Tag Archives: Intelligent Network

The Next Wave

As part of my summer reading, I finished Paul Mason’s book “PostCapitalism: A Guide To Our Future” and although it’s an engaging read with many thoughtful insights, the concluding chapters on the future and policy implications were disappointing.

Mason points to many of the same issues as Martin Wolf did in his book (see post) as reasons for our current situation, namely the inherent instability in allowing private profit seeking banks to create fiat money, ineffective regulation (and the impossibility of effective regulation), increased financialization, global flow imbalances, aging populations, climate change and the disruptive impact of new information technologies. This 2005 paper from Gretta Krippner on the financialization of the US economy and reports from S&P (here and here) on the policy implementations of aging demographics are interesting sources cited in the book.

It is on the impact of the information technology and networks that Mason has the most interesting things to say. Mason uses Nikolai Kondratieff’s long wave theory on structural cycles of 50-60 years to frame the information technological age as the 5th wave. The graphic below tries to summarise one view of Kondratieff waves (and there are so many variations!) as per the book.

click to enlargeHistory Rhyming in Kondratieff Waves

The existence of such historical cycles are dismissed by many economists and historians, although this 2010 paper concludes there is a statistical justification in GDP data for the existence of such waves.

Mason shows his left wing disposition in arguing that a little known theory from Karl Marx’s 1858 notebook called the Fragment on Machines gives an insight into the future. The driving force of production is knowledge, Marx theorises, which is social and therefore the future system will have to develop the intellectual power of the worker, enhancing what Marx referred to as the general intellect. Mason contends that the intelligent network we are seeing unfold today fits into Marx’s theory as a proxy for the general intellect.

Mason also promotes the labour theory of value, as espoused by Marx and others, where automation is predicted to reduce the necessary labour in production and make work optional for many in a post-capitalist world. To highlight the relevance of this possibility, a 2013 study asserted that 47% of existing jobs in the US would be replaced by automation. References to Alexander Bogdanov’s sci-fi novel Red Star in 1909 may push the socialist utopia concept driven by the information age too far although Mason does give realistically harsh assessments of Soviet communism and other such misguided socialist experiments.

The network effect was first discussed by Theodore Vail of Bell Telephone 100 years ago with Robert Metcalfe, the inventor of the Ethernet switch, claiming in 1980 that a network’s value is the number of users squared. Mason argues that the intelligent network, whereby every person and thing (through the internet of things) is wired to the network, could even reduce the marginal cost of energy and physical goods in the same way the internet has for digital products. Many of these ideas are also present in Jeremy Rifken’s 2014 book “Zero Marginal Cost Society”. Mason further argues that the network makes it possible to organise production in a decentralized and collaborative way, utilizing neither the market nor management hierarchy, and that info-capitalism has created a new agent of change in history: the educated and connected person.

The weakest part of the book are the final chapters on possible policy responses which Mason calls Project Zero with the following aims: a zero carbon energy system, the production of products and services with near zero marginal costs, and the goal of pushing the necessary labour time close to zero for workers. Mason proposes a trial and error process using agent based modelling to be adopted by policy makers to test post-capitalism concepts. He refers to a Wiki-State, a state that acts like the business model of Wikipedia nurturing new economic forms without burdensome bureaucracies. Such a state should promote collaborative business models, suppress or socialize info-monopolies, end fractional banking (as per the Chicago Plan), and follow policies such as a minimum basic wage for all to accommodate the move to new ways of working. All very laudable but a bit too Red Star-ish for me!

Nonetheless, Mason’s book has some interesting arguments that make his book worth the read.

 

An aside – As highlighted above, there are many variations on the Kondratieff long wave out there. An interesting one is that included in a 2010 Allianz report which, using the 10 year average yield on the S&P500 as the determinant, asserts that we are actually entering the 6th Kondratieff wave (I have updated it to Q3 2015)!

click to enlarge6th Kondratieff Wave

Looking through some of the mountain of theories on long waves reminds me of a 2004 quote from Benoit Mandelbrot that “Human nature yearns to see order and hierarchy in the world. It will invent it if it cannot find it.

Level3 flying high

It has been over 6 months since I have posted on the prospects for the telecommunications firm Level3 (LVLT) following its merger with TW Telecom (TWTC). I had previously posted on the strength of TW Telecom’s business model and its admirable operating history so I am extremely positive on the combination. At the time of the last post, LVLT was trading around $45 a share, a five year high. Since that time, the stock fell to a low of $38 in October 2014 before reaching a new high in recent weeks around $54.

My previous post, using figures disclosed in a S-4 filing on the merger negotiations, made a projection that the combined entity could get to $9 billion of revenue and $3 billion of EBITDA by 2016. Based upon the Q4 figures, the firm’s guidance, and the recently filed 10K, I did some more detailed figures and now estimate that the $9B/$3B revenue/EBITDA threshold will more likely be in 2017 rather than 2016. My estimates for each against the consensus from analysts are below.

click to enlargeLevel3 Revenues and EBITDA estimates 2015 to 2017

LVLT is an acquisitive firm and has learned through multiple deals the optimal way of integrating new firms through a shape focus on the customer experience whilst prudently integrating operations and reducing costs. Taking the Global Crossing integration as a template, the graphic below illustrates how my estimates fit in the past.

click to enlargeLevel3 Operating Metrics 2005 to 2015

So, the question now is whether a share price in the mid to high 50s is justified (the average consensus is around $57 with the highest being Canaccord’s recent target of $63). Using an enterprise value to EBITDA multiple based upon a forward 12 month EBITDA figures (actual where relevant and my estimates from Q1-2015), I think a target between $50 and $60 is justified assuming a forward multiple of 10 to reflect growth prospects, as the graphic below illustrates. My DCF analysis also supports a target in the low 60s.

click to enlargeLevel3 10year EVtoEBITDA versus Share Price

Such a target range assumes operating results show positive momentum and that the overall market remains relatively stable with expectations on interest rate increases in the US within current estimates. Due to LVLT’s net debt load of just under $11 billion and a proforma leverage ratio of 4.4 to EBITDA, the stock is historically exposed to macro-economic volatility. A mitigant against such volatility is the increasing level of free cash that the business will generate (I estimate $600/$900/ $1,000 million over 2015 to 2017). Also, about $6.5 billion of its debt is fixed (current blended rate is 7.2%) and LVLT’s CFO has shown considerable skill in recent years at managing the interest rate down in this yield hungry environment. Its remaining floating debt (blended rate of 4.2%) has a minimum LIBOR rate of 1% and therefore offers headroom against movements in current LIBOR rates

In my view, the key in terms of valuation is that the integration goes smoothly and that revenue growth in the enterprise market is maintained. One of the principal reasons for my optimism on LVLT is the operational leverage the business has as the mix of its business moves more towards the higher margin and stickier enterprise market, as the pro-forma revenue split shows.

click to enlargeLevel3 Proforma Revenue Split

As always with LVLT, I recommend using options to protect downside and waiting for a pull-back from current highs for any new investment. This stock has historically not been one for the faint hearted. I do believe however that they are on the path to a more stable future and it remains a core holding for me.

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.