needs to be demonstrating the success of this IP with earnings and it needs to be trading (or for sale) at a reasonable multiple of these earnings (significantly less than MNF). The IP must also be easily integrated with existing MNF services or technology so that significant value can be added without stepping outside their domain.

This criteria is sensible, particularly the focus on IP. They don’t seem interested in acquiring customers, they are more focused on leveraging their IP to grow customers. In terms of protecting their economic moats, this is a good thing.

When quizzed about how much they would bend their acquisition policy if growth flat-lined, management suggested that they have other options for accelerating the business. By way of example, they pointed out that marketing spend only amounts to approximately 2% of revenue, so there’s significant opportunity here to increase efforts in this area. As a side note, it’s impressive the company has grown at the rate it has, from a start up with such a small marketing budget.

It should also be noted that they have made all acquisitions to date without increasing debt. Debt to equity peaked at 2.6% in 2013. If they continue this approach the consequence of a poor acquisition will be limited to perhaps a bad result rather than some kind of critical outcome. They have issued shares periodically presumably to fund some acquisitions. This hasn’t slowed earnings per share growth.

The risk remains but there are mitigating factors. Currently at least, management seem to have a good combination of discipline and patience regarding acquisition decisions.

Decline in landlines

Landline use is in terminal decline. The data available suggests that minutes are declining at between 8% and 13% per annum, see below chart. See this blog post for an excellent discussion on these trends.

This is a serious concern, however, for MNF there is a great deal of headroom before this becomes a direct threat to earnings, purely because they are so small at present. Some numbers help to demonstrate this point.

In 2014, the Australian Telco industry made approximately $8.5B in revenue from fixed line calls. MNF only generated $60M in revenue, a mere 0.7% of the $8.5B. MNF is growing significantly however, whilst total fixed line revenue is shrinking significantly. Assume that landline call minutes keep declining at 13% (max of last 8 years) and there’s also an additional price squeeze of 5% per annum. This gives a total annual decline in fixed-line call revenue of 18% per annum. At a growth rate of 30%, MNF would achieve 50% market share in revenue for all fixed line calls in Australia within 10 years. Essentially they would need to re-invent themselves or expand overseas in order to keep growing at this rate, two very difficult undertakings. Due to the significant headroom at the moment it’s not something that will threaten earnings quickly, however the business will need to evolve within ten years to deal with this.

Key Man Risk

The CEO Rene Sugo is clearly a driving force within the business. His investor presentations highlight his knowledge of the domain and the business. He has a large shareholding, so he is also well motivated to continue the excellent business performance.

My Net Fone don’t publicly state their succession plans and it was only recently they appointed a CFO. Although there may be a successor in waiting, their ability to fill Mr. Sugo’s shoes is a total unknown quantity. Fortunately Mr. Sugo is relatively young, so this risk is certainly not imminent, not withstanding an accident or serious illness.

Summary of Risks

My Net Fone has significant risks, but none require urgent attention. The acquisitions need to be closely monitored by existing or prospective shareholders. A poor acquisition seems the most likely event that will cause significant damage to MNF.

The Tough Questions

I like to ask myself these questions before making an investment.

Is this a business I’d be happy to buy now and forget about for 10 years?

Probably, but I’d much prefer to turn up to the AGM every year and ask management for an update on their “acquisition policy” just to make sure their heads are still in the right space. As a consequence of this I’ve reduced the holding period in my DCF model to 10 years (from my normal 15).

If I had a punch card with only 20 slots on it for capital allocation decisions, is buying this business worthy of one of these slots?

The business seems like a good bet. Earnings are going to grow, not withstanding a very left field event. They will likely grow very significantly too. Despite the business being in such early stages, they are demonstrating very consistent performance.

Is there any element of impatience influencing my decision making process? (Don't let “missing out” tempt you).

In terms of making a buy today, on the positive, the current price is 30% below the previous high, so timing seems right. However, within the last year the business has been traded at a discount of 30% to today’s price. If my prediction on continued earnings growth is correct, the price will likely climb significantly from where it is today relatively shortly, and may not retreat to this level. It would seem a better buying opportunity would only present in the instance of a market wide correction. The problem being that this may be some time off, and again, today’s price may not be broken as a floor. Certainly, significant discounts to the current price are unlikely. With this in mind, I don’t think purchasing today forfeits any diligence in other areas on my part.

Is this business inside your circle of competence?

Yes, but it’s been a relatively steep learning curve.

Valuation

I have a high level of confidence in this business. To value the business I ran two DCF models:

• Present value of ten years worth of future cash flows using the below assumptions, which yielded a value of $4.38.
• The above earnings in addition to revenue gained by selling the company at the 10 year mark for 5 x PE it would be worth $9.27 today.

10 years is a long time frame, particularly when looking at a growth stock like MNF. However, when you're looking for truly excellent businesses 10 years is probably a short time frame (Buffet: "Our favourite holding period is forever"). Taking a long term view also helps one to carefully consider the risks and galvanises the research effort.

Either valuation method indicates the stock is trading well below fair value. Even with a margin of safety of 150% (estimated value to price ratio), a price of $2.92 is fair.

DCF Assumptions:

Sales Growth – 25% (Well below historical average of 40%+)

Profit Margin – 9.7% (2014 NPM, despite the fact profit margin is increasing, have held this at 2014 level).

Discount Rate: 4.5% (long term cash deposit rate)

Recommendation

Accumulate whilst the business is trading under $2.92/share. Currently at $2.82.