Tag Archives: EV/EBITDA multiple telecom

COLT calls time

COLT announced plans this week to cut €175 million of low margin voice wholesale business and take a €30 million restructuring charge in an attempt to address declining margins and halt operating cash burn, issues which I highlighted in a previous post. The stock took a hit and is down about 10% on the month. Press reports, like this FT article and this Guardian article, speculate that majority shareholder Fidelity is losing patience and the business is effectively for sale. Robert Powell at Telecom Ramblings is also speculating on potential buyers.

The graph below shows my rough estimates of the revenue and EBITDA margin (excluding restructuring charges) for 2014 and 2015 based upon COLT’s guidance (2015 is purely based upon my guestimates). The execution risk in the restructuring based upon the firm’s recent history doesn’t match up against any potential M&A upside in my opinion. This one is best to watch from the side-line. It should be interesting.

click to enlargeCOLT Telecom 2006 to 2013 Revenue & EBITDA Margin 2014 & 2015 forecast

Consistency with ambition, the case for TWTC

Valuations remain high (S&P PE at 19.5 and CAPE over 25) despite recent volatility and I have posted on my views previously. A recent post on Level3 (LVLT) in December referred to increases in telecom valuation multiples. Since then LVLT reported a very good end to the year and has rocketed to around $38, or an approx 9.4 EV to 2014 guided EBITDA multiple (and 8.7 to my 2015 estimated EBITDA). An analyst report, whilst upgrading the stock, commented “with a focus that has shifted from a slow deleveraging exercise via acquisitions to now focusing on integration and execution of assets the company possesses, we believe we are on the cusp of a sustained outperformance”. Although I generally ignore anything analysts say, I too am bullish on LVLT over the longer term based upon the virtuous circle of improving operating results and decreasing debt. However I think valuation may have gotten ahead of itself with LVLT up 70% in 6 months. I have taken some profits to buy some downside protection. There is likely to be some bumps on the road in 2014 both for companies like LVLT and from an overall market viewpoint. Structural changes in the rapidly changing telecom market like net neutrality or the proposed Comcast/Time Warner Cable (TWC) merger may also have an impact.

Speaking of Time Warner, there is a telecom that was spun off from Time Warner in the late 1990s called TW Telecom (TWTC) that has a history over the past 10 years of outstanding execution. Over that time, TWTC has diversified itself away from its roots (top 10 customers make up 18% of revenues in 2013 compared to 23% 5 years ago and 40% 10 years ago) with a current focus on business Ethernet, data networking, IP VPN, Internet access, and network security services for enterprises. The graphic below illustrates how successful and consistent TWTC’s operating results has been. I would particularly highlight their results through the troubled 2007 to 2009 period. TWTC have had solid 35% EBITDA margins for the past 10 years with average capital expenditures of 25% as they build their last mile metro fiber network to their business customers on a success basis. Their execution is in no small measure down to one of the best (and most consistent) management teams in the business, led by long term CEO Larissa Herda.

click to enlargeTW Telecom a history of consistent operating results

In addition to solid operating results, TWTC have always shown disciplined balance sheet management with net debt well below 2 times EBITDA in the past 5 years (except for 2013 at 2.3 times as per the changes below). As a result of the factors highlighted above, TWTC has always enjoyed a premium valuation multiple in the market as the graph (of enterprise value to twelve month trailing (TTM) and future twelve months (FTM) EBITDA) below shows.

click to enlargeTW Telecom EV to EBITDA Multiples

TWTC has long been talked of as an acquirer or a target for others but nothing of substance has materialised since their Xspedius acquisition back in 2006. The firm has increasingly undertaken shareholder friendly actions such as the $400 million spend on its own shares in 2013. TWTC has also bought back convertible debt and pushed out the maturities on its debt which has increased from YE2012 of $1.76 billion to just below $2 billion as at YE2013.

The reason for the increase in debt plus an additional one-off capital expenditure of $120 million in 2013 on capital leases (not included in graph above), with another one off $50 million due in 2014, is a strategic market expansion announced by TWTC in late 2013. The strategic market expansion is to extend its metro fiber footprint into 5 new high demand markets and accelerate the density of its metro-fiber footprint in 27 existing markets by 17%. Given TWTC’s history of execution, their plans for expansion and the (almost giddish) optimism of management during their Q4 conference call caught my attention. These are people who have not make such promises lightly in the past.

One of the factors behind their expansion is the success of new product innovation introduced in 2012, namely products called Enhanced Management and Dynamic Capacity. Such products allow enterprises to automate, manage and purchase network capacity on a flexible real time framework based upon their needs and offer flexibility in accessing connections to private, hybrid and public clouds. TWTC refer to their state of the art network as the Intelligent Network and are marketing their range of products on the basis of what they call their Constellation Platform which “will connect our customers nearly instantaneously through data centers directly to numerous applications in the cloud with increasing network automation”. All of these fancy products names and high minded assertions shouldn’t in themselves be taken as anything earth shattering in the rapidly changing IT and telecom market. What may be special is that TWTC has indicated increased interest in their offerings and that, through partnerships with cloud providers such as Amazon, they are getting interest from new enterprises with big data needs . TWTC state that their expansion is “a very targeted opportunity to rapidly increase our market density to drive additional revenue growth and greater cash flow” and that it “is all part of our broader vision of bringing better, faster and easier solutions to customers as we continue to innovate and create market differentiation”.

Given the history of execution by TWTC’s management, I would be positive on their ability to deliver on their promises. They have indicated that EBITDA margins will be under pressure in 2014 as they staff up for the new expansion. For 2015 & 2016, EBITDA expansion of 10% to 15% does not seem unreasonable to me based upon my calculations. Given a current EV/EBITDA on a TTM basis of over 11, TWTC is not cheap and, as stated in the beginning of this post, there are likely to be bumps in the road over 2014. Such bumps may provide an opportunity to back TWTC and its expansion at an attractive valuation.

I, for one, will be looking out for it.

Will it be different for Level3 this time?

As per my previous post on telecom experiences, I reviewed my projections and valuation methodology for Level3. Level3 has a frustrating yet fascinating past. It miraculously survived the telecom implosion with an over sized debt load through growing into its debt by buying up smaller metro focused telecoms and its most recent merger with a post chapter 11 Global Crossing.

Level 3 struggled with the integration of its numerous merger partners from 2005 to 2007 and, with the downturn in 2008 to 2010, suffered reductions in the both of the top and bottom lines of the combined entities. There is however now some hope that the integration with Global Crossing will not suffer the same fate. For a start, Level3 approached the integration with a much sharper focus on the customer experience during the merger and ensuring minimal service disruptions. Also, Global Crossing itself had a number of years following its restructuring where it focused on its core products and de-emphasised the low margin commodity business. Finally, the recent replacement of long time CEO Jim Crowe with the COO Jeff Storey seems to have brought a new focus in the company on growing the larger business organically rather than through continuous M&A.

I developed 3 scenarios to illustrate the benefits and the dangers of the current Level3 leveraged business model. The pessimistic scenario assumes that Level3 does not succeed in growing the top line and stumbles on achieving material ebitda margin improvement, only managing margins in the middle 20’s range. The base scenario assumes that Level3 does grow its higher margin business modestly (against a stodgy economic background with interest rates gradually stepping up over the medium term) which offsets reductions in voice based business, achieving an ebitda margin around 30% in the medium term. The optimistic scenario assumes Level3 gets on-going synergies and material ebitda margin improvement achieving a 33% margin by 2017 and thereafter. Graphs representing the scenarios are below and also show the resulting leverage ratios the business achieves.

LVLT Projection Pessimistic Scenario (click to enlarge)Level3 Pessimistic

LVLT Projection Base Scenario (click to enlarge)Level3 Base

LVLT Projection Optimistic Scenario (click to enlarge)Level3 Optimistic

The pessimistic scenario assumes that Level3 can’t get its leverage materially below 500% and would ultimately need to be restructured. Assuming the equity would be wiped out here may be conservative given the equity’s history to date at higher leverage levels. Also, a takeover may give the equity some value in this scenario. Notwithstanding these possibilities, the pessimistic scenario does illustrate the dangers to investing in a highly leveraged firm and given the current macro-economic headwinds and the likely higher interest rate environment to come, I believe an equity wipe-out remains a risk for Level3 in a pessimistic scenario.

The thin line between madness and sanity for highly leveraged firms is illustrated by the upside that modest and healthy growth of both bottom and top lines could result in the base and optimistic scenarios respectively. The following table shows the DCF results at discount rates ranging from 5% to 15%. The discounted cash-flow analysis assumes a termination multiple of discounted free cash-flow after 10 years in 2022 (different multiples for each scenario). As I stated in the previous telecom post, I take the results of a DCF analysis for these firms with a healthy pinch of salt given the timeframe involved and the number of assumptions that have to be made (e.g. cost of debt). Focussing on a discount rate of between 7.5% and 12.5% (which is where I think LVLT should be) does show that the leveraged business model of Level3 provides a 2 to 3 times upside against a 100% downside risk profile (assuming a current $21 per share price).

Summary of DCF Analysis (click to enlarge)

LVLT Share Price Upside & Downside

An alternative valuation method is to look at the EV/EBITDA multiple valuation that the scenarios above may imply. This analysis confirms a possible 200% to 300% upside for the base and optimistic scenarios respectively over a 5 year time horizon (and the 100% downside!).

EV/EBITDA Projection Pessimistic Scenario (click to enlarge)Level3 Pessimistic EV EBITDA multiple

EV/EBITDA Projection Base Scenario (click to enlarge)

LVLT EVtoEBITDA Project BASE

EV/EBITDA Projection Optimistic Scenario (click to enlarge)

LVLT EVtoEBITDA Project OPT

Conclusion

Level3 has broken many hearts in the past. However, if the new CEO can execute on organic growth and margin improvement, the stock offers an attractive upside over the next few years due to its leveraged balance sheet and operating model. A lack of macro-economic turmoil will also be an important factor in any success. For even more aggressive investors, playing the stock through long dated out of the money options offers the prospect of leveraging returns even further (with the accompanying increase in risk profile). As I keep stating, Level3 has promised much in the past and failed to deliver on a spectacular basis. This time, maybe, just maybe, it could deliver something for patient investors. Anybody considering Level3 should always keep in mind that it remains a high risk/return play and is not for the faint hearted.

My Erratic Telecom Habit

One of the sectors that I have followed for nearly 15 years now is the emerging telecom sector, specifically the so called altnet or CLEC sector. My affiliation with this sector has been the cause of many highs and lows, some very painful lows, through the telecom/internet bubble & bust, the 2000’s and to this day. Initially the attraction was the boom in internet and data traffic and the leveraged nature of many of the firms. After spectacular gains in the go-go days of the bubble (I bought hook line and sinker into the “picks and shovel” rationale), the subsequent reality of the telecom bust and the “nuclear winter” left me with big losses. For those unfamiliar with the stories of the bubble era, Om Malik’s excellent book “Broadbandits: Inside the $750 bilion Telecom Heist” goes deep into the madness that prevailed.

Over the past 10 years odd, I have had a much more cautious and opportunistic approach on the sector and have had some success at dipping in and out of stocks/debt/options of restructured companies as they moved in and out of favour (particularly prior to the financial crisis). Successes in recent years include the post-bankruptcy Virgin Media and Global Crossing. One notable failure was a firm called XO Communications backed by the vulture investor Carl Icahn. A self publicised champion of the minor investor, when it suits him, investing alongside Icahn in XO proved to be a grave error. This article illustrates some of the drama. I Iearned much from the experience including the dangers of illiquid stocks, the nonsense of following a self hyped dominant “star” investor, and the obvious perils of over-leveraged stocks with poor balance sheets in commoditising businesses. Despite these up and downs, the core thesis of a rapidly increasing data consuming society with the potential for high return/high risk (and often leveraged) investments remains for those with an aggressive risk appetite, particularly now that most of the overcapacity from the telecom boom years is becoming less of a factor. For any investor in this space, Robert Powell’s website Telecom Ramblings is the go-to place to get sensible and experienced insights.

One commonly used valuation metric for telecoms is the EV/EBITDA multiple (although it needs to be supplemented with other metrics such as debt and cash-flow measures to get a holistic picture in the altnet space). The graph below shows the variation that has been prevalent in the sector (for selected firms that survived & there is many names that didn’t).

Historical EV/EBITDA Valuations (point selections as at Year End) click to enlarge

Historical EVtoEBITDA Multiples CLEC sector May 2013

As I was preparing to crystallise my thoughts & analysis on this sector (the discipline of having to write down my analysis for this blog is a big reason I am continuing with this blog experiment), the comments from Keith Meister of Corvex at the Ira Sohn conference this week on Level 3 and TW Telecom have been extremely timely. By the way, Meister is an old colleague of Carl Icahn and served as his envoy on the XO board. Given this pedigree, I would therefore totally discount anything he says as 100% self serving. This post will outline some of the historical experience and a follow-on post will outline my valuation analysis for the future of Level 3 and TW Telecom.

Anybody familiar with this space is well aware of the ups and downs of the soap opera that is Level 3. One of the key players in the telecom boom, it built a wholesale network with the help of vast amounts of equity and debt in the bubble years (raised $14 billion in 1998!) and through the 2000’s became a serial consolidator purchasing firms such as Genuity, Wiltel, Progress Telecom, ICG, Telcove, Looking Glass networks and Broadwing to rebalance its business away from the wholesale business into the enterprise space. It is quite incredible that this company avoided the Chapter 11 route that so many companies in this space had to go through to right-size their balance sheets in the face of the new reality of the sector in the 2000’s. With its merger with the restructured Global Crossing announced in 2011, Level 3 seems to have finally reached a level where its balance sheet fits its business. The company also now has diversity across products and regions which indicate that it may be the right time to focus on organic growth. The arrival of the new CEO, Jeff Storey who previously served as Level 3’s COO and previously was the CEO of Wiltel, and his comments on the latest conference call seem to have signalled that Level 3’s consolidation days are behind it and the focus will now be on driving the company forward given its extensive global assets and improved balance sheet. The company is also a potential attractive takeover target for larger established telecoms looking to expand or from regional telecoms or bandwidth hungry technology companies looking for diversification (the more fanciful speculation highlights Level 3’s chairman Walter Scott & his friendship with Warren Buffet and his place on Berkshire’s Board). Again, Robert Powell posts, such as the one this week on TW Telecom, are the place to go to get sensible and knowledgably views on items such as M&A speculation.

TW Telecom, on the other hand, is at the opposite end of the spectrum to Level 3. It always had a focus on the enterprise space and has such a determined management that its business execution normally results in an ability to predict its quarterly result to the nearest million. Its leverage has always being far more rational than that of Level 3 and it has grown into its balance sheet gracefully over the past years. TW telecom is the sensible stable child to Level 3’s wild rebel in this space. Indeed, TW Telecom’s lack of adventure has been recently cited as a reason why it may be ready for a takeover.

In order to get some context on these two US based firms and a view of what has happened to a European focussed altnet, I also include a historical review of a European company called COLT Telecom (recently cited by Telecom Ramblings as a potential acquisition target for Level 3).

Graph of Historical Share Price for LVLT, TWTC, COLT click to enlarge

Historical Share Prices LVLT TWTC COLT

The historical operating figures for these three companies are highlighted below.

Historical Level 3 Operating Metrics (US$s) click to enlarge

Historical Operating Metrics LVLT

Historical TW Telecom Operating Metrics (US$s) click to enlarge

Historical Operating Metrics TWTC

Historical COLT Group Operating Metrics (€s) click to enlarge

Historical Operating Metrics COLT

In the interests of open disclosure, I currently own stock & options in Level 3 and have owned some of the other companies named in this post in the past. I am currently re-examining my valuation methodologies for the sector, specifically for estimating Level 3’s future path using TW Telecom as an example of firm’s experience in a relatively steady state and COLT as an example of firm’s experience on a cross border basis. I have used traditional discounted cash-flow and EV/EBITDA multiple analysis in the past but have recently become more sceptical about the underlying theory for such methods. I am trying to adapt them to get a more realistic view of the sector based upon previous experiences. I will post a follow-up of my thoughts and conclusions.