Company: Pipe Networks LtdASX Code: PWKShare Price: $6.03Market cap: $356mRecommendation: ‘Hold’

Sideways trends have dominated the major market indices over recent months, but technology remains one of the few bright spots. While the S&P500 has made little progress since October, telecom service providers, computer, and semiconductor manufacturers have all broken convincing new highs in recent trade. A boom in wireless and high speed internet appears to be the key driver, hence our interest in local internet cable operator, Pipe Networks. The ASX is fairly light in terms of potential exposures to the sector, and our most high profile member, Telstra, leaves a lot to be desired in terms of leadership and growth. However outside our blue chip indices are a small group of emerging players reaping the benefits of this boom in demand for internet traffic.

Pipe Networks is the first to come under the spotlight after receiving an all cash takeover bid in recent weeks. The company listed in 2005 owning Australia’s largest collection of internet exchange (IX) points, with 16 IX points in 6 cities and over 130 active connections. Internet exchange points allow service or content providers to share traffic between their networks. Pipe’s customers include some of Australia’s largest content and internet service providers including WebCentral, The Australian Broadcasting Corporation, iiNet, Primus, TPGi and AsiaNetcom. To supplement its IX assets, PIPE Networks began constructing its own fibre network to host internet traffic in 2003. Initially rolled out in Brisbane, the company has since expanded its domestic fibre network into the metropolitan areas of Sydney, Melbourne and Hobart. The network was recently rolled into Adelaide and Perth and now stretches over 1,300 km covering key strategic IT infrastructure locations. These domestic exchange assets and fibre networks have been the key driver of earnings over recent years, but are now set to be supplemented by a new submarine cable system (PPC-1) linking Australia to Guam.

PPC-1 effectively links Australia to the rest of the digital world and its commissioning in October heralded a profit upgrade that maintained the company’s impressive record of earnings growth since listing. Driven by its domestic business, earnings and revenue have increased at average compound rates of 80-90% pa. Much of this growth came off a very small base, and the company’s recent expansion rate has been closer to 40%, although this is still quite impressive. Since delivering its FY09 result, which saw net profit increase 46% to $10.5m, the company has upgraded its forecast for what was already strong growth during FY10. Revenue and EBITDA forecasts have been upped by 2%-7%, but illustrating the leverage inherent in the company’s fixed cost base, profit guidance has been upgraded by 7-22%. Net profit is now expected to be $23-25m, an increase of 128% over last year’s result.

With most capital needs behind the company, a largely fixed cost base and plenty of spare capacity left to sell on its submarine cable, a period of potentially serious growth has been interrupted by a takeover bid from TPG Telecom (ASX: SOT). With a growing customer base of its own generating strong demand for bandwidth, it isn’t hard to see the motivation behind TPG’s $6.30 per share bid. The deal would secure future capacity for those customers and lower TPG’s costs by eliminating the need to ‘rent’ bandwidth from other parties.

However the benefits appear one sided and we are surprised that the offer has attracted support from Pipe Network’s Board of Directors. Unfortunately as major shareholders, their support for the bid has given TPG a relevant stake of 19.9%, which is likely to deter rival offers. We view the offer as inadequate in light of Pipe’s track record and future growth potential. The Board’s claim that the offer represents a 29% premium to Pipe’s 6 month volume weighted average price (VWAP) is an attempt to disguise the offer as ‘fair’. What they aren’t flaunting is that the bid represents less than a 5% premium to the stock’s VWAP since the company issued its latest profit upgrade. It is standard practice for suitors to pay an attractive premium for control, but in this case the ‘premium’ is hardly enticing.

Pipe’s share price performance over recent months has been driven by improving fundamentals and the passing of a critical milestone in the commissioning of PPC-1. In the absence of this offer we expected recent momentum to continue, and just a few weeks ago CEO Bevan Slattery appeared to share a similar view, stating that “shareholders are now reaping the rewards of our investment”. So with the fruits of Project Runway (the PPC-1 stgelopment) now starting to bear, why is Mr Slattery supporting an offer that appears to short change his fellow shareholders? Being all cash, the offer doesn’t even allow existing shareholders to participate in any future growth that TPG may gain through the deal. The fact that Pipe’s share price has remained stagnant while TPG’s has surged following this announcement is a clear indication that Pipe’s minority shareholders are set to be ‘short changed’. The cash nature of the bid does insulate Pipe’s downside risks over the next few months, hence there is no harm in continuing to hold the stock. But we advise shareholders to not accept the bid. Given the strategic nature of Pipe’s assets, a rival offer may still emerge.

Tim Morris is an analyst at wise-owl.com. Please note that TheBull.com.au simply publishes broker recommendations on this page. The publication of these recommendations does not in any way constitute a recommendation on the part of TheBull.com.au. You should seek professional advice before making any investment decisions.

 

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