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Buy the Telecom Plus recovery

Poor market conditions have made it hard for Telecom Plus to grow, but changing regulation should prompt a recovery in the coming years
October 11, 2018

Britons tend to agree that the UK's energy market is broken; what they don’t agree on is how to fix it. Energy providers think more competitive prices are key to helping consumers – regulator Ofgem plans to impose a price cap, the Labour party wants to nationalise the market to create a high-quality service that rewards long-term loyalty over repeated switching. The latter is a strategy already in action at Telecom Plus (TEP). The multi-utility group, which operates under the trade name Utility Warehouse, bundles together energy, telecoms and insurance contracts and rewards loyal consumers who use all its services.

IC TIP: Buy at 1112p
Tip style
Income
Risk rating
Medium
Timescale
Long Term
Bull points

Energy price cap winner

Improving margins from communications services

Strong balance sheet and cash flow

Dividend yield close to 5 per cent

Bear points

Risk from nationalisation of energy market

Lower energy revenues due to price cap

It’s worth noting that a shift in power in the UK could be problematic for Telecom Plus – if the Labour party was to nationalise the energy market, it could create major issues for the business – but for now, it remains on the right side of politics. By the end of 2018, energy regulator Ofgem is expected to have enforced its price cap, which aims to give customers a fairer deal for their energy. This should close the gap between the standard variable tariff (SVT) and one-off ‘teaser tariffs’ (which are used to entice new customers) and therefore reduce switching between suppliers.

Telecom Plus – which has an SVT that is already among the cheapest in the UK – is expected to benefit from this shift. Lower SVTs means energy companies will be forced to cut back on their excessive introductory discounts, which should drive more people to the fair prices and good service of Telecom Plus. Lower switching is expected to reduce the company’s churn, which at 12.7 per cent is already well below the industry average (19 per cent for the Big 6 energy providers and 30 per cent at small and medium-sized groups).

The shift in the regulatory environment also has implications for the group’s wholesale costs which, under the terms of its 2013 agreement with NPower, are linked to the SVT. Although this deal has proved problematic for Telecom Plus in recent years as the oil price crashed and SVTs rose, it should protect margins under the price cap. That helps underpin expectations that pre-tax profits will climb steadily in the next two years, despite lower average energy revenues.  

While energy continues to dominate Telecom Plus’s revenues, still accounting for about four-fifths of the total, it’s worth noting that, based on the estimates of broker Numis, it only contributes 51 per cent of its gross profits, down from 58 per cent four years ago. This reflects the group's expansion into other higher-margin services, especially fixed-line, broadband and mobile communications, which now account for almost two-fifths of gross profit according to Numis, but just 18 per cent of revenue. The group has also branched out into new services including insurance and boiler maintenance. 

Communications services boast gross margins of about 40 per cent, compared with just 10 per cent for the energy business, while the number of ‘double gold’ customers (those who take all the group’s services), who are highly reliable and unlikely to switch, which makes them very valuable. In the short term, margin expansion has been constrained by the fact that Telecom Plus offers each new double gold member free energy-efficient lightbulbs, but in the long term margins are expected to expand. Broker Peel Hunt forecasts that operating margins will rise from 6.9 per cent last year to 7.4 per cent by 2020, while mid-single digit adjusted cash profit growth is expected for each of the next three years.

This growth falls short of what investors may have expected from Telecom Plus three years ago – in both 2014 and 2015, the group reported double-digit sales and gross profit growth as huge volumes of customers signed up to its services – but the challenging energy market and competitive telecoms industry have constrained progress. Despite those challenges, Telecom Plus has remained a highly cash-generative company. In 2018, the group generated £48.0m operating cash before tax from £41.9m of operating profits.

The balance sheet is in good shape, partly thanks to the £71m proceeds from the sale of the group’s 20 per cent stake in energy company Opus in 2017. Net debt represents just 0.2 times cash profits and is expected to remain at less than one times, which still gives the group plenty of fire power to make acquisitions and keep paying its dividend, which currently yields 4.9 per cent. The company also seeks to enhance shareholder returns with regular buybacks.

TELECOM PLUS (TEP)   
ORD PRICE:1,124pMARKET VALUE:£874m
TOUCH:1124-1130p12-MONTH HIGH:1,292p. LOW: 995p 
DIVIDEND YIELD:4.8%PE RATIO:18
NET ASSET VALUE:292p*NET DEBT:5%
Year to 31 MarTurnover (£m)Pre-tax profit (£m)Earnings per share (p)Dividend per share (p)
201674554.456.446.0
201774053.353.348.0
201879454.355.350.0
2019**83157.058.052.0
2020**84061.061.754.0
% change+1+7+6+4
Normal market size:500   
Matched bargain trading    
Beta:0.45   
*Includes intangible assets of £185m, or 238p a share
**Broker Peel Hunt forecasts, adjusted PTP and EPS figuers