This hidden winner will benefit from BT’s big idea

BT hopes this move will mean big returns on the billions it has spent on fibre-optics. But under the radar there is another beneficiary of this transition. Gamma Communications (GAMA), a self-described unified Communications-as-a-Service company, provides software that allows customers to make calls over the internet. In effect, this equates to a service that integrates traditional phone lines, mobile phones and the internet.

The looming PSTN switching deadline has already pushed some businesses toward Gamma’s services. However, as in most walks of life, there is a tendency leave things to the last minute, so as we approach 2025 the number of companies switching from PSTN to voice over internet protocol (VoIP) will continue to accelerate.

To capitalise on this opportunity, Gamma has created a cheaper product called PhoneLine+. Targeted at “micro businesses”, this cloud-based solution enables small firms with a few employees to forgo costly integrated software in favour of a product that allows a customer to continue to call a number on the side of a van and speak to someone.

In June, PhoneLine+ had 8,000 users, more than double the 3,000 it had in December, making it the fastest-growing part of the business. However, this should be taken in context. There are 1.04mn users of Gamma’s legacy service, which integrates the traditional phone line with a digital service. This routes calls from the switchboard to the internet. There are then another 777,000 users for its cloud product, which is a completely digital service, without any need for traditional telephone lines.

Gamma is currently trying to transfer customers from its traditional services to its cloud service before the PSTN is shut down. In the six months to June, its users in the traditional business fell 1 per cent while cloud users were up 4 per cent. A subsection of the cloud includes PhoneLine+.

At last month’s half-year results, chief executive Andrew Belshaw told the IC there are around 3mn small businesses in the UK that are currently using PSTN. Gamma hopes to convert around 10 per cent of them into customers, in addition to the current customers it is planning to switch from its legacy service to the cloud.

 

Growth slowdown

The concern with Gamma is that this is just a growth ‘story’, after a couple of years in which growth has been found badly wanting. Revenue may have climbed 9 per cent in the first half of 2023, but this was a slowdown from the double digit levels it was seeing before the pandemic. Europe has been a particular drag: although the region had been earmarked for growth, it makes up just over a tenth of revenue, and increased its cloud customers by just 1 per cent in the period.

In part, the recent slow growth can be attributed to pandemic lockdowns. Although some digital communication services companies thrived during this period, many of Gamma’s small business customers were in survival mode, barely keeping their heads above water. While many knew that transitioning away from traditional phone lines needed to be done at some point, the inclination to push the job down the to-do list is likely to have been strong.

Despite this slowdown in growth, the drop in the share price looks disproportionate. Since its peak in mid-2021, Gamma is down 55 per cent despite no actual downgrading in its earnings per share forecasts. Numis analyst John Karidis believes this was due to a combination of fear of its customers going bankrupt, the departure of the previous chief executive and concern that services such as Microsoft Teams could be used as a replacement.

Some of these concerns are more valid than others. There hasn’t been a wave of small business insolvencies, but they are creeping up and we are not out of the economic woods yet. More positively, it appears the previous chief executive did not leave under any sort of (metaphorical) cloud, and in the case of Teams, it isn’t a practical replacement service. Gamma offers add-on services which make it possible to integrate calls using the software into the wider package – allowing them to complement one another rather than compete.

There is real competition out there, though. BT will look to transition its customers onto its own internet service, which is why Gamma is aiming for just around 10 per cent of the switching market. There is also US-based VoIP company 8×8 (US:EGHT). But all businesses come with competition and Gamma’s stable margins suggest it is holding its own. In the six months to June, gross margins were flat at 51 per cent, while operating margins held at 16 per cent.

 

Lots of cash to invest 

As with many recurring software businesses, Gamma is good at converting these profits into cash. Around 90 per cent of its revenue is recurring, while operational cash flow in the first half of 2023 was 101 per cent of its adjusted cash profit (up from 95 per cent the year before). This strong cash flow enables Gamma to up its spending on capital projects and shareholder distributions: in the six months to June, the former rose from £7.8mn to £10.5mn due to an increase in capitalised development costs; meanwhile, the interim dividend leapt by 14 per cent. 

 

Gamma’s cash flow

This all suggests that the shares are starting to look good value at 13 times forward consensus earnings. A 6 per cent free cash flow yield is equally appealing, as is expected growth: Numis expects earnings per share (EPS) to jump 28 per cent by 2025 as potential customers increasingly rush to shift their businesses away from PSTN.

But despite the high margins and cash generation, Gamma is being priced like a business with not much space to grow. That may stem from the perceived risk that when the PSTN is switched off, the legacy customers that currently use Gamma’s services to integrate the phone line into their wider digital communications won’t transition to the cloud, and instead opt for another provider. That would be the flipside to the 2025 switch.

However, strong margins usually suggest a good-quality product. The key is the sales team getting the product in front of potential customers. Gamma sells through channel partners as well as directly to customers, and they will be working to get customers over to the cloud as quickly as possible. When this starts to happen and cloud growth picks up, a re-rating in the share price could follow. 

The reason for the weakness is its ‘growth’ prospects are just a story. The upside is that most growth companies are unprofitable. Few can already boast a double-digit post-tax profit margin and return on equity above 20 per cent. The downside should be limited while the upside looks enticing. 

Company Details	Name	Mkt Cap	Price	52-Wk Hi/Lo
	Gamma Communications  (GAMA)	£1.02bn	1,052p	1,252p / 954p
Size/Debt	NAV per share*	Net Cash / Debt(-)	Net Debt / Ebitda	Op Cash/ Ebitda
	308p	£111mn	–	106%

Valuation	Fwd PE (+12mths)	Fwd DY (+12mths)	FCF yld (+12mths)	EV/Sales
	13	1.7%	7.3%	1.8
Quality/ Growth	EBIT Margin	ROCE	5yr Sales CAGR	5yr EPS CAGR
	13.6%	22.2%	14.9%	15.9%
Forecasts/ Momentum	Fwd EPS grth NTM	Fwd EPS grth STM	3-mth Mom	3-mth Fwd EPS change%
	6%	8%	-6.6%	5.9%

Year End 31 Dec	Sales (£mn)	Profit before tax (£mn)	EPS (p)	DPS (p)
2020	394	63.8	51.3	12.0
2021	448	73.6	64.0	13.2
2022	485	87.0	71.8	15.0
f’cst 2023	526	92.8	75.1	16.9
f’cst 2024	564	99.1	79.7	18.5
chg (%)	+7	+7	+6	+9
source: FactSet, adjusted PTP and EPS figures
NTM = Next 12 months
STM = Second 12 months (ie one year from now)
*Includes intangibles of £97mn, or 128p per share