iiNet shifts from buyer to seller

Last month’s Business News shareholder return event unearthed the startling revelation that each of the three high-performing businesses we had chosen to represent Western Australian industry had focused on organic growth.

All three – Sirius Resources, Cedar Woods properties and Amcom Telecommunications – said they indulged in the occasional bit of mergers and acquisitions activity, but the real growth in their business had come from expanding their existing operations.

A company that might easily have been on that stage was iiNet, the Perth-based internet service provider that has emerged as a top three telco nationally.

Ranked 13th out of 695 WA-listed companies by one-year total shareholder return, iiNet is a standout success in anyone’s language; but it is different from these three because its growth has definitely been by acquisition.

The group has purchased numerous smaller ISPs and their customer bases, chasing the scale that allows it to stay in the race by investing in the next level of technology in this costly business.

iiNet has learned a lot from that at-times-traumatic process, gaining a capability to cost effectively buy competitors and absorb them.

The problem for iiNet is that skillset is not nearly as useful today as it has been over the past few years. The market in which Michael Malone’s company operates is maturing and, arguably, the biggest and best of the M&A opportunities are behind it. The fact is that iiNet now has the scale it wanted, and there is less to gain from gobbling up incrementally smaller rivals. The possibility of big M&A deals with other major players – Telstra, Optus or TPG – is low, especially if the market is to remain a competitive one.

Due to the shape of Australia’s market, iiNet’s most likely strategy is to focus on growing the business organically in this country.

In recent years, it has been quietly letting the market know that this is its intention.

In the 2010-11 annual report, the term “per customer” can be found once, referred to in the detail around management performance hurdles and the need to diversify the revenue base to other products. In his review that year, iiNet chairman Michael Smith highlighted the fact that the company “has over 640,000 broadband DSL subscribers, supporting over 1.3 million broadband, telephony, Internet Protocol TV (IPTV) and other services”. I read that as just over two products, or services, per customer.

In the 2011-12 annual report it more clearly identified this area as a strategy and provided a goal, albeit with a loose timeframe, saying it wanted to grow from two products per customer to three “over the next few years”.

This year, the term “per customer” is sprinkled more liberally throughout the annual report; so we can presume the board and management are signalling how serious their intentions are.

“With over 840,000 connected households and businesses at the end of FY13, we have been successfully increasing the average number of products per customer to 2.23 over the past 12 months, reducing churn and driving new revenue and margin growth,” the 2012-13 report states, offering a clear ratio that shows some progress towards the goal of three products.

Just in case anyone thought iiNet’s M&A strategy was dead, however, it is worth noting that it has since completed the acquisition of a further 70,000 customers by purchasing Adam Internet at a cost of about $900 per customer (the $60 million price was at a multiple of just over five times earnings).

Initially, that waters down iiNet’s ratio because the provider did not offer telephony (either a home phone or mobile). A home phone is now a basic product offered by most ISPs that at least will double the product per customer if those iiNet newbies can be convinced to expand their purchases and bring the ratio back to two.

But that is probably the low-hanging fruit. The offering here is simply about bundling a home phone and the internet, just to get back to square one – two products per customer. And it is worth mentioning that doubling products per customer doesn’t mean doubling revenue or profit.

The bigger challenge is in the mobile space, where iiNet is at a disadvantage compared to its two major telco rivals Optus and Telstra.

In fact iiNet uses the Optus network for its mobile product. Then again, iiNet might argue, it has long used Telstra’s copper wires augmented by its own technology at local exchanges.

The big test will be just how successful iiNet is at shifting from growing by acquisition to expanding organically in this sector where the number of customers is stagnating but the number of products is increasing rapidly.

The most important question will be how much of that additional product per customer sold by iiNet generates real extra profit.