“It’s almost implicit in its strategic focus that M2 Telecommunications Group Ltd (ASX: MTU, OTC: MTCZF),” I wrote in a Sector Spotlight in the Dec. 16, 2012, issue of AE, introducing the company to the Portfolio’s Conservative Holdings, “is on constant lookout for opportunities to add services that it can include in tailored packages for its small and medium-sized businesses in Australia and New Zealand.”

In April 2012 M2, then the No. 7 telecom in Australia, finalized negotiations on its acquisition of Primus Australia, then No. 8 Down Under, to create the fifth-largest such company in the country.

It was described by M2 management at the time as a “transformative” deal, one that would reshape the acquirer’s business model and expand its opportunities for growth–on which score it had already had considerable success–in the age of the National Broadband Network.

Based on M2’s forecast for fiscal 2013, this bold choice of adjective–“transformative”–has proven apt, if only for what it’s implied for the top and bottom lines: Management guided to fiscal 2013 EBITDA of between AUD108 million and AUD118 million, 79.7 percent to 96.3 percent higher than fiscal 2012. M2 expects fiscal 2013 net profit of AUD43 million to AUD48 million on revenue of AUD610 million to AUD650 million.

During fiscal 2012 M2 posted an 8 percent decline in revenue to AUD393.5 million from AUD427.9 million a year ago but also recorded a company record statutory net profit after tax (NPAT) of AUD33 million, up 20 percent from fiscal 2011. Underlying NPAT was up 22 percent to AUD38.1 million. Earnings before interest, taxation, depreciation and amortization (EBITDA) climbed 24 percent to AUD60.1 million.

Primus added significant scale and positions the business to maximize opportunities presented by the deployment of Australia’s National Broadband Network (NBN). M2 paid AUD192 million for Primus in April 2012. In calendar 2011 Primus recorded AUD280 million in revenue and AUD40 million in EBITDA.

The acquisition lifted M2’s net debt to AUD125.2 million at the end of June 2012 from AUD17.3 million a year ago. But net debt is expected to fall back to about AUD100 million by the end of 2013.

“It absolutely equips us with all of the expertise and the sales and service capability we need to acquire to take advantage of what we think are significant opportunities for us to grow share in an NBN world,” CEO Geoff Horth said during an April 2012 a conference call to discuss the deal that united Australia’s seventh- and eighth-largest telecommunications companies.

“It reinforces our position as the preeminent challenger to the incumbents in the business telecommunications space.”

The Primus purchase added 165,000 customers across residential, small and medium enterprises and wholesale served by 500 staff.

The Primus network includes data centers and technology that allow the company to sell the latest generation “cloud” and hosted/managed services, including facilities in in Sydney and Melbourne and 100 kilometers of fiber and metro fiber rings in five capital cities, switch facilities in five major cities, including Sydney, Melbourne, Perth, Brisbane and Adelaide.

In addition to customers and fiber Primus brings with it 290 DSLAMs. A “DSLAM” is a digital subscriber line access multiplexer, a network device often located in the telephone exchanges of telecommunications operators. It connects multiple customer digital subscriber line (DSL) interfaces to a high-speed digital communications channel using multiplexing techniques.

By placing additional DSLAMs at locations remote from the telephone exchange, telephone companies provide DSL service to locations previously beyond effective range.

This is infrastructure, and it’s counter to M2’s traditional business model.

Upon completion of the acquisition in June 2012 M2 reoriented around four main brands: iPrimus for residential customers, Commander for small to medium-sized businesses, Primus Telecom for corporate contracts and M2Wholesale. “What we will be doing post completion,” said Mr. Horth, “is taking a whole new range of service offerings to existing customers.”

Through iPrimus and Commander the company offers a full suite of traditional and next-generation telecommunications services, including fixed-line voice services, 3G mobile, mobile broadband, ADSL2 broadband, hosted/managed data services and IP/hosted voice solutions.

The wholesale division provides wholesale fixed line, mobile and data telecommunications services to small and medium-sized telecommunications service providers and Internet Service Providers.

M2 recently noted in a conversation with analysts that the Primus acquisition has progressed as expected, with positive a positive trajectory seen in churn rates in the consumer division.

M2 sees itself as a sales and service business, a telco reseller that prides itself on its ability to acquire and keep customers–minimize churn–than traditional telcos by offering more value-add. It doesn’t care how a customer accesses services so long as M2 has established and maintains the relationship. This approach has resulted in consistent growth through organic and acquisitive means, seven straight years of earnings and dividend growth.

Gross margins are generally relatively low, so controlling costs is a key element of the company’s success. M2 recently consolidated seven support centers into one, a demonstration of its ability to enforce efficiency after it acquires.

Prior to acquiring Primus its business model was to be “infrastructure-lite” but this changed somewhat as a result of the recent deal.

According to management iPrimus’ monthly EBITDA has improved quicker than expected and better than the unit performed in its prior incarnation; new management took over during the past 12 months. Primus’ revenue had been declining over the past five years, and iPrimus is now net positive in terms of daily service contracts after previously losing 300 consumer customers.

New orders are improving as well.

M2 expects AUD5 million in synergies from Primus in the next three years. Primus has underperformed in recent years but has improved its run rate lately, with a new CEO implemented in the middle of last year. This has made a remarkable difference, with earnings improving from AUD36 million to annualized AUD45 million, based on a six-month run rate, already.

Though revenue has declined for last five years, M2 management attributes this to Primus’ former US parent going through a restructuring. As of the last 12 months with new management, Primus has performed well. Now the new order intake trajectory is improving.

May was the best month Primus ever had until the company beat that record in June with four fewer working days.

M2’s main supplier is fellow Conservative Holding Telstra Corp Ltd (ASX: TSX, OTC: TTRAF, ADR: TLSYY, with which it has a good relationship. The supplier relationship is covered by a contract that will run for the next two fiscal years. M2 even sought and received Telstra’s “approval” of the Primus deal. M2 is one of Telstra’s biggest wholesale customers, with the value of its business three times the average customer.

M2’s strategy is to not compete in voice infrastructure, so it doesn’t go head-to-head with Telstra, although there is some infrastructure involved in the acquisition that would bring the combined entity into contact with the giant.

Telstra has a regulatory obligation to provide access to copper network, although some parts it must supply while others are matters of competition. The Australian Competition and Consumer Commission sets pricing for wholesale line rental, local calls and transmission. International calls and mobile calls are subject to market forces.

M2 won’t necessarily use acquired infrastructure if Telstra can show it a better way of accomplishing its ends. If Telstra can’t come up with a solution to M2’s customer needs then M2 has the option to move to an infrastructure model. But there is no plan to do so.

Management professes to be “pretty excited” about the opportunities presented by Australia’s National Broadband Network, essentially because it will allow M2 better access to customers. A typical customer gets five copper services from Telstra, for example. Under the NBN this five-wire setup will be replaced by a single fiber strand, so M2 is in the game to provide voice services. Primus has an IP voice platform, hosted telephony product, infrastructure and a full suite of cloud services, which M2 sees as absolutely critical in an NBN world.

And following the transaction M2 can now offer “infrastructure as a service,” or IAAS, and “software as a service,” or SAAS, to customers.

M2 doesn’t use offshore call centers because it’s hard to justify to its customers who pay AUD500 to AUD2,000 per month the use of such a low-budget function.  It only does customer service in Australia, but it does it efficiently.

M2 had 450 staff to generate AUD400 million in revenue, while Primus had 500 staff to generate AUD280 million. M2’s plan to reshape the new business is focused on doing more than AUD900 million with 900 people.

Most customers sign up for a single product. The internal sales team up-sells to more products. At the time it was acquired Commander had a rate of 1.0004 products per customer; that figure is up to around 1.5 products, but there’s still significant room for improvement given the industry average is three products per customer.

Revenue for the combined M2/Primus is 52 percent business, 32 percent residential, 15 percent wholesale and 2 percent based on calendar 2011 metrics.

M2 targets small to medium-sized businesses, including the “SOHO” (Small Office/Home office) market, made up of customers who may not spend as much but are consumers of all three products. This “sweet spot” consists of between one and 20 “seats,” but the company also has some business customers in the 20-to-200 seat range.

It doesn’t do anything above 200 seats. Telstra owns this market. But there are 80,000 businesses in Australia in the 20-to-200 seat range and 875,000 in the 1-to-20 range.

Despite now directly competing with Telstra in some aspects due to infrastructure acquired in the

Primus acquisition, MT2 actually gained Telstra’s consent before execution. The understanding is that if Telstra can show the company a superior offering, M2 won’t necessarily use the infrastructure acquired.

When it was acquired Commander had 1.004 products per customer. M2 has improved this to approximately 1.5 products currently but still has a significant way to go to achieve the industry average of three products. This is a core focus of M2.

M2 has consistently delivered growth in profit year-on-year since listing on the Australian Securities Exchange in 2004 and in June 2012 was added to the S&P/Australian Securities Exchange 200 Index.

The company paid full-year dividends of AUD0.176732 for fiscal 2012, up 14.6 percent from a year ago. This amount equates to a payout ratio based on reported earnings per share of 70 percent.

M2 Telecom is a buy under USD3.45 on the Australian Securities Exchange (ASX) using the symbol MTU and on the US over-the-counter (OTC) market using the symbol MTCZF.

M2’s fiscal year runs from Jul. 1 to Jun. 30. The company reports full financial and operating results twice a year; it typically posts first-half results in late February, with full fiscal year numbers out in late August.

The board approved and management declared a final dividend of AUD0.09 per share on Aug. 27, 2012. It will be paid Oct. 26, 2012, to shareholders of record as of Oct. 5, 2012. Shares will trade “ex-dividend” on this declaration as of Sept. 28, 2012.

An interim dividend of AUD0.086732 was paid Apr. 16, 2012, to shareholders of record on Mar. 22, 2012. It was declared Feb. 27, 2012, when the company reported results for the first half of fiscal 2012. Shares traded ex-dividend on Mar. 16.

Dividends paid by M2 are “qualified” for US tax purposes. The Australian government withholds 15 percent, based on the US-Australia tax treaty on double taxation. The two countries have not taken the step of eliminating withholding from dividends paid in respect of shares held in a US IRA, as have the US and Canada.

Among the analysts who cover the stock, four rate it a “buy” according to Bloomberg’s standardization of brokerage house recommendation terminology. There are three “hold” and one “sell” ratings on the stock at present. The “best consensus” 12-month target price among the six analysts that provide such a number is AUD4.05, with a high of AUD5.00 and a low of AUD3.50.