Monday, 25 February 2008

Reverse Corp (REF) BUY

Reverse Corp (REF) as it's name suggests, provides reverse call charge services. Basically if you are 'out and about' and need to make a call to a fixed line phone and you either have no money, or your pre-paid mobile is out of money, you can call Reverse Corp's service and get connected free of charge, if of course the call recipient chooses to accept the call.

That's it, that's all they do and they are able to do it very profitably, As can be seen below, the company is able to generate EBIT margins in excess of 50%.

The company's automated technology platform has significant spare capacity enabling increased call volumes to be handled with little or no increase in costs. Thus capital expenditure is largely by way of maintenance and support.

The biggest cost for Reverse Corp is it's marketing expenses. A well recognised brand in both it's target markets of the UK and Australia is key to the company's success. REF's biggest competition comes from the incumbent telecommunications providers, Telstra in Australia and BT in the UK. However, since the reverse charge market is a very small portion of the incumbents revenue, they have no incentive to invest substantially in building brand awareness.

This also provides some insulation from competition, which would need to substantially invest in advertising to gain a foothold in the reverse charge market. Thus REF is a niche player that can drive high profit margins due to their low cost operating model and relatively limited competition.

This is the kind of business I like. It's simple and thus easy to understand, they have a niche and there are reasonably high barriers to entry. And most importantly the company requires very little capital to derive it's profits from. So what happened to it's share price?

As you can see the share price has basically fallen off a cliff in the last 6 months losing more than -63% from the peak in August 2007. Now just because a company's share price plummets doesn't make it cheap. The first thing you should ask yourself is did it actually deserve that high share price in the first place.

In my humble opinion, the answer without doubt is no. I would never have paid $6 for a share in this company, I probably wouldn't even have paid $3. However after falling another -7.0% today I picked some up at $2.22. This price for me, provides a reasonable margin of safety, not to mention the $0.12 cent dividend the company just declared.

The company recently reported earnings of $10.9m for 1H08. Below is the track record of the company's earnings broken down by halves. Whilst the company increased revenues and profits from 1H07, they actually declined slightly from 2H07 levels.

Some of the decline can be explained by the strong $AUD. The company derives 60% of their earnings from the UK. With the RBA set to raise interest rates at least once more, the UK operations will continue to be pressured by the strong $AUD. To offset this somewhat the company has raised prices effective from January 1st. Also the company unwound a currency hedge in January resulting in a one-off $1.0m profit.

Apart from a strong $AUD, REF is currently pursuing several contracts in the UK with both mobile and fixed line service providers, however none are likely to come to fruition in the current financial year.

Look ahead the company has already completed building a platform in Ireland and is set to launch by the end of August. In addition the company is in negotiations with the major incumbent in Spain, is holding talks with Telecom New Zealand and will also submit a proposal to the French incumbent in 4Q08 providing growth into FY09 and beyond.


Because REF requires just a small amount of capital to derive it's profits, the company has an outstandingly high return on equity. That return on equity is further enhanced by the high dividend payout ratio. In the last 2 halves the company has payed out almost 100% of profits in fully franked dividends.

Given the unfavourable AUD/GBP exchange rate and the absence of further growth opportunities in the current half I have forecast flat profit growth for the second half from the first. Also I have assumed a 100% payout ratio of dividends.

Whilst the company has typically paid out less than 100% of earnings I have assumed they will pay out 100% of profits this year in an attempt to maintain the dividend at current levels.

The payout ratio is important for a company that produces such a high return on equity (currently forecast at 255%). The value increases significantly with the amount of retained profits that can be reinvested back in the business at those high rates of return. Assuming a 100% payout ratio actually lowers the value of business because it assumes profits are not reinvested.

Thus assuming flat profit growth, a 100% payout ratio and discounting back at 15% I come to a conservative valuation of $2.52.

As with all valuations, they can change significantly by making minor changes to assumptions. If for example, I assumed a payout ratio of 90%, which is more in line with the historical average, the valuation almost doubles because 10% of retained profits can be reinvested at that very high return on equity.

The point is not to get bogged down in coming up with a precise valuation, but rather as Warren Buffet says, "it is better to be approximately right than precisely wrong."

REF will do it tough in the second half due to the strong $AUD and the lack of growth opportunities. However the business fundamentals remain strong and the company is poised to leverage it's low cost base with future international growth opportunities in the years ahead.


Anonymous said...

Greatly enjoy your thoughtful blog and read it daily.Some large blocks of REF being sold and persistent selling at the current level($1.60)
Spoke to CEO who says he has no idea who is selling."The company is performing well with new ventures on track".

The Fundamental Analyst said...

Thanks for the comments.

The AUD/GBP exchange rate continues to hurt however obviously not too much as indicated by the reply to the speeding ticket yesterday. Announcements on Hutchison deal and Tritel agreement were positive. Would like to hear more about overseas venture in Ireland, New Zealand Spain etc.

At current prices and assuming another 12 cent divi this half, FY08 dividend yield is currently at 14%. I'm still positive on this one, even more so at current prices.