Slotting shares in utilities-services provider Telecom Plus (TEP) into the Bearbull Income Portfolio (see last week's Bearbull) triggers this dilemma, prompting two related questions: are shares in Telecom Plus wildly overrated, and why does the Bearbull fund get such a low rating?
Let's focus on the first question. Recall that, superficially at least, a holding in Telecom Plus offers good things for the income fund. At their current 989p, the shares come with a 4.7 per cent yield on 2015-16's promised 46p payout. Simultaneously, a combination of the high volatility in Telecom Plus's share price, the above-average monthly gain in the price and its low correlation with price movements in the Bearbull income fund make Telecom Plus shares a useful addition to the portfolio. These benefits aren't in question - though that doesn't mean they are certain to materialise - but it may be that I'm paying too high a price for them. Put bluntly, it's difficult to find value in the shares that's remotely close to the current share price.
Given that Telecom Plus shares are rated at about 22 times forecast earnings for the year to end-March, that may not be surprising. True, I pay little attention to PE ratios. Even so, a high earnings multiple can indicate useful things - in particular, that the interest rate that capitalises a company's earnings is very low. This infers that most of the future growth is already factored into the share price and that, therefore, anyone buying around current prices must expect low returns (and that - paradoxically - is pretty well the opposite of what's expected by punters who buy on high earnings multiples).
We can turn this proposition around and find out how much profit Telecom Plus should make in order to justify its current share price. True, an investor can't answer that without first supplying the return that he wants from holding the shares. For Bearbull, that's usually 8.5 per cent. To satisfy that requirement, either Telecom Plus should make twice last year's £38m operating profit or its share price must first halve.
Neither of these is likely to happen soon. Sure, its operating profits will eventually double, and it's heartening to note they did just that in the five years to March 2015. That said, such a pace won't be sustained. To grow, Telecom Plus chiefly relies on two factors: first, signing more customers ('Members' - with a capital 'M' - it calls them) and generating more revenue per customer by selling extra services from the pallette of utilities that it offers. Currently it has about 600,000 customers, with the aim of raising that number to 1m over "the medium term". "This," says executive chairman Charles Wigoder, "would represent a UK market share of less than 4 per cent and seems eminently achievable" - a proposition which seems equally reasonable. Meanwhile revenue per customer is static. It topped out at £1,359 in 2012-13 and drifted down to £1,279 last year, from which level it will recover some lost ground this year.
The other route to growth is for Telecom Plus to extend its services. It says it is "actively exploring" ways to offer home and motor insurance (presumably vendor branding policies as a broker, not a principal). It is probably just a matter of time and regulatory relaxation before it offers water supply to its utility services (though that will hardly be a game-changer). However, without regulatory help, adding television to its telephony and broadband packages seems out of the question - the cost of content is too high and the revenues too low.
All of this points to growth moderating but remaining decent and, hopefully, there will be the trade-off of less volatility in profits and cash flow - four times in the past eight years free cash has been negative. Dividend growth must also slow. Arguably, Telecom Plus distributes more than it should anyway. In those same eight years it has paid £138m in dividends, while it has recorded £173m of net profits, but more importantly has generated just £57m of free cash. True, its balance sheet remains healthy, but that's largely because Telecom Plus has raised £140m of new equity in that period.
In time, if lively growth morphs into reliable cash flow as the group matures, then all will be fine. Telecom Plus will come to look more like the income stock that its yield implies than the growth stock that its bouncy share-price performance suggests and, in the process, its contrarian value to the income fund will diminish, too. So the dilemma of putting the growth stock into the income fund will resolve itself. And that just leaves me with the basic question that underlies almost all equity-investing decisions: is it worth it? In this case - and reluctantly - probably not.
