Tag Archives: operating metrics

CenturyLink levelled

It’s been over 6 months since I last posted on the upcoming merger of Level 3 (LVLT) and Centurylink (CTL). Since then, LVLT’s CEO Jeff Storey has been named COO of the combined entity and CEO from January 2019, after a gentle push from activist investor Keith Meister of Corvex Management (here is an article on their latest position), effectively meaning the merger is an operational LVLT takeover of CTL. In June, CTL also got hit by a lawsuit from an ex-employer alleging a high-pressure sales culture which ripped customers off (an avalanche of class action suits followed). And, potentially more damaging, the recent results of CTL continue to point to deteriorating trends in the legacy part of their business and lackluster growth on the strategic part of the business. CTL missed their quarterly estimates again in the most recent quarter, the third miss in a row.

Picking up on my recent telecom industry post, the sector will struggle in the short term to find top line growth before the full impact of new “digital lifestyle” opportunities emerge. The figures below for enterprise, including public sector, and wholesale revenues for some of the biggest US players (which have been adjusted judgmentally for items such as the impact of the XO acquisition on Verizon’s revenues and the ever-changing classifications and reclassifications that telecom’s love) illustrate the current struggle in getting newer IP enabled services to fully compensate for declining legacy revenues.

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These figures imply average quarterly declines since 2014 of -0.3% and -1.2% for enterprise and wholesale business respectively. However, the trend has been getting worse. The average quarterly change was 0.2% and -1.1% for enterprise and wholesale business respectively from 2014 to 2015. Since 2016, the average quarterly change is -0.9% and -1.3% for enterprise and wholesale respectively. Not exactly a cheery trend when contemplating the prospects of a merged CTL/LVLT!

As can be seen below, the share price of LVLT and deal implied price have converged, particularly as CTL’s dividends get paid, albeit with a sharply downward bias in recent weeks over worries about dividend sustainability, valuation, sector trends, lawsuits and uncertainty over the closing date of the merger (a delay by California, the last State approval needed, may mean the end of September deadline is missed).

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My estimates for a standalone LVLT compared to analyst figures and those presented by LVLT management in the S4 (figures presented for merger negotiations are generally on the optimistic side) are below. Even factoring in higher interest rates (about 40% of LVLT’s debt is floating) over the coming years, I am comfortable with a standalone share price around the current mid-50’s, in the unlikely event the merger falls apart.

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To recap on my confidence in the ability of LVLT’s current management team to deliver, the results of the last merger between LVLT and TWTC show that management delivered a 40% uplift in the amount of free cashflow (e.g. EBITDA less capex) on flat revenues from 2014 to 2017 (e.g. combined FCF of both entities in the year prior to the merger to actual H1 results and my estimates for H2 2017). Some of my many previous posts on LVLT are here, here and here. Such a repeat in FCF in the CLT/LVLT merger is not a realistic expectation given the larger scale and different business mix, as the analysis below illustrates. Of course, the flat revenues over the past 3 years is a key concern (but worthy of praise given the industry trends highlighted above) and one of the catalysts for the CLT deal. Also, the health of designate CEO Jeff Storey may also be a factor over the next few years given his heart issues a few year ago.

My knowledge of CTL’s business is not as deep as that of LVLT’s and my confidence in their prospects on a standalone basis is nowhere near as lofty. My projections, split over a conservative base scenario and a more conservative low business scenario, can be seen below. My projections are primarily based upon the more recent trends in their business lines across their legacy and strategic enterprise and consumer businesses. The vast variance in my estimates, based upon recent trends, and those presented by management in the S4 (again, acknowledging that these are generally optimistic) illustrates why the market has lost such confidence in the outgoing management team at CTL, in my opinion.

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In terms of trying to model the merged CTL/LVLT, I have assumed the deal closes by the end of 2017 with 2018 being the first year of the merged entity. I have made a number of judgmental adjustments in my model, including assuming some loss of revenue due to the merger and cost reductions above published target synergies (e.g. $1 billion of operating synergies by end 2020 and $150 million of capex synergies by end 2019, higher than the announced target savings of $850 million and $125 million for opex and capex respectively). I have taken analyst estimates as an optimistic case (in CTL’s case I have taken their EBITDA estimates but still can’t get anywhere near their revenue figures) and called it the high scenario. My two projections above are used for the base and low scenarios. The resulting operating metrics for each scenario is shown below.

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The high scenario shows revenues flat-lining slightly above $24 billion for 2018 and 2019 with top-line growth returning in 2020 (YoY above 2.5%). EBITDA margins hit 40% by 2019 and remain stable around 40% thereafter. Capex is assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 30% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The base scenario shows revenues flat-lining around $23.5 billion for 2018 through 2020 with top-line growth returning in 2021 (YoY just below 2%). EBITDA margins hit 40% by 2019 and slowly trend down toward 39% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 22% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

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The low scenario shows revenues around $23.5 billion for 2018 and drifting down to $23 billion before slowly hitting $23.5 billion again by 2022. Thereafter revenue growth builds slowly from 1.5% to 2.5% by 2027. EBITDA margins hit 39.5% by 2019 and slowly trend down toward 38.5% thereafter. Capex is again assumed to hit 15.5% of revenues by 2019 and remain at that percentage thereafter. This scenario assumes that management will be able to generate an approximate 18% uplift in the amount of free cashflow (e.g. EBITDA less capex) from 2017 (e.g. combined FCF of both entities in the year prior to the merger) to FY 2020.

I also assume the merged entity will carry $38 billion of debt from the offset (resulting from merger expenses, the cash payout to LVLT shareholders, and existing debts from both firms, after factoring any proceeds from recent CTL divestitures). I estimate that only 30% of this debt load is subject to a floating rate. In all scenarios, I assume the LIBOR rate linked to the floating rate increases incrementally by 275 basis points over the next 3 years (the current 12 month US rate is about 175 basis points). With a net debt to EBITDA ratio of approximately 3.8 at the end of 2018 across all scenarios, I believe that getting that ratio below 3 within 4 years by 2021, at the latest, will be a primary objective of the new management team. That would only be prudent in my view given the likely tightening monetary environment over the next few years which will punish valuations of corporates with high debt levels. Also, management will want to remain flexible if higher capex is needed to compete in new technologies for the IoT and digital lifestyle era (see recent sector post). I haven’t factored in an upside from LVLT’s CFO Sunit Patel proven ability to actively manage debt rates and maturities (his ability is highlighted by the fact that LVLT’s fixed debt costs 5.5% compared to CTL’s admittingly much larger fixed debt costing 6.8%)

That leads to the thorny question of the sustainability of the annual dividend of $2.16 per share (particularly given that share count will double, amounting to $2.3 billion per year). Under the high scenario, maintaining the current dividend and getting the net debt multiple below 3 by 2021 is doable if a little tight (primarily due to the cashflow benefits of LVLT’s NOLs). For both of the base and low scenarios maintaining the current dividend level is not realistic in my view, with a cut in the dividend to $1.30 and $1.00 needed in each scenario respectively (a 40% and a 55% cut). The current dividend yield on CTL is over 10%. Each of the cuts above would reduce that yield to approximately 6% and 5% for the base and low scenarios respectively based upon the current share price. Addressing the uncertainty over the dividend should be one of the priorities of the new management (and may even result in Jeff Storey’s move to the CEO position ahead of the planned January 2019 date).

Finally, before I reveal my per share valuations, I haven’t given any consideration to the financial impact of the current legal cases on alleged aggressive sales tactics as the level of current detail makes any such estimate impossible. Some of the class action cases claim anything from $600 million to $12 billion but these claims are always bloated and the eventual settlement figure, if there even is one, are often for a lot less than that claimed. Nor have I considered the potential impact of a spin-off of the consumer business (that’s for another time!).

So, based upon the analysis outlined in this post and using a discount rate of 8.5%, my valuation estimates for each of the three scenarios are below.

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The market’s current valuation of CTL around $20 indicates scenario 3 as the current expectation. This emphasizes the need to address the uncertainty over future dividend levels and the validity of the legal cases. Uncertainty over the closing date of the deal is overblown, in my view, and a few months of delay will not prove material. I do think the current valuation is harsh, given the potential upsides from the deal and longer-term industry trends. Interestingly, my base scenario valuation of £31 is not too far off the value of $34.75 by BofA Merrill Lynch and Morgan Stanley in the S4 (see this post on the S4). The base scenario is the one I would have the most confidence in, based upon my current knowledge, rather than the high scenario of $43 which does look too optimistic to me given current market trends.

I was never going to reinvest the cash component of the deal for LVLT shareholders given my current reservations about market valuations and move to cash across my portfolio. The analysis presented in this post indicates to me that the CTL shares due from the deal for LVLT shareholders are worth holding from a valuation perspective. For now.

For new investors, I’d wait to see how some of the uncertainties play out, particularly the dividend issue.

More musings on the online gambling sector

A previous post on Paddy Power, William Hill and Ladbrokes showed how online sportsbook and gaming revenue are becoming an important part of the revenues of these firms. Another recent post on Betfair showed a similar import. This post will focus on the online gaming (which is a gentlier word used in the sector for what is more aptly described as online gambling) part of the equation.

As a recap, the graph below shows the online gaming revenues from Paddy Power, William Hill, Ladbrokes and Betfair (with PP converted to sterling at today’s rate) which make up 17%, 16%, 8% and 17% of their 2013 revenues respectively. Ladbrokes has approximately half the amount of its competitors. The considerable growth in William Hill’s online gaming (mainly casino) revenue after the creation of WH Online (WHO) in 2008 can clearly be seen. H2 Gambling Capital are forecasting an approximate 9% annual growth in online gaming gross win figures over the next few years

click to enlargeNet Gaming Revenue

None of the firms above split out their operating margins for the online gaming sectors. As casino is the dominant source of revenue for many of the firms, it is interesting to look at a diminutive online casino firm called 32Red, as per the graph below. Although 32Red is relatively small, the reduction in its margin to an average of 6% suggests that competition has pushed margins down in this business.

click to enlarge32Red Operating Metrics

Another two public firms that have a majority of their business in online gaming are 888 and BWIN. 888 is a well established player, particularly in the online casino market, with 40% of revenues in the UK and 40% in the rest of Europe in 2013, and it has been rebuilding its profit margins in recent years. 888’s operating metrics are summarized in the graph below.

click to enlarge888 Operating Metrics

BWIN, following its merger with PartyGaming in 2011, has a higher revenue base across Europe (excluding UK) making up approx 70% of 2013 revenues (25% from Germany) with only 10% from the UK. After some poor results and pressure from shareholders, BWIN is currently cutting its expense base by €30 million or approx 5.5% and is looked at ways it “can increase shareholder value”. BWIN’s operating metrics are summarized in the graph below.

click to enlargeBWIN Operating Metrics

The share performance of these firms has been distinctly mixed in recent years with little old 32Red blowing the others away, as per the graph below. BWIN has clearly underperformed and may likely be broken up. Analysts have speculated that a number of potential bidders, including William Hill and Paddy Power, are looking at various BWIN assets. Janus Capital Management has being building its stake in BWIN over recent months to 11% as at mid-July.

click to enlargeShare price since 2011 888 BWIN 32Red

Comparing the mainly online gaming firms with their more established betting firms in terms of the PBT margin shows the trend for both is downwards, as per the graph below. Headwinds include increased regulation and taxes such as the proposed UK POC tax. Opportunities include the explosion in mobile gambling, the slow re-opening of the US market (although I am sure established US bricks and mortar gambling firms will fight hard for their turf), new product development such as social gaming and the expected market consolidation. Amaya’s recent purchase of PokerStars has focussed minds on what will be needed to succeed in the US.

click to enlarge2003 to 2013 PBT Margin Betting & Online Gaming Firms

One of the more colourful firms in the sector, Playtech, has some interesting things to say about where the future is leading. On increased regulation, Playtech say that “the regulation of online gambling can be a catalyst for market growth, depending on how regulation is introduced, what product verticals the regulator allows and the tax rate applied” and that ”opportunities exist as markets move from a ‘dot.com’ to a ‘dot.national’ regime, although some uncertainties through the transition period are expected”.

Specifically on the UK, Playtech commented that “many smaller operators are understood to generate operating margins lower than the expected tax rate of 15% and in the view of industry experts, will struggle to compete. Larger operators can rely on economies of scale and their leading brands to remain competitive. Analysts expect that in 2015 the UK market will undergo significant change led by consolidation, as those operators with the strongest brands, best technology and means to invest in marketing will prevail”.

Playtech is a software gaming firm which offers a fully integrated platform across games and sports-betting called IMS that many of the main players use (licensees include Betfair, bet365, William Hill, Paddy Power and Sky, amongst others). They also run a white label turn-key operation called PTTS and a joint venture business. Their most well known joint venture was one where they very successfully partnered with William Hill in 2008 in the creation of William Hill Online (WHO). William Hill recently bought out Playtech of their 29% stake for £424 million. In March 2013, Playtech entered into a deal with Ladbrokes (in an attempt by Ladbrokes to diversify their business and catch up with their competitors – see first paragraph of this post) where, according to Morgan Stanley, Playtech “has effectively been given a quasi-equity stake, where it will “own” 27.5% of any increase in profits”. A Morgan Stanley report, although over a year old, has more interesting background on Playtech (they are still hot on the stock). The graph below highlights some of the metrics behind Playtech.

click to enlargePlaytech Revenues and PBT Margin 2009 to 2013

Much of the colour behind the firm has been provided by its 40 year old Israeli playboy founder, Teddy Sagi, who has a bribery and insider trading conviction from his youth in the 1990s. Playtech bought many of the assets used in the WHO 2008 deal from Sagi and also the PTTS assets (70% of this business is from Imperial e-Club licensed in Antigua and Barbuda!) in 2011 which caused concerns about conflicts of interest. Concern over such conflicts on what Playtech may do with its new cash pile from the WHO sale (they returned £100 million in a special dividend earlier this year but still have £376 million in cash as at end Q1) and on potential problems that Sagi’s ownership position may do in gaining access to the US resulted in an offering in March this year which reduced his 49% stake to 34%.

Playtech has stated that their “the Board is seeking transformational M&A opportunities to take the business to the next level.” Although it’s a bit too colourful for me, a number of analysts estimate a 20%+ upside on its current share price and it’s interesting to note that David Einhorn’s Greenlight Capital is a believer with an ownership of 3.8%. That, I think, is a good place to end a post on gambling!