| 2012 | 2013 | ||||||
| Price: | 3.53 | EPS | $0.26 | $0.29 | |||
| Shares Out. (in M): | 196 | P/E | 13.6x | 12.2x | |||
| Market Cap (in $M): | 691 | P/FCF | 3.3x | 2.8x | |||
| Net Debt (in $M): | 2,180 | EBIT | 323 | 325 | |||
| TEV (in $M): | 2,871 | TEV/EBIT | 8.8x | 8.8x | |||
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Summary Investment Thesis:
I believe that Cincinnati Bell (“CBB”) is an orphaned hybrid stock that is out of favor with yield-seeking telecom investors and largely overlooked by data center / technology-focused investors. Due to this disconnect, CBB's large and growing data center colocation business trades like a telecom business.
With financial leverage as a result of an ill-timed acquisition under former management, CBB has spent the last few years reducing its debt burden and pushing out maturities. The current CEO has the majority of his liquid net worth in CBB stock, and has been working hard to unlock long-term shareholder value.
With growing earnings, free cash flow that is shielded by NOLs and boosted by ongoing debt reduction, and possible corporate action that may serve as catalysts, I believe that CBB is an attractive investment. In addition, agreeing with my views, the largest shareholder of CBB is Peninsula Capital, whose founder Ted Weschler was just hired to manage the public investment portfolio at Berkshire Hathaway.
Investment Thesis:
Compelling Valuation – CBB trades at 5.4x LTM EBITDA. Ascribing industry multiples to the wireless (assuming 6x LTM EBITDA), wireline (assuming 5x LTM EBITDA) and IT (assuming 4x LTM EBITDA) businesses implies that the data center business is trading at less than 5x LTM EBITDA, despite its strong growth potential and the fact that its data center peers trade at significantly higher multiples. For example, Rackspace Hosting trades at 21x LTM EBITDA and Equinix at 12x due to lower maintenance capital requirements of the business model, and high free cash flow growth over the last ten years as companies have moved to outsource data. In the private market, as shown below, multiples paid are substantially higher than that implied for CBB's data center business at the current stock price.
Recent Data Center Acquisitions
Acquiror Target Date Announced Deal Value ($MM) FY1 EV / EBITDA
CenturyLink Savvis 4/27/2011 $2,500 10.9x
Verizon Terremark 1/27/2011 1,400 18.0
Equinix Switch and Data 10/21/2009 856 9.4
CincinnatiBell Cyrus One 5/12/2010 526 12.5
Equinix IXEurope 6/28/2007 482 14.0
ABRY Partners Q9 Networks 8/24/2008 345 13.1
Time Warner Navisite 2/1/2011 230 10.0
I believe that CBB may seek to separate the data center business to capture its full value, and that management is appropriately incentivized to do so.
Attractive, High Growth Data Center Colocation Business – Heightened data consumption, internet usage and new regulatory requirements are driving the need for more complex, secure and redundant networks, leading to increasing demand for data center services, since the cost of running such complex solutions in-house can be prohibitive. According to research estimates, the global data center industry is $12 billion in size, growing at 18-20% as internet usage and cloud computing ramp up. As a data center colocation provider, CBB provides cabinets, power, operations space and storage space rentals for customers’ IT infrastructure equipment. The business is characterized by 3-5 year contracts, sticky customers due to high switching costs, and extremely stable recurring cash flows. Moreover, as CBB grows this business in the US and overseas, management is keen to emphasize that 50% of new growth comes from simply following existing customers to new locations. Currently it provides data center colocation services in Cincinnati, Houston, Dallas, Austin, Chicago, South Bend, London and Singapore, with new growth planned in Phoenix, Arizona. CBB's data center business caters only to non-technology Fortune 500 companies who are looking to outsource the capex and inconvenience of running a data center in-house.
Stable, Cash-Generative Wireline and Wireless Assets – The core telephony wireline and wireless assets are a strong source of cash. As a regional market leader in the Ohio area offering a full bundle of integrated telecommunications services, the company has successfully defended market share against intense competition, and held EBITDA margins stable at approximately 30% in the wireline business and high teens in the wireless business through aggressive cost reductions. Industry work indicates that CBB is a highly effective telecom operator, running low-cost infrastructure at high margins. As a result, even as revenues have declined in these secularly challenged businesses, I estimate that the wireline and wireless businesses combined generated approximately $360 million of EBITDA less maintenance capex in the LTM period ending September 30, 2011. In total, the company generated $220 million in LTM levered free cash flow (excluding growth capex), after a $215 million interest payment on its debt, and the bulk of this cash flow was generated by the telephony assets. Thus the wireline and wireless assets are a relatively stable and defensive source of funding for the company's data center investments. Moreover, the high frequency of M&A activity in the wireline space bodes well for the takeout potential of these assets by a large strategic buyer.
Management Compensation Plan may be Indicative of Impending Corporate Actions – Post the Cyrus One acquisition, management has housed the data center colocation assets in a separate holding company. The company also moved CFO Gary Wojtaszek, who joined from a KKR portfolio company, to head CyrusOne as President and CEO, indicating that the company may be poised for a separation in 2012. Moreover, per a new compensation plan drawn up in December 2010, management stands to gain financially (exact details not disclosed) if they generate $1 billion or more of organic value creation in the data center business, as ascertained by a "qualifying transaction". The Board may also permit a proportional payout if value creation exceeds $500 million. Moreover, compensation plans for the other telephony and IT businesses have also been configured to participate in any upside in the data center colocation business. Reading between the lines of these various actions, I am inclined to believe that management is highly likely to separate the data center colocation business once it can demonstrate organic value creation of $1 billion or more. The business currently generates approximately $110 million in run rate EBITDA, and with public and private market EBITDA multiples in the range of 9 - 12x, is already worth $990 million to $1.3 billion in aggregate, and this value could increase rapidly as the capacity currently under construction comes online in 2012 and 2013.
Other corporate actions that may help unlock value include the reinstatement of a dividend, which will attract traditional yield-seeking telecom investors, or an opportunistic share repurchase.
High Free Cash Flow Yield and Solid Capital Allocation – CBB's LTM levered free cash flow yield (before discretionary growth capex) on its equity value is approximately 36%, and the LTM unlevered free cash flow yield (before discretionary growth capex) on the enterprise value is approximately 13%, assuming a normalized tax rate (although the company currently has NOLs). Moreover, management has been a prudent allocator of this cash flow. Since 2007, the company has bought back 22% of its shares outstanding. Now, as discussed previously, the company is reinvesting the cash flow into the high ROIC data center colocation business.
Enhanced Returns Due to Leverage – 90% of CBB's debt maturities are in 2017 and beyond. Meanwhile, the company continues to generate stable free cash flow that is shielded by approximately $1 billion of pre-tax NOLs. The 4.5x Net Debt / EBITDA ratio implies that the returns to the equity holders will be magnified as the company delevers from the relatively high ratio.
Risks:
Declining Wireless and Wireline Businesses – The company's traditional telephony business faces challenges from intensifying competition in wireless, and secular declines in the consumer wireline business. The advent of smart phones has hit the company especially hard, since the roaming charges on data (which the company bears), are onerous. While the company has done an excellent job of focusing of profitability and has maintained EBITDA margins at approximately 30% in wireline, and high teens in wireless by cutting costs aggressively, the fact remains that these businesses are under pressure.
Heavy Dependency on Data Center Industry – The success of CBB's strategy of investing the proceeds from its mature telephony businesses into growing its data center colocation business is heavily dependent on continued growth in the data center industry. While diligence suggests that demand continues to outpace supply in the industry, that pricing and competitive dynamics are rational, and that the underlying fundamentals support the high multiples across the data center industry, a change in these facts will change the outlook for CBB.
Low Liquidity – CBB only trades about $4 million worth of shares a day. This limits flexibility to enter and exit the position.
Valuation:
Sensitivity of Price Target to Telephony (Wireline & Wireless) and Data Center 2012 EBITDA multiples
2012 EBITDA Break-down: Wireline = $323MM, Wireless = $75MM, Data Center = $120MM, IT Services = $24MM, Other = ($19MM)
Wireline & Wireless Multiple on Horizontal Axis; Data Center Multiple on Vertical Axis
3.5x 4.0x 4.5x 5.0x 5.5x 6.0x 6.5x 7.0x
6.5x $0.68 $1.47 $2.27 $3.06 $3.79 $4.52 $5.25 $5.95
7.0x $0.97 $1.77 $2.57 $3.33 $4.06 $4.79 $5.53 $6.20
7.5x $1.27 $2.06 $2.86 $3.60 $4.34 $5.07 $5.78 $6.45
8.0x $1.56 $2.36 $3.14 $3.88 $4.61 $5.34 $6.03 $6.70
8.5x $1.86 $2.66 $3.42 $4.15 $4.88 $5.61 $6.28 $6.95
9.0x $2.16 $2.95 $3.69 $4.42 $5.15 $5.86 $6.53 $7.21
9.5x $2.45 $3.23 $3.96 $4.69 $5.42 $6.11 $6.78 $7.46
10.0x $2.75 $3.50 $4.23 $4.96 $5.68 $6.36 $7.03 $7.71
10.5x $3.04 $3.77 $4.50 $5.23 $5.93 $6.61 $7.28 $7.96
11.0x $3.31 $4.04 $4.77 $5.51 $6.18 $6.86 $7.53 $8.21
11.5x $3.58 $4.31 $5.05 $5.76 $6.43 $7.11 $7.78 $8.46
12.0x $3.85 $4.59 $5.32 $6.01 $6.69 $7.36 $8.04 $8.71
12.5x $4.13 $4.86 $5.59 $6.26 $6.94 $7.61 $8.29 $8.96
13.0x $4.40 $5.13 $5.84 $6.51 $7.19 $7.86 $8.54 $9.21
13.5x $4.67 $5.40 $6.09 $6.76 $7.44 $8.11 $8.79 $9.46
14.0x $4.94 $5.66 $6.34 $7.01 $7.69 $8.36 $9.04 $9.71
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