Service Stream (SSM) has been a great investment for Forager’s Australian Shares Fund and the company, which provides blue-collar network services for telecommunication companies and utilities, produced an excellent full-year result. It reported operating profit before tax of $19m, more than double last year’s effort and exceeding management’s guidance.
Now the second largest investment in the Australian Shares Fund, Service Stream has redeemed itself after a disastrous period in 2013 where it was forced to relinquish contracts with the National Broadband Network (NBN), wind up a joint-venture with Lend Lease (LLC), and suspend trading in its shares while it restructured debt.
With the debt repaid, the company has a promising future. If it can grow modestly while maintaining margins, full-year profit after tax this year could be around $16m, or 4.3 cents per share. Those recurring earnings could easily be worth $0.50 per share, which is why we have not rushed to sell shares notwithstanding the gains made on our average purchase price of $0.19.
There is the possibility it could do even better. Service Stream’s Fixed Communications division, for several years the problem child, is performing well and should grow handsomely as the NBN construction gains pace. In 2015, around 400,000 homes were connected to the NBN. But with some 10 million homes still to be connected, there is plenty of work for a decade to come.
As shareholders lick their lips on the NBN prospects, the company has found itself in a fantastic, but slightly awkward, tax position. Service Stream has run out of franking credits and won’t be paying income tax due to its available tax losses. It therefore can’t pay franked dividends for a couple of years. Not having to pay tax is great; and as we did with Watpac (WTP) in the same circumstance, we have indicated to Service Stream we would rather it not pay unfranked dividends for this period.
Shareholders pay full income tax on unfranked dividends, which spoils the whole benefit of the company’s tax losses. A capital return or share buy-back would make much more sense. Ideally, common sense (rather than dividend fixation) prevails and the dividend is cut. After all there’s no sense in just handing value to the tax office, is there?
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.