Telemasters (TLM) has built itself up out of a 'least cost routing' (LCR) business model that sought to arbitrage South Africa's high telecoms costs in order to benefit clients through savings and Telemasters through what is essentially commission on those savings.

Unfortunately, the increasingly deflationary pricing of local telecommunications and the slow (but steady) deregulation in the sector (particularly the dropping of inter-connect rates) has seen LCR's long-term sustainability diminish to arguably a dead business model. Hence, Telemasters (and other LCR's, like Vox's Orion) has had to begin getting realistic and reinventing itself.

With this background, Telemasters released its FY 11 results yesterday that saw its revenue rise c.13% and HEPS jump to 23.8cps (FY 10: 19.4cps). The Group upped its dividend for the year to 17cps (FY 10: 14cps, including a 5cps capital distribution).

On the surface, these are good results, but dig a little deeper and you begin to see some cracks showing.

Beyond even the issues with Telemasters' LCR business model, the following worrying numbers jumped out at me:

Telemasters wrote of bad debts of R1,6m (FY 10: R1.3m) or c.10% of Profit Before Tax (FY 10: c.9% of PBT). If FY 11's bad debts are compared to FY 11's average debtors (i.e. FY 10 debtors + FY 11 debtors and divided by two) of R19,4m, this implies that 8.4% of the debtors have gone bad. Let's round down to 5% (for various pre-provision for bad debts technicalities that are hard to take into account), but even this lower percentage implies that 1 in every 20 debtors Telemasters adds to its books goes bad.

Simply, there appears to be something wrong with Telemasters' credit controls.

This is further backed up by the fact that this same process repeated for FY 10's bad debts of R1,3m compared against FY 10's average debtors arrives at a percentage of debtors of 6.3% going bad.

Now, later on in Telemasters' FY 11 results, the Group admits that R85m of its revenue in the financial year came from a single customer. Further more, this customer was "...once off... [and] ...not expected to be a recurring business in the new year...".

Fair enough, that is excellent disclose and I applaud the Group for willingly providing it to us.

That said, though, this large, once off customer accounts for 32% of Telemasters' revenue and, in the absence of its R85m, implies that revenue for the Group actually shrank during FY 11. Further more, given Telemasters' worrying record with bad debts (i.e. almost 1 in 20 clients get written-off as bad debt), what if this large, once-off customer is in fact that 1 in 20th customer and the Group never gets its money?

Not enough disclosure is given to work out if this customer has yet paid or not, but debtors at the end of FY 11 is R20m. So at the very worst the majority of the R85m has been paid. Still, in the worst case scenario if the full R20m debtors is from this single customer and he doesn't pay, the bad debt write-off from this would decimate the Profit Before Tax of only R14,8m in FY 11.

Now, I'll be the first to admit that these are slightly paranoid concerns regarding Telemasters, but it doesn't change the fact that all of this is occurring during a period when Telemasters is changing its LCR business to one of "...an ICASA licensed busines..." and the "...the conversion process will take a longer period before the increased profitability will be realized [than was first anticipated]..."

In other words, be careful of Telemasters. At a PE of 6.9x and DY of 10.4%, an investor may be tempted to view the share as cheap. All the above risks coupled with the fact that directors expect lower dividend payments in FY 12 all lead me to believe that perhaps the share is not in fact as cheap as it first appears.

In fact, perhaps to the contrary.

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