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Stocks
Stock picks for the long haul: Service Stream and Redflex Holdings
Jill Fraser - November 28, 2007
Fund manager stock pick: Service Stream and Redflex Holdings
Current share price: Service Stream (SSM) $2.01; Redflex Holdings (RDF) $3.44
Fund manager: Dion Hershan, Goldman Sachs JBWere
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Dion Hershan, Goldman Sachs JBWere | In this section, CompareShares picks fund managers' brains for the stocks to watch in the year ahead. Jill Fraser reports
In September service provider Service Stream was awarded a $1 billion dollar Telstra contract, which will constitute 40% of its revenue as of FY09E. But as part of its plan to reduce its dependence on telecommunication companies, last month the company moved further into the utilities sector with the acquisition of the McCourt Dando group of companies.
This strategy is indicative of Service Stream’s "dynamic team" and its ability to deliver, maintains Goldman Sachs JBWere’s Dion Hershan.
Confident that the small cap company will achieve north of 20% upside of its current $2.01 stock price, Hershan says "if we didn’t think we could make that sort of return we wouldn’t be involved".
Service Stream in its present incarnation was formed from the merger of TCI and Service Stream in late 2006. It provides outsourced managed services - including installations and maintenance, labour hire, call centres, back office functions and mobile infrastructure engineering services –primarily to telecommunications operators.
Its acquisition of McCourt Dando, a construction and technical services provider to the water, power, telco and infrastructure sectors, for $13m led Citi to upgrade its EPS forecasts by 4% and in a recent report note that it is looking for 12% EPS growth in FY08E followed by 45% in FY09E when the Telstra contract ramps up.
The Telstra contract, the largest deal Telstra has ever awarded in this space, is for four years (two years with a two year option) with Service Stream estimating revenues in excess of $300 million per annum.
McCourt Dando, which Service Stream says is expected to contribute revenues of "approximately $36 million in the current period", signals the beginning of Service Stream’s push into the electricity, water and gas infrastructure sectors.
Hershan says that risks are linked to the fact that it’s a relatively small, high-growth company that grew its revenue over 45% and doubled its profit during the past year. "Anything that’s small and growing fast has execution risks."
Another potential danger is a prolonged and severe downturn of the telecommunications industry. But even in the unlikely event of this happening Hershan doubts whether Service Stream will suffer because it deals more with maintenance than capital expenditure and bills, "and even in tough times payphones still need monitoring and consumers still need phones and broadband installed".
Hershan’s second stock pick, traffic enforcement products and services company Redflex Holdings, lists at $3.44.
Redflex Holdings consists of Redflex Communications Systems and Redflex Traffic Systems and provides red light and speed photo enforcement systems, back office processing services and associated traffic violation management systems in Australia, the United States and the Middle East.
Redflex do most of the traffic cameras in Oz but about 80% of its revenue comes from the US where it has around 50% market share and is ahead of expectation on traffic camera installation.
Its success in winning new contracts has enabled Redflex to ramp up its rollout to more than 360 cameras a year, which translates as a 40% growth during the past 12 months.
Hershan notes, "while at first glance this stock screams at being quite expensive at 28 times earnings when we did our fundamental analysis on the company we realised that a lot of the earnings are depressed through accounting treatment".
"They over-depreciate equipment and whereas their books suggest that equipment might last five years it will probably last 10. Consequently they tax their earnings very heavily, which reduces their earnings and their taxes. But the underlying business is extraordinarily strong."
Citi puts Redflex in the high-risk category. In a recent report it stated: Rollout of red light camera systems in the US is the primary driver of earnings growth. While Redflex has a substantial order book, earnings would be impacted by any slippage in the pace of the rollout.
Citi goes on to say, that much of Redflex's success over the past 12-18 months reflects its leading technology. With at least six suppliers in the US market, a technology lead is unlikely to endure, but the potential market is large and our market share assumptions are relatively conservative.
Citi also notes that if the rate of red light violations falls below expected rates, income from revenue share contracts would fall and fixed price contracts could be re-negotiated.
More articles from this edition of CompareShares:
Investing: Overseas shares not so taxing
Resident Trader: Of speculation, share placements and sophisticated investors
Stocks: Stock picks for the long haul: Service Stream and Redflex Holdings
Trading: The ultimate guide to trading shares - part 2
Analyst report: When funds fall over
Economics: Mining boom teeters
Stocks: Stock to watch - VDM Group
Smart Investing: ATO reviews use of instalment warrants in SMSFs
Expert Panel: Pairs trading - maximise returns from share price divergence
Whatever your views, you can discuss this article - or any of Jill's articles - on our message board Your 2 Cents.
Jill Fraser has 25 years' experience in the media as a radio producer on 2UE and journalist for News Ltd, Australian Consolidated Press and Key Media.
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