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CBEYOND INC CBEY
October 06, 2010 - 7:28pm EST by
macklowe
2010 2011
Price: 13.25 EPS NM NM
Shares Out. (in M): 31 P/E NM NM
Market Cap (in $M): 408 P/FCF NM NM
Net Debt (in $M): -52 EBIT 43 52
TEV (in $M): 356 TEV/EBIT 8.3x 6.8x

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Description

Note that I submitted this for my VIC application at the end of August, so some of the market-based figures and valuation discussion reflects the prevailing share price (around $12).  CBEY has risen to the mid $13s along with the broad markets over the past six weeks.  Also, please note that CBeyond has been discussed as a short idea in VIC previously and as I held a divergent view, I thought it would be helpful to provide a full business and strategy description, as this weighs heavily in my thesis.

Summary

I am advocating a long thesis on CBeyond.

CBeyond provides a suite of IT and communication services to 53,000 small businesses in 14 major metropolitan markets (henceforward "MSAs") in the United States.  CBeyond officially targets firms with 5 to 249 employees, but in reality really just targets the low end of that range.  This market segment has historically been under-served and the vast majority of its customers do not have dedicated IT personnel.

CBeyond is categorized as a competitive local exchange carrier (CLEC), a group that has been much maligned by investors due to a history of under-performance, highly leveraged balance sheets and in some cases, high-profile bankruptcies.  Moreover, CBeyond actually trades at a significant discount to this peer group even though it has significantly higher growth and a higher quality and more profitable revenue stream.

CBeyond has a differentiated business model from the traditional CLEC and shares many elements with Software-as-a-Service ("SaaS") companies - contracted recurring revenue, high upfront sales "investment" that impacts near-term accounting earnings, ability to rapidly deploy new services to the existing customer base, and particularly attractive to small businesses.  However, "Communications-as-a-Service" may be more appropriate to describe CBeyond as there is a greater hardware aspect to its business.

The market does not appreciate this for two key reasons: (i) CBeyond's underlying profitability is masked by its aggressive investment into new MSAs - investment that, based on a ten-year track record, has yielded MSA-level IRRs in the 20-30% range, and (ii) while it has out-performed its CLEC peers, CBeyond's operating performance (growth, churn, profitability) has been negatively impacted by the recent economic downturn, which has disproportionately affected its core customer base of small businesses.

Citing slower growth rates and longer time-to-profitability at the newer MSAs, the alternative view is that expansion into newer MSAs will not be as profitable as the original MSAs.  I take the view that this was primarily the result of the economic downturn, which has been particularly harsh on small businesses.  Indeed, as I describe in more detail below, the benefits of scale may more than compensate for lack of a first mover advantage as CBeyond targets additional MSAs for expansion.

The catalyst for unlocking value will come when aggressive expansion into new MSAs from 2007-2008 begin converting into profitable MSAs over the next 2-4 quarters.

 

Business and Strategy Overview

CBeyond provides IT and communications services (a.k.a. "applications") to small business that range from traditional voice and broadband to value-added services such as data backup and security, mobile workforce enablement and web marketing.  CBeyond's mission statement is to bring large enterprise IT and communications services to small businesses, or to be  "the last communications company a small business will ever need."

These services are delivered as applications over a 100% IP network and are specifically designed to be simple to use because their customers almost invariably do not have dedicated IT personnel.  The average CBeyond customer has around 14 employees, 8 telephone lines and utilizes more than 7 different applications.  They are local firms like doctor's offices, law offices and local retail.  Because CBeyond is providing more than commoditized voice and data services, the company is able to generate higher gross margins and limit churn (more applications, greater stickiness).  Evidence of this can be seen in CBeyond's 66-69% gross margins which is higher than its CLEC peers which range from 45% to 58% (see below for more details).  CBeyond's churn rates are relatively low (1.0% per month in a good economy, 1.5% at the bottom of the recession, currently 1.4%), even during this most recent economic environment.

 

Industry Background

In the past, for regulatory and technology reasons, small business customers only had one alternative for their voice and data services, the local telephone company.  The Telecommunications Act of 1996 made it possible for new entrants to offer local voice and data services and launched a massive wave of debt-fueled investment in network infrastructure during the late 1990s that ultimately ended in a bust with a number of high-profile bankruptcies in the 2000 to 2003 time period.  The advent of telecom-grade IP communications technology also made it increasingly cost effective to deliver voice, data and software as services over a single data pipe.

CBeyond recognized that the confluence of these trends enabled a new business strategy that could effectively target small business customers.  CBeyond developed a business model that could (i) effectively reach these small business customers through a local, direct and highly regimented salesforce and (ii) offer these small businesses a growing set of simplified "large enterprise" services that they could not afford before.

 

Competition and Positioning

The telecom services industry is extremely competitive with high barriers to entry.  CBeyond's competitors can be grouped into several categories:

  • Cable companies (e.g. Time Warner Cable, Comcast) - Cable companies are the greatest potential threat in the long-term, although they have little to no impact today. The main reasons include (i) strong moats and demonstrated ability to add alternative revenue streams such as Voice-over-IP (VoIP), (ii) ability to reach businesses locally - they have made strong inroads in the SOHO market (1-4 employees working from home). To date, CBeyond management has noted on its conference calls that few customers (numbered in the "dozens") have been lost to cable companies - and many of these are small businesses that have "downgraded" to the home office (SOHO) category. Leveraging its first-mover advantage, CBeyond has already captured significant market share in its original markets - up to 16% in the Denver MSA. Because they are infrastructure-agnostic, CBeyond can more easily offer services such as mobile and mobile data that cable companies will struggle to offer. As an example, CBeyond recently announced a partnership with Clearwire to offer 4G data broadband services. Cable companies are somewhat tied to their existing cable infrastructure, while CBeyond has the freedom to use whatever technology is best or most appropriate. While potentially a major competitive threat, I also view cable companies as a potential strategic acquirer of the business - notably, Comcast purchased a small Chicago-based CLEC in 2009.
  • Local telephone companies (e.g. AT&T, Qwest, Verizon) - as described earlier, CBeyond targets small business customers and has consistently acquired 70% of its new customers from local telephone companies - a figure that has been relatively constant from the beginning. I do not view telephone companies as a serious threat for now, because they are not focused on this market segment and do not have a business model (local direct sales force, package of simplified applications) that effectively targets the types of customers that value CBeyond's services. Telephone companies have been preoccupied about losing existing consumers to cable companies and fighting for market share in the large enterprise space with new entrants such as traditional CLECs. By developing a similar business model to CBeyond, they are at risk of cannibalizing their existing customer base - which explains why they have not done so to date. Lastly, similar to the cable companies, they are tied to their existing telecom infrastructure.
  • Traditional CLECs and alternative carriers (e.g. Paetec, Integra Telecom) - CBeyond's competitive differentiation against CLECs is its focus on small business customers and a relatively "asset light" strategy. Many CLECs took on debt for heavy infrastructure buildouts and many were cobbled together through acquisitions, resulting in disparate network architectures (e.g. Paetec) that make it more difficult to efficiently roll out new services. CLECs competed directly with the incumbent telephone company and built competing infrastructure. CLECs targeted large enterprises and competed primarily by offering a lower-price alternative to the incumbent telephone company. However, over-supply of these highly commoditized voice and data services pressured returns, which in many cases could not even cover the cost of debt, and many CLECs went bankrupt. CBeyond started later and had the benefit of hindsight, and avoided the debt-fueled boom that wiped out many CLEC equityholders during that period. Their business strategy was also more differentiated, focusing on small businesses in a handful of MSAs at the outset. They did not build out expensive infrastructure, instead utilizing existing infrastructure by leasing lines that telephone companies were mandated to provide at a regulated wholesale prices. This allowed them to focus their capital and efforts on acquiring long-term customers (investment in local direct sales) and by providing higher value-added services that are simple to deploy.
  • Alternative communication service providers (e.g. 8x8, J2 Global/Onebox, Ringcentral) - Other competitors include non-traditional service providers, many of whom are purely software-based and do not have direct local presence. While there is certainly a place in the market for these businesses, having a local direct presence like CBeyond's makes it easier to upsell new services, market through local business organizations, etc. These alternative communication service providers find it difficult to upsell higher value-add products and have large stuck to commoditized voice services. As a result, they compete in a more price-sensitive environment and have higher customer churn rates compared to CBeyond.

 

Underlying Profitability Analysis

Accounting statements do not provide an accurate snapshot of CBeyond's underlying profitability.  CBeyond incurs significant startup costs ($20 to $40 million) in the form of capex, local sales personnel and customer support over a 3-5 year period whenever they enter a new MSA.  Thus, aggressive expansion directives, such as during 2007-2008, will have a negative impact on accounting earnings in the first 2-4 years before adding meaningfully to the bottom line.

CBeyond provides full disclosure at the MSA level of revenue, adj. EBITDA, operating income, depreciation and capex.  In its "Fully Developed" MSAs, CBeyond has been able to achieve MSA-level operating margins of 40-50%.  What is not included in the MSA-level operating margin are corporate G&A costs, some of which are fixed (headquarters, finance, admin etc.) but a significant portion of which are variable (customer support).  To properly analyze CBeyond's underlying profitability, one must allocate corporate costs on a revenue basis to each of the MSAs (all of the operating income figures reflect this adjustment).  The resulting adjusted financials and other MSA metrics are summarized in the table below:

Table I: Summary by MSA

  Launch Amount Revenue (2) Operating Income (2) Quarters MSA Est. Market Intrinsic
$ in thousands Date Invested (1) 2009A 2010F 2011E 2009A 2010F 2011E to FCF+ (3) IRR (%) Share (%) Value (4)
Fully Developed MSAs                      
Atlanta Q2 2001 $76,456 $85,327 $85,606 $86,890 $15,284 $16,259 $17,881 7 13.9% 14.6% $126,823
Dallas Q4 2001       39,218       75,097       76,156       77,679       10,462       10,140       11,533 7 16.8% 12.1%       79,092
Denver Q1 2002       20,702       71,016       66,168       64,183       11,392       10,785       11,792 5 32.3% 16.0%       84,120
Houston Q1 2004       12,671       50,272       50,101       50,352         4,493         5,477         6,241 6 35.1% 10.0%       42,719
Chicago Q1 2005       20,613       39,159       37,973       36,834           (628)            376         1,586 7 19.6% 4.4%       42,020
Sub-total   $169,659 $320,871 $316,004 $315,937 $41,002 $43,037 $49,033   17.9% 11.4% $374,775
Established MSAs                      
Los Angeles Q1 2006 $27,046 $37,157 $50,666 $66,372 ($5,820) ($1,910) $2,954 8 31.3% 2.9% $56,075
San Diego Q1 2007       18,087       18,330       21,662       26,000        (3,881)           (920)            102 8 16.5% 6.7%       25,279
Detroit Q3 2007       23,659         9,646       13,260       17,500        (5,476)        (4,147)        (3,619) 11 -9.7% 2.9%       17,268
San Francisco Q4 2007       21,730       12,900       20,588       28,000        (6,628)        (3,841)        (2,266) 9 17.7% 2.9%       24,481
Sub-total   $90,522 $78,033 $106,176 $137,872 ($21,805) ($10,816) ($2,828)   20.2% 3.8% $123,103
Emerging MSAs                        
Miami Q1 2008 $28,635 $9,027 $16,765 $23,500 ($8,537) ($7,250) ($6,870) 14 NM 2.2% $21,118
Minneapolis Q2 2008       18,827         4,140         7,386       12,000        (6,059)        (4,299)        (4,759) NM NM 1.9%       10,200
Washington, D.C. Q1 2009       22,301         1,603         7,047       15,000        (6,929)        (7,670)        (7,093) NM NM 0.6%       10,089
Seattle Q4 2009       14,401              97         2,796       11,000        (1,851)        (6,360)        (6,179) NM NM 0.5%         4,440
Boston Q3 2010       10,475                -            125         5,000                -        (3,357)        (7,118) NM NM --            796
Sub-total   $94,640 $14,867 $34,119 $66,500 ($23,376) ($28,936) ($32,020)   NM 1.3% $46,643
                         
Total CBeyond   $354,821 $413,771 $456,299 $520,310 ($4,179) $3,284 $14,184   NM NM $544,521
                         
Notes:                        
(1) Peak amount of accumulated net operating losses (NOLs).  Proxy for amount of investment into the MSA.  The figures for Atlanta, Dallas and Denver are estimates.  
(2) Based on MSA Operating Income less allocations (by revenue) of corporate expenses.              
(3) Number of Quarters it took to become "FCF" (Adj. EBITDA less Capex as defined by the Company) positive at the MSA level.        
(4) Based on P/E mult. of 12x for profitable MSAs and a EV/revenue mult. of 1.0x for MSAs that are not profitable. Also includes est. value of NOLs, calculated as 20% of accumulated losses.
 

Note that in the above analysis, the IRR calculations for the original three MSAs incorporate significant losses incurred in the startup period (2000-2002).  These startup costs have a significant negative impact on the MSA-level returns, although they are still solidly positive.  Excluding these startup costs, the Atlanta and Dallas MSAs would be in the 20-30% IRR range.  Indeed, Atlanta, Dallas and Denver are considered by management to be amongst the best-performing MSAs.

Based on this analysis, one can appreciate the true profitability of the business.  In 2009, CBeyond had 5 breakeven/profitable cities that provided, collectively $41 million in operating profit, funding approximately $45 million in operating losses related to the remaining MSAs.  By 2011, based on current trajectories, Los Angeles and San Diego will become profitable MSAs, increasing operating profit from profitable MSAs to approximately $52 million, and funding an estimated $38 million in operating losses at the unprofitable MSAs.  In addition, CBeyond may announce additional expansion initiatives, which would result in additional operating losses.  Ironically, although expansion would affect near-term profitability, it should be seen as a positive, indication that management continues to believe that expansion efforts will produce strong long-term returns..

The proper way to analyze CBeyond is to break out the profitable MSAs and value them separately, while recognizing that reinvestment back into the unprofitable MSAs - if they follow the same historical performance - will provide an attractive long-term rate of return and should be attributed some positive value.  This is a fairly significant "if" that one needs to be comfortable with before investing in CBeyond:

  • CBeyond has generated very attractive returns at the first five MSAs, which have all operated through the full economic cycle.
  • It is reasonable to believe that the slower growth rates at newer MSAs are a result of a difficult economic environment vs. deteriorating competitive economics. Customers are more price sensitive, slower to make decisions, and many are going out of business or curtailing operations. That being said, certain markets (Los Angeles, San Francisco) are showing growth rates comparable to the original MSAs, which is early evidence that they can be just as successful as the original ones.
  • Lack of a first-mover advantage in future expansion initiatives is mitigated by the benefits of scale, namely (i) larger customer base to amortize costs of development of future applications, (ii) greater leverage in purchasing and negotiations, and (iii) higher scale in customer support operations leads to greater efficiency.

Thus, instead of viewing the unprofitable cities as a drag on valuation, one should view them as long-term investments that have a track record of IRRs in the 20% to 30% range through the economic cycle.  CBeyond is a company that has a track record of compounding invested at superior rates of return with a customer base that is still under-penetrated.

 

Management/Insider Alignment

The senior management team is largely comprised of telecom executives, led by Jim Geiger who founded the company in 2000.  In aggregate, insiders own approximately 4% of the total shares outstanding, with additional equity exposure through unvested option grants.  There was a fair degree of insider selling in the 2007-2008 timeframe, as the stock traded as high as $45 per share.  All of the original venture capital investors (Madison Dearborn, VantagePoint Venture Partners) have substantially exited their positions.

 

Value Dislocation

In general, the market lumps CBeyond into the CLEC peer group, and CLECs have been accorded relatively low valuations because of their mediocre returns on capital, low growth, pricing pressure, high leverage ratios and a number of high-profile bankruptcies in the past.

Analysts generally view EBITDA less capex as a proxy of free cash flow (FCF) and argue that CBeyond is not generating any FCF, as capex has grown in line with EBITDA.  However, the market fails to recognize that CBeyond has been aggressively expanding into new MSAs and that a significant portion of that capex is true expansion capex.  And as I discuss in more detail below, they are expanding into new MSAs by replicating a proven model that has provided very attractive returns on capital in the past, but need 3-5 years to be realized.  Based on analysis at the MSA level, I estimate expansion investment generating 15% IRRs at the low end and 35% at the high end.

In addition, small businesses have been disproportionately hurt during the most recent economic downturn and have still have not seen much recovery - and CBeyond has not escaped this impact.  This impact has shown in CBeyond's churn rates which increased from a steady 1.0-1.1% per month (2004 to 2008) to a peak of 1.5% per month in Q3 2009 (now 1.4%).  While "involuntary" churn (e.g. bankruptcies, downsizing etc.) has increased, CBeyond has consistently reported that "voluntary" churn (i.e. competitive reasons) has held constant throughout this period.  Also, customers take longer to make decisions when times are tough, and are more price sensitive to boot.  It is still notable that despite the fact that small business customers were probably hurt more than large enterprise customers (traditional CLEC customer base), CBeyond has grown significantly faster than its CLEC peers.

As mentioned earlier, CBeyond shares many elements with SaaS businesses such as salesforce.com or Constant Contact - contracted recurring revenue, high upfront sales investment that impact near-term GAAP earnings, ability to rapidly deploy new services to the existing customer base, particularly attractive to small businesses.  SaaS businesses typically trade at higher multiples (2x+ revenue) - though I am certainly not advocating a valuation of CBeyond close to that multiple as there are major differences, notably the hardware aspect.  However, CBeyond does justify a valuation significantly above its current 0.7x EV/revenue.

 

Catalyst for Unlocking Value

CBeyond's performance has been held back in recent years more than most, because of its dependence on small businesses, which have been disproportionately affected by the recession and have not yet recovered.  As a result, even when you strip out the unprofitable MSAs, CBeyond has still seen its operating margins stagnate as churn rates increased as well as increased pricing pressure.  The catalyst for value, in my opinion, will be when the slight declines CBeyond has experienced in the original MSAs is reversed in addition to increased rates in new gross customer addition.  Both of these are highly dependent in part on how fast the small business economy recovers.

Even without a noticeable uptick in the economy, CBeyond should begin to see positive impact from the MSAs that it invested in the 2007 to 2008 timeframe (a period in which they increased their launch rate of new MSAs).  These MSAs have been a drag on earnings over the last three years, but historical rates of turning profitable within 3-5 years would suggest that 2010-2012 time period is the inflection point for profitability in those cities.

 

Current Valuation / Margin of Safety

I have valued each of the MSAs separately, applying a 12x P/E multiple to the profitable MSAs and calculating the terminal/intrinsic value of the remaining MSAs using a 1.0x EV/Revenue multiple.  In addition, for MSAs with accumulated losses, I have added the value of the NOLs by multiplying by 20%.  For example, the Atlanta MSA will achieve operating income this year of about $16.3 million (fully allocated), or pro forma net income of $10.6 million.  Applying a 12x P/E multiple yields an MSA valuation of $127 million.

This bottoms-up analysis yields an enterprise valuation of $545 million for CBeyond.  $375 million is attributable to the first five MSAs.  In addition, CBeyond has $52 million in cash and equivalents, which yields an equity valuation of close to $600 million.  This valuation does not place value on the option to expand to future MSAs, which could yield significant value creation in the long run (I view this growth potential as a counter-balance against downside risks in the business).  Compared to the current market capitalization of $367 million implies a margin of safety of approximately 40%.

 

Downside Risks

As with all businesses, there are significant risks and uncertainties involved in an investment in CBeyond.

Competition is a significant risk and the telecommunications industry is notorious for pricing pressure, mediocre returns on capital and rapid technological obsolescence.  Even so, I believe CBeyond's disruptive business model helps to mitigate some of these risks.  First, CBeyond's customer base is relatively sticky as customers sign up to three-year contracts and utilize on average more than 7 applications.  Second, CBeyond has taken an "asset light" approach and is less dependent on point technologies and therefore less exposed to technology obsolescence.  For example, CBeyond recently announced they would start offering connections over fiber-based metro-ethernet connections (greater bandwidth at far lower prices, though not yet widely available).

Moreover, there is risk that competitive dynamics change such that it is no longer profitable to invest in new MSAs.  I would argue that CBeyond's business model offers some economies of scale but this is nonetheless a risk to be aware of and if true, would limit CBeyond's growth potential.

Financial risk is low as the company is sufficiently funded with more than $50 million in cash and no debt.  This is relatively unique in an industry where most CLECs have significant debt but reflects CBeyond's differentiated business model.  In addition, CBeyond has five profitable MSAs that generated a run rate of $40-45 million of operating income which provides additional downside protection (they control investment into new MSAs and have the ability to scale back operations at the remaining MSAs if they deem it to be unprofitable).

In the past, CBeyond has been identified as a short idea.  These occurred when CBeyond was trading at a higher valuation and I also take the opposite view on certain key investment considerations.  In any case, the stock's trading price has been quite volatile and I would not be surprised if this continues.  As CBeyond maintains a strong balance sheet, it should not be significantly impacted by this, and in the same way, such volatility may present buying opportunities for a patient investor that has strong conviction in the investment thesis.

 

Upside Potential

In an upside scenario, CBeyond is successful in maintaining its growth and margins by continuing to add new services.  Historically, CBeyond has announced one new service offering per quarter.  For example, in Q1 2009 they announced they were licensing a mobile workforce product that allows businesses to track their mobile assets (workers, trucks etc.) on their mobile smartphones.  Most recently, CBeyond announced a partnership with Clearwire to offer 4G data broadband services.  In 2009, CBeyond launched an inside sales team whose sole responsibility it is to upsell these various services to the existing customer base.

Moreover, in such a scenario, CBeyond continues its methodical expansion into additional MSAs at a pace of 2-3 per year.  Within each MSA, CBeyond still has significant market penetration to capture - it has demonstrated the ability to achieve over 15% market penetration in its original MSAs, giving it a lot of room to grow in its more recent MSAs.  Although CBeyond faces increased competition and less of a first-mover advantage in a new MSA, at the same time it brings a deeper service offering and should benefit from economies of scale.

CBeyond's vision is to eventually be the outsourced IT and communications provider for small businesses.  Remember that small businesses with between 10 to 50 employees typically do not have full-time IT professionals.  They have discussed future plans to offer cloud and datacenter services and recently expanded their customer support capacity by opening a new center in Denver - in the future, one can see how these customer support professionals take over as the role as a part-time IT professional for small businesses that will never be able to afford a full-time IT professional.  Today, small businesses spend about $1,400 per month on average on IT and communications and CBeyond is capturing on average about 50%.  Upside will be for them to capture a gradually increasing share of that spend, by rolling out additional applications and up-selling them over time.

Eventual improvement in the small business environment would lead to lower churn (closer to historical 1.0% per month) as well as increased sales profitability.  While this recession has been disproportionately difficult for small businesses, in the United States, small businesses have historically been the dynamic growth driver for both employment and innovation, and I do expect this to continue over the long term.

 

The Bottom Line

With a differentiated value proposition from traditional CLECs, the group in which it has been lumped by the market, CBeyond offers the ability to compound returns at an attractive rate as the company replicates a proven business formula by expanding into new MSAs.  Despite being launched in a tough economic environment particularly for telecom firms (2000-2002) and going through its second difficult economic recession that has disproportionately impacted its core small business market segment (2008-2010), the CBeyond business model has proven to still be able to generate high returns due to identified competitive advantages from its disruptive approach.  By uncovering the true profitability of the business model, one can recognize that CBeyond generates superior rates of return compared to its peers and has higher growth potential.  Meanwhile, CBeyond has achieved this with no debt, allowing it to focus on profitable growth.

 

Appendix I: MSA Level Profitability

Fully Developed MSAs

Atlanta Launch: Q2 2001 31-Dec-02 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue     $11,262 $27,033 $42,236 $53,719 $63,259 $72,811 $81,059 $85,327 $85,606
Operating Income - MSA Level          (3,838)         7,384       18,922       24,255       32,808       37,632       41,063       42,239       43,759
MSA Operating Margin (%)   NM 27.3% 44.8% 45.2% 51.9% 51.7% 50.7% 49.5% 51.1%
Corporate Allocations        (18,115)      (14,887)      (15,545)      (16,654)      (20,096)      (22,535)      (25,390)      (26,955)      (27,500)
Operating Income          (21,953)        (7,503)         3,377         7,601       12,712       15,097       15,673       15,284       16,259
Operating Margin (%)   NM NM 8.0% 14.2% 20.1% 20.7% 19.3% 17.9% 19.0%
Pro Forma Taxes   35.0%                -                -                -                -                -                -                -                -        (3,342)
Net Income          (21,953)        (7,503)         3,377         7,601       12,712       15,097       15,673       15,284       12,917
Terminal Value - NI   12.0x                      126,823
NOL Value                      
Total IRR: 13.9%      (21,953)        (7,503)         3,377         7,601       12,712       15,097       15,673       15,284      139,741
 

Dallas Launch: Q4 2001 31-Dec-02 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue     $6,064 $19,813 $33,129 $42,277 $51,335 $61,184 $69,501 $75,097 $76,156
Operating Income - MSA Level          (5,319)            678         7,281       13,374       18,934       25,717       32,571       34,185       34,604
MSA Operating Margin (%)   NM 3.4% 22.0% 31.6% 36.9% 42.0% 46.9% 45.5% 45.4%
Corporate Allocations          (9,754)      (10,911)      (12,193)      (13,106)      (16,308)      (18,936)      (21,770)      (23,723)      (24,464)
Operating Income          (15,073)      (10,233)        (4,912)            268         2,626         6,781       10,801       10,462       10,140
Operating Margin (%)   NM NM NM 0.6% 5.1% 11.1% 15.5% 13.9% 13.3%
Pro Forma Taxes   35.0%                -                -                -                -                -                -                -                -           (651)
Net Income          (15,073)      (10,233)        (4,912)            268         2,626         6,781       10,801       10,462         9,489
Terminal Value - NI   12.0x                       79,092
NOL Value                      
Total IRR: 16.8%      (15,073)      (10,233)        (4,912)            268         2,626         6,781       10,801       10,462       88,582

 

Denver Launch: Q1 2002 31-Dec-02 31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue     $3,630 $18,667 $35,051 $47,916 $58,531 $64,829 $70,707 $71,016 $66,168
Operating Income - MSA Level          (4,151)         2,568       13,404       19,773       26,985       31,355       34,339       33,826       32,040
MSA Operating Margin (%)   NM 13.8% 38.2% 41.3% 46.1% 48.4% 48.6% 47.6% 48.4%
Corporate Allocations          (5,839)      (10,280)      (12,900)      (14,855)      (18,594)      (20,064)      (22,148)      (22,434)      (21,255)
Operating Income            (9,990)        (7,712)            504         4,918         8,391       11,291       12,191       11,392       10,785
Operating Margin (%)   NM NM 1.4% 10.3% 14.3% 17.4% 17.2% 16.0% 16.3%
Pro Forma Taxes   35.0%                -                -                -                -                -        (1,541)        (4,267)        (3,987)        (3,775)
Net Income            (9,990)        (7,712)            504         4,918         8,391         9,750         7,924         7,405         7,010
Terminal Value - NI   12.0x                       84,120
NOL Value                      
Total IRR: 32.3%        (9,990)        (7,712)            504         4,918         8,391         9,750         7,924         7,405       91,129

 

Houston Launch: Q1 2004   31-Dec-03 31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue       $0 $2,895 $13,051 $26,382 $38,990 $46,843 $50,272 $50,101
Operating Income - MSA Level               (210)        (4,658)           (285)         5,974       13,035       19,306       20,374       21,571
MSA Operating Margin (%)     NM NM NM 22.6% 33.4% 41.2% 40.5% 43.1%
Corporate Allocations                    -        (1,066)        (4,046)        (8,381)      (12,067)      (14,673)      (15,881)      (16,094)
Operating Income                 (210)        (5,724)        (4,331)        (2,407)            968         4,633         4,493         5,477
Operating Margin (%)     NM NM NM NM 2.5% 9.9% 8.9% 10.9%
Pro Forma Taxes   35.0%                  -                -                -                -                -                -                -        (1,015)
Net Income                 (210)        (5,724)        (4,331)        (2,407)            968         4,633         4,493         4,462
Terminal Value - NI   12.0x                       42,719
NOL Value                                    -
Total IRR: 35.1%             (210)        (5,724)        (4,331)        (2,407)            968         4,633         4,493       47,181

 

Chicago Launch: Q1 2005     31-Dec-04 31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue         $0 $2,134 $12,281 $26,748 $36,367 $39,159 $37,973
Operating Income - MSA Level                 (568)        (6,090)        (2,913)         4,332         9,487       11,742       12,574
MSA Operating Margin (%)       NM NM NM 16.2% 26.1% 30.0% 33.1%
Corporate Allocations                      -           (662)        (3,901)        (8,278)      (11,391)      (12,370)      (12,198)
Operating Income                   (568)        (6,752)        (6,814)        (3,946)        (1,904)           (628)            376
Operating Margin (%)       NM NM NM NM NM NM 1.0%
Pro Forma Taxes   35.0%                    -                -                -                -                -                -                -
Net Income                   (568)        (6,752)        (6,814)        (3,946)        (1,904)           (628)            376
Terminal Value - Revenue 1.0x                       37,973
NOL Value                             4,047
Total IRR: 19.6%               (568)        (6,752)        (6,814)        (3,946)        (1,904)           (628)       42,396

 

Established MSAs

Los Angeles Launch: Q1 2006       31-Dec-05 31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue           $0 $1,828 $12,347 $23,669 $37,157 $50,666
Operating Income - MSA Level                   (382)        (6,254)        (3,198)         2,334         5,918       14,366
MSA Operating Margin (%)         NM NM NM 9.9% 15.9% 28.4%
Corporate Allocations                        -           (581)        (3,821)        (7,414)      (11,738)      (16,276)
Operating Income                     (382)        (6,835)        (7,019)        (5,080)        (5,820)        (1,910)
Operating Margin (%)         NM NM NM NM NM NM
Pro Forma Taxes   35.0%                      -                -                -                -                -                -
Net Income                     (382)        (6,835)        (7,019)        (5,080)        (5,820)        (1,910)
Terminal Value - Revenue 1.0x                       50,666
NOL Value                             5,409
Total IRR: 31.3%                 (382)        (6,835)        (7,019)        (5,080)        (5,820)       54,165

 

San Diego Launch: Q1 2007         31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue             $0 $2,510 $10,728 $18,330 $21,662
Operating Income - MSA Level                     (631)        (5,828)        (2,691)         1,910         6,039
MSA Operating Margin (%)           NM NM NM 10.4% 27.9%
Corporate Allocations                          -           (777)        (3,360)        (5,791)        (6,959)
Operating Income                       (631)        (6,605)        (6,051)        (3,881)           (920)
Operating Margin (%)           NM NM NM NM NM
Pro Forma Taxes   35.0%                        -                -                -                -                -
Net Income                       (631)        (6,605)        (6,051)        (3,881)           (920)
Terminal Value - Revenue 1.0x                       21,662
NOL Value                             3,617
Total IRR: 16.5%                   (631)        (6,605)        (6,051)        (3,881)       24,360

 

Detroit Launch: Q3 2007         31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue               $576 $5,472 $9,646 $13,260
Operating Income - MSA Level                    (3,830)        (4,695)        (2,429)            113
MSA Operating Margin (%)             NM NM NM 0.9%
Corporate Allocations                       (178)        (1,714)        (3,047)        (4,260)
Operating Income                      (4,008)        (6,409)        (5,476)        (4,147)
Operating Margin (%)             NM NM NM NM
Pro Forma Taxes   35.0%                          -                -                -                -
Net Income                      (4,008)        (6,409)        (5,476)        (4,147)
Terminal Value - Revenue 1.0x                       13,260
NOL Value                             4,008
Total IRR: -9.7%                  (4,008)        (6,409)        (5,476)       13,121

 

San Francisco Launch: Q4 2007         31-Dec-06 31-Dec-07 31-Dec-08 31-Dec-09 31-Dec-10
Revenue               $39 $3,372 $12,900 $20,588
Operating Income - MSA Level                    (1,539)        (6,388)        (2,553)         2,773
MSA Operating Margin (%)             NM NM NM 13.5%
Corporate Allocations                         (12)        (1,056)        (4,075)        (6,614)
Operating Income                      (1,551)        (7,444)        (6,628)        (3,841)
Operating Margin (%)             NM NM NM NM
Pro Forma Taxes   35.0%                          -                -                -                -
Net Income                      (1,551)        (7,444)        (6,628)        (3,841)
Terminal Value - Revenue 1.0x                       20,588
NOL Value                             3,893
Total IRR: 17.7%                  (1,551)        (7,444)        (6,628)       20,640

 

Appendix II: Comparison vs. Peer Group

    Revenue Gross Profit Operating Income (1)
    2008 2009 LTM 2008 2009 LTM 2008 2009 LTM
CBeyond (CBEY)   $349.7 $413.8 $435.9 $240.0 $275.7 $292.5 $43.3 $41.6 $43.0
Competitive Local Exchange Carriers (CLECs)              
Paetec (PAET)   $1,570.4 $1,580.2 $1,596.4 $789.0 $797.8 $807.8 $42.6 $60.9 $67.0
Time Warner Telecom (TWTC)      1,159.0      1,211.4      1,276.1         613.6         707.4         742.7           89.9         114.0         130.7
XO Holdings (XOHO)      1,477.6      1,521.3      1,511.0         662.6         696.3         708.2          (80.7)          (24.1)          (21.9)
ITC DeltaCom (ITCD)         497.9         469.3         450.8         265.0         256.7         252.5             8.3           16.1           22.9
Telephone Companies / Incumbent Local Exchange Carriers (ILECs)          
AT&T (T)   $124,028.0 $123,018.0 $123,285.0 $74,475.0 $72,613.0 $72,922.0 $20,631.0 $18,947.0 $20,003.0
Qwest (Q)       13,475.0     12,311.0     11,944.0      8,971.0      8,593.0      8,387.0      2,570.0      2,032.0      2,087.0
Sprint Nextel (S)       35,635.0     32,260.0     32,020.0     18,889.0     15,825.0     15,244.0        (743.0)     (1,019.0)        (964.0)
Verizon Communications (VZ)     97,354.0   107,808.0   108,042.0     58,452.0     65,186.0     65,050.0     18,111.0     19,480.0     18,657.0
CenturyLink (CTL)        2,599.7      4,974.2      7,275.8      1,644.3      3,222.2      4,809.8         734.6      1,504.6      2,336.7
Cable Companies                    
Cablevision (CVC)   $7,230.1 $7,773.3 $7,959.4 $3,974.9 $4,412.7 $4,534.1 $1,144.9 $1,439.5 $1,584.3
Comcast (CMCS.A)     34,423.0     35,756.0     36,639.0     20,784.0     21,360.0     21,857.0      6,858.0      7,295.0      7,622.0
Time Warner Cable (TWC)     17,200.0     17,868.0     18,363.0      9,055.0      9,313.0      9,650.0      3,113.0      3,407.0      3,560.0
Others                    
8x8 (EGHT)   $65.2 $63.3 $64.7 $43.5 $41.0 $43.7 $1.6 ($0.9) $4.4
j2 Global (JCOM)           241.5         244.9         244.3         195.3         200.1         201.9           97.9         106.2         103.5
                     
Notes:                    
(1) CBeyond's Operating Income excludes unprofitable MSAs              

 

    Latest Q (6/30/2010) Shareholders' Equity Total Assets
    Cash Debt 2008 2009 Latest Q 2008 2009 Latest Q
CBeyond (CBEY)   $51.8  $ - $143.5 $158.6 $166.7 $212.5 $228.9 $237.0
Competitive Local Exchange Carriers (CLECs)            
Paetec (PAET)   $125.6 $975.0 $198.4 $199.1 $183.9 $1,496.5 $1,457.6 $1,492.8
Time Warner Telecom (TWTC)         486.9      1,343.1         673.2         732.0         982.5      2,281.9      2,374.2      2,651.3
XO Holdings (XOHO)           67.9         872.9          (58.5)        (107.7)        (163.1)      1,376.0      1,409.8      1,129.0
ITC DeltaCom (ITCD)           76.5         318.3          (12.4)          (16.7)          (22.0)         382.7         368.5         378.9
Telephone Companies / Incumbent Local Exchange Carriers (ILECs)        
AT&T (T)   $1,377.0 $69,998.0 $96,347.0 $101,900.0 $103,046.0 $265,245.0 $268,752.0 $267,556.0
Qwest (Q)        1,779.0     13,228.0     (1,386.0)     (1,178.0)     (1,241.0)     20,141.0     20,380.0     18,959.0
Sprint Nextel (S)        4,277.0     20,301.0     19,915.0     18,095.0     16,493.0     58,550.0     55,424.0     53,226.0
Verizon Communications (VZ)      5,225.0     57,468.0     41,706.0     41,606.0     39,254.0   202,352.0   227,251.0   226,251.0
CenturyLink (CTL)         186.4      7,675.2      3,163.0      9,460.7      9,544.6      8,254.2     22,562.7     22,199.6
Cable Companies                
Cablevision (CVC) $517.5 $11,848.6 ($5,368.0) ($5,156.0) ($6,199.6) $9,383.2 $9,325.7 $7,631.6
Comcast (CMCS.A)      4,081.0     31,059.0     40,450.0     42,721.0     43,437.0   113,017.0   112,733.0   115,627.0
Time Warner Cable (TWC)         814.0     21,547.0     17,164.0      8,685.0      9,172.0     57,889.0     43,694.0     43,098.0
Others                  
8x8 (EGHT)             18.1               -            10.3           12.1           14.9           21.9           23.1           26.0
j2 Global (JCOM)           223.3               -          250.0         336.2         374.4         322.0         414.0         443.1

 

    Gross Margin Operating Margin Revenue Growth
    2008 2009 LTM 2008 2009 LTM 2008 2009
CBeyond (CBEY) 68.6% 66.6% 67.1% 12.4% 10.1% 9.9% 24.9% 18.3%
Competitive Local Exchange Carriers (CLECs)            
Paetec (PAET)   50.2% 50.5% 50.6% 2.7% 3.9% 4.2% 50.9% 0.6%
Time Warner Telecom (TWTC) 52.9% 58.4% 58.2% 7.8% 9.4% 10.2% 6.9% 4.5%
XO Holdings (XOHO) 44.8% 45.8% 46.9% -5.5% -1.6% -1.4% 3.4% 3.0%
ITC DeltaCom (ITCD) 53.2% 54.7% 56.0% 1.7% 3.4% 5.1% 1.2% -5.7%
Telephone Companies / Incumbent Local Exchange Carriers (ILECs)        
AT&T (T)   60.0% 59.0% 59.1% 16.6% 15.4% 16.2% 4.3% -0.8%
Qwest (Q)   66.6% 69.8% 70.2% 19.1% 16.5% 17.5% -2.2% -8.6%
Sprint Nextel (S) 53.0% 49.1% 47.6% -2.1% -3.2% -3.0% -11.2% -9.5%
Verizon Communications (VZ) 60.0% 60.5% 60.2% 18.6% 18.1% 17.3% 4.2% 10.7%
CenturyLink (CTL) 63.2% 64.8% 66.1% 28.3% 30.2% 32.1% -2.1% 91.3%
Cable Companies                
Cablevision (CVC) 55.0% 56.8% 57.0% 15.8% 18.5% 19.9% 11.5% 7.5%
Comcast (CMCS.A) 60.4% 59.7% 59.7% 19.9% 20.4% 20.8% 10.8% 3.9%
Time Warner Cable (TWC) 52.6% 52.1% 52.6% 18.1% 19.1% 19.4% 7.8% 3.9%
Others                  
8x8 (EGHT)   66.7% 64.8% 67.5% 2.5% -1.4% 6.8% 9.2% -2.9%
j2 Global (JCOM) 80.9% 81.7% 82.6% 40.5% 43.4% 42.4% 9.4% 1.4%
                   
Notes:                  
Paetec's 2008 revenue growth and CenturyLink's 2009 revenue growth are both primarily the result of acquisitions.  

(Note: the comparables table below reflects market prices as of the end of August 2010, when the VIC application was submitted.) 

    Market Enterprise EV / Revenue EV / Operating Income Return Ratios (2) Credit Ratios
    Cap Value 2009 LTM 2009 LTM ROA ROE Debt / EBIT Debt / Assets
CBeyond (CBEY)   $367.1 $315.3 0.76x 0.72x 7.6x 7.3x 18.9% 17.9% 0.0x 0.0%
Competitive Local Exchange Carriers (CLECs)                
Paetec (PAET)   $552.3 $1,401.7 0.89x 0.88x 23.0x 20.9x 4.1% 19.9% 14.6x 65.3%
Time Warner Telecom (TWTC)          2,629.8          3,486.0 2.88x 2.73x  NM  26.7x 4.9% 10.5% 10.3x 50.7%
XO Holdings (XOHO)             118.3             923.3 0.61x 0.61x  NM   NM  -1.7% NM  NM  77.3%
ITC DeltaCom (ITCD)             126.3             368.1 0.78x 0.82x 22.9x 16.1x 4.3% NM 13.9x 84.0%
Telephone Companies / Incumbent Local Exchange Carriers (ILECs)              
AT&T (T)   $157,888.5 $226,509.5 1.84x 1.84x 12.0x 11.3x 7.1% 12.4% 3.5x 26.2%
Qwest (Q)            9,844.2 $21,293.2 1.73x 1.78x 10.5x 10.2x 10.0% NM 6.3x 69.8%
Sprint Nextel (S)          11,788.9 $27,812.9 0.86x 0.87x  NM   NM  -1.8% -3.5%  NM  38.1%
Verizon Communications (VZ)        83,304.1 $135,547.1 1.26x 1.25x 7.0x 7.3x 9.1% 30.4% 3.1x 25.4%
CenturyLink (CTL)          10,855.1 $18,343.9 3.69x 2.52x 12.2x 7.9x 9.8% 15.5% 3.3x 34.6%
Cable Companies                    
Cablevision (CVC)   $7,412.9 $18,744.0 2.41x 2.35x 13.0x 11.8x 15.4% NM 7.5x 155.3%
Comcast (CMCS.A)        47,870.8 $74,848.8 2.09x 2.04x 10.3x 9.8x 6.5% 11.4% 4.1x 26.9%
Time Warner Cable (TWC)        18,358.4 $39,091.4 2.19x 2.13x 11.5x 11.0x 6.7% 17.1% 6.1x 50.0%
Others                      
8x8 (EGHT)                86.4              68.3 1.08x 1.06x  NM  15.5x -4.0% -5.2% 0.0x 0.0%
j2 Global (JCOM)               965.3             742.0 3.03x 3.04x 7.0x 7.2x 28.9% 23.6% 0.0x 0.0%
                       
Notes:                      
(2) ROE is calculated as Operating Income x (1 - Tax Rate of 35%) divided by the Average Shareholders' Equity over the Period        

 

Catalyst

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