Gamma Communications: strong progress for an under-appreciated serial acquirer


FTSE Aim-listed Gamma Communications released its full-year results during March. I first published an article on Gamma, the communications software business, in March 2021, so with its recent results, I wanted to take the opportunity to update my financial models and share my thoughts on Gamma’s progress.


Firstly, if you are new to Gamma’s business and their niche within the telecoms industry (SIP Trunks, Ucaas and CCaas) I suggest you take a read of my first article here. In short, Gamma sells recurring subscriptions to unified cloud-communication software. This software makes it much easier for businesses to communicate between customers and employees both on and off company premises and across varied platforms (such as Microsoft Teams and standard mobile phone operations).


My ongoing thesis for Gamma suggests that Gamma Communications is an early-stage serial acquirer, utilising its free cash flow to make prudent bolt-on acquisitions within its telecoms niche. A review of the cash flow statement in 2022 indicates that Gamma has continued to execute well on this strategy. In my opinion, the success of Gamma’s acquisition strategy and the future potential of this serial acquirer will revolve around the following four points highlighted below.


1. Fragmented market


The cloud-communications software industry is highly fragmented. Typically, large communications companies provide overarching technologies (Microsoft, Verizon, Cisco) and smaller, regionally-based companies provide tailored solutions and capture regional market share within their niche.


This means that for Gamma to expand there is a plethora of opportunities to add additional regional exposure (for instance in Europe, which Gamma has done in 2021) or purchase software in adjacent niches to expand capabilities. Gamma likes to look for businesses similar to itself and has named its acquisition targets ‘mini-Gamma’s’.


Below is an outline of its potential target list. 247 companies make its long list for potential acquisitions, which shows that the fragmented market offers plenty of scope for further bolt-ons.



Source: Gamma Communications Capital Markets Day (Nov 2021)


2. Underlying growth


Gamma’s core business continues to exhibit robust underlying revenue growth, led by the structural requirements for cloud-communications services.


Gamma reports results for the UK ‘direct’ and ‘indirect’ segments separately from its European operations. With many of Gamma’s acquisitions focused on the ‘land-and-expand’ model in Europe, its UK revenues have been largely exposed to organic forces since 2018.


Whilst the UK market is more mature and Gamma’s growth rate here is slowing, it is a positive sign that until very recently organic growth in this market was in double digits. It is also worth keeping in mind that Gamma operates with no debt and a lean investment model --- choosing to acquire businesses with its spare cash. I am sure Gamma could increase this growth rate by spending more capital on sales and marketing if no acquisitions are made during the year.



Source: Gamma Communications Annual Report, The Quality Compound

3. Operating leverage


Operating leverage occurs when a set fixed-cost base gets spread over a large amount of revenue. This has the effect of increasing profit margins, as the business grows revenues and becomes larger in size. If a business has a reliable method of generating operating leverage, this can be a powerful tool for wealth creation --- and scale should be prioritised by such a company.


Looking into Gamma’s financial track record (more on this below), it is quite clear that Gamma is a business that can generate operating leverage. The graph below depicts Gamma’s operating margin profile, with the business growing revenues from £213 million in 2016 to £447 million in 2021. Across those six years, the operating margin profile has increased from 10% in 2016 to 15.3% in 2021. Margins spiked in 2020 due to the sale of a business netting £19 million in profit for the parent. Without this disposal, Gamma’s margin expansion has followed revenue growth in linearity.


Source: Gamma Communications Annual Report, The Quality Compound

Further to this point, I have taken a slide from Gamma’s 2021 capital markets presentation, which shows the evolution of UK margins with the incremental rise of PBX seats (Private Branch Exchange telephone units). One can see that with an increase in units sold, margins rise for Gamma. In simple terms, we can suggest that each new unit sold is worth more to Gamma due to positive-unit economics.


Source: Gamma Communications Capital Markets Day (Nov 2021)

4. Acquisitions continue to be 'bolt-on' in nature


Acquisition size is of critical importance for investor returns. More often than not, ‘transformational’ acquisitions of vast proportions end up going wrong. Think Kraft-Heinz, Bayer-Monsanto, AB inbev-SABMiller, and I am sure, given the widely publicised commentary from UK fund manager Terry Smith, the proposed Unilever-GSK tie up would have gone down equally as badly.


However, as documented through several sources (I personally like to read notes from Andvari Associates on serial acquirers), companies that can make small, revenue-enhancing acquisitions within near adjacencies to their existing business can propel operating performance to success over the long term.


Taking a look below at Gamma Communications’ use of net operating cash flow, we can see that Gamma continues to make great use of free cash to enhance the prospects of the business. In 2021, Gamma produced £77 million of net operating cash flow, and from this balance, Gamma acquired Mission Labs, a Manchester based software company for £49 million. Gamma remained debt free and able to return £11 million in cash to shareholders through dividends across the year.


Source: Gamma Communications Annual Reports, The Quality Compound

Gamma Communications six-year financials


Source: Gamma Communications Annual Report, The Quality Compound

Summary and valuation


2021 was another year of solid operating performance for Gamma. The acquisition strategy continues to work well, with Gamma able to deploy £49 million in excess cash towards the purchase of Mission Labs, a software business that will bring Gamma increased capabilities and strengthen Gamma’s relationship with the likes of Microsoft and Amazon.


Operating leverage at Gamma continues to strengthen; when adjusting for the 2020 disposal, operating margins, which have grown sequentially as the business grows scale, are likely to provide an attractive return profile for Gamma shareholders in the years to come.


With average EPS growth over the last six years of 20%, we could forecast that Gamma will produce anywhere between 66-72p of earnings in 2022 (guidance from Progressive Equity Research suggests an EPS of 68p). At today’s price, this would put Gamma on a forward P/E of 18-20x earnings, depending on where the results land for the year.


I believe Gamma is a very high-quality business when compared to the UK mid-cap spectrum, and the fundamentals for Gamma’s acquisition strategy look to remain in good shape. At a valuation below 20x forward earnings, I think Gamma Communications is highly attractive.


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At the time of writing, James owned shares in Gamma Communications.


To see the first 20 portfolio holdings in both of James' portfolios, click here.


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