ZAYO GROUP HOLDINGS INC ZAYO S
December 02, 2014 - 4:53pm EST by
Fletch
2014 2015
Price: 26.90 EPS -0.76 -0.27
Shares Out. (in M): 239 P/E NA NA
Market Cap (in $M): 6,429 P/FCF 80.7 63.6
Net Debt (in $M): 2,841 EBIT 57 143
TEV ($): 9,270 TEV/EBIT 163.2 64.9
Borrow Cost: General Collateral

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  • Accounting
  • Telecommunications

Description

 

 

 

 

Company Description

 

Zayo Group LLC provides high bandwidth infrastructure and carrier neutral colocation. The Company offers services including dark fiber, wavelengths, private line, ethernet, and custom solutions. Zayo Group serves carrier, enterprise, school, hospital, and government customers throughout the United States.

 

Investment Summary

Short equity at 26.90. Aggressive accounting, minimal earnings or free cash flow, high valuation, high leverage, constant M&A, confusing financials and lack of real comps and make Zayo a compelling short opportunity

 

Capital Structure & Relevant Financial Metrics

 

 

Coupon

Maturity

9/30/14

 

 

$250 Million Revolver (L+275)

2.985%

3/18/2017

0.0

 

 

Term B (L+300; 100 Floor)

 

4.000%

3/18/2019

1,990.1

 

 

Secured Bonds

 

8.125%

12/31/2019

675.0

 

 

Cap Leases & Other

 

8.500%

 

25.3

 

 

Total Senior Secured Debt

 

 

2,690.4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Senior Bonds

 

10.125%

6/30/2020

325.6

 

 

Total Debt

 

 

 

3,016.0

 

 

Cash

 

 

 

175.5

 

 

Net Debt

 

 

 

$2,840.5

 

 

 

 

Shares

Price

 

 

 

Equity Cap Class A

 

239.009

$26.90

6,429.3

 

 

Total Equity Value

 

 

 

$6,429.3

 

 

 

 

 

 

 

 

 

Total Enterprise Value

 

 

 

$9,269.8

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2013

2014

LTM

E. 2015

E. 2016

E. 2017

Revenues

$1,004.4

$1,224.1

$1,245.7

$1,321.4

$1,427.1

$1,541.3

PF Reported EBITDA

$540.0

$681.3

$694.1

$748.4

$806.3

$901.6

Adj. EBITDA Margin

53.8%

55.7%

55.7%

56.6%

56.5%

58.5%

PF Adj. EBITDA

$343.7

$571.1

$582.0

$629.5

$677.9

$762.9

EBITDA Margin

34.2%

46.7%

46.7%

47.6%

47.5%

49.5%

CAPEX

$332.5

$360.8

$389.1

$455.3

$499.5

$539.4

Interest Expense

$202.5

$203.5

$198.9

$174.4

$170.0

$170.0

Taxes

($24.2)

$37.3

$37.4

$17.6

$16.1

$26.3

FCF

$29.2

$79.7

$68.7

$101.1

$120.8

$165.9

OCF-CAPEX

$60.8

$199.5

$171.2

$101.1

$120.8

$165.9

Earnings

($145.6)

($181.6)

($190.9)

($63.9)

$91.0

$149.2

EV/ PF Reported EBITDA

17.2x

13.6x

13.4x

12.4x

11.5x

10.3x

EV/ PF Adj. EBITDA

27.0x

16.2x

15.9x

14.7x

13.7x

12.2x

P/E

(44.2x)

(35.4x)

(33.7x)

(100.7x)

70.6x

43.1x

Price / FCF

220.4x

80.7x

93.6x

63.6x

53.2x

38.8x

Price / (OCF-CAPEX)

105.7x

32.2x

37.5x

63.6x

53.2x

38.8x

 

 

Current Situation

 

  • Zayo was formed in 2007 and has grown mostly through acquisitions

    • Company has made 30 acquisitions since forming for $3.46 billion

    • Top 5 Acquisitions account for $685 million of total revenue and were purchased on average for 9.x LQA EBITDA

    • As a result, Zayo has grown from $125 million in revenues and $36 million in EBITDA in 2009 to YE 2014 Revenues of $1.123 billion and Company Adjusted EBITDA of $648 million (more on this later)

  • On October 16, Zayo sold 16 million shares stock in its IPO for $19, raising $282 million. Additionally, some existing shareholders sold 8 million shares in the offering.

    • Proceeds of the transaction are allocated for general corporate purposes, but will most likely be used to pay down high coupon debt at a premium

    • Zayo initially marketed their offering between $21-$24 a share, but due to extreme market volatility during their roadshow they had to lower their range and price the offering at $19. However, on the first day of trading, the stock was up over 15% to 22

    • The stock has now risen over 40% in under 2 months

  • Zayo primarily operates in 2 segments Physical Infrastructure and Lit Services

  • Physical Infrastructure- This represents 47% of revenues and 53% of EBITDA

    • This segment provides raw bandwidth infrastructure (Dark Fiber) that are leased to customers who light the fiber themselves using their own optronics – This area, representing 70% of this segment and 32% of the entire company, is the crown jewel of Zayo with the highest growth, the best margins and the least competition

    • This segment also has data centers that offer colocation and interconnection services, most of which was acquired in Zayo’s purchase of Fibernet (FTGX) in 2009

  • Lit Services – Classic telco services over its fiber network

 

Investment Thesis

 

  • The business:

    • ZAYO actually tries to give clarity about its business to investors and inundates investors with minutia about its business. (I actually really like companies

    • However, at the end of the day, 60% of Zayo is a Telecom company providing access to its fiber rings. They compete with all the big telco’s, cable companies & CLEC’s

    • Despite being in the same industry CLEC’s have varying metrics and margins……over the last few years…..

      • LVLT EBITDA Margins have ranged between 14.5% and 29% and CAPEX has ranged from 5%-12% of revenues

      • TWTC EBITDA Margins have ranged between 27% and 38% and CAPEX has ranged from 15%-29% of revenues

      • CCOI EBITDA Margins have ranged between 6% and 32.5% and CAPEX has ranged from 11%-21% of revenues

      • ZAYO Adjusted EBITDA Margins have ranged between 32% and 47% and CAPEX has ranged from 32%-39% of revenues

      • Prior to its merger with Zayo, ABVT margins ranged between 18% and 41% and CAPEX has ranged from 30%-36.6% of revenues (ABVT represents over 40% of Zayo’s Revenues and also used SBC to inflate its EBITDA)

    • One metric that is relatively consistent across all of these names is (EBITDA less CAPEX) / Revenues for the last few years, this has averaged:

      • 13% for LVLT

      • Projections in the LVLT 3 Proxy have it going from 16% in 2014 to 20% in 2018

      • 12% for TWTC (range 11%-14%)

      • 17% for CCOI (range 15.5%-17.7%)

      • 17% for ZAYO last year 12% the prior year and 11% in the latest quarter (this assumes EBITDA without adding back SBC as will be explained below)

      • 13% for ABVT,

      • Projections in the ABVT Proxy had it going from 15% in 2012 to 26% in 2018

    • While CLEC’s want everyone to think that most of their CAPEX is “growth” and not “maintenance”, the reality is that when they cut back on CAPEX, revenues do not grow and in fact start to decline (mostly due to the ever declining prices). As a result, the majority of the CAPEX is RECURRING. The only ones that have lowered their CAPEX and as a result achieved 20%+ EBITDA-CAPEX margins are the ILEC’s and they are all suffering from revenue declines

  • Growth:

    • The company has been growing nicely, primarily through acquisitions.

    • Secular growth in the last quarter was a little over 7%, which is comparable to comps

      • 8% for TWTC

      • 3.8% for LVLT (LVLT Core communications up 6.1%)

      • 9% for CCOI

  • Stock Based Comp (SBC)

    • Like many other companies, Zayo reports EBITDA with adding back Stock Based Comp. However, unlike other companies, Zayo has a tremendous amount of SBC

    • In 2014, ZAYO’s SBC was $253 million, which was 23% of revenues and 39% of their reported EBITDA. EBITDA.

    • SBC in 2014 and 1Q 2015 was an anomaly, and was exaggerated due to a “one-time” bonus related to the IPO. Looking at their 2013 SBC, historical Abovenet SBC, and what the company was saying on its roadshow, more normalized SBC would be closer to $30 million a quarter or 9% of Revenues

      • This amount is still much higher than comp’s which typically pay out 2% of their revenues in SBC

    • Backing out this real SBC (9% of revenues), would lower EBITDA by $110 million (16%) in 2014

    • It is my opinion that SBC should not be added back to EBITDA, because

      • It is a real cost, that the company would have to pay their employees. I.e., if they stopped paying any SBC (and didn’t supplement that amount with cash) the employees would leave

      • it is the equivalent of the company just selling shares into the market every quarter and counting the proceeds as EBITDA

    • while this could be somewhat ok when looking at the debt (since they do not care about dilution), when looking at the equity companies need to be compared without SBC addbacks

      • if LVLT were to have the same level of SBC as ZAYO, their EBITDA (pre TWTC merger) would increase by 23%.

    • SBC is a great method of payment in a high valuation company like ZAYO as the dilutive effect is better than using cash, but it can snowball in a declining stock environment, especially when the decline is more related to declining multiples than declining fundamentals

    • Part of the SBC is actually related to the stock price, so if the stock falls (even if fundamentals are strong and employees are doing their jobs well) employees will get a lower comp

  • Cash Flows:

    • Ultimately, value is all about cash flows and this business has very little.

      • After years of promises, LVLT will first be delivering FCF this year and mainly a result of being able to refinance their balance sheet at much lower interest rates

      • TWTC, which had consistent growth for years, and has been FCF positive since 2007, has only produced $500 million of total free cash flow over that 7 year period, a very small amount relative to the $5.9 billion equity value LVLT paid for them

      • Virtually, all of the free cash flow at ZAYO is a result of SBC. PF for all acquisitions, ZAYO had $694 million in reported LTM EBITDA (with all SBC added back), $389 in CAPEX, $198 in Interest and $37 in taxes which totals $69 million in free cash flow. LTM SBC, was $338 million, I estimate the real amount to be $112 (the other amount was one time awards associated with going public, and therefore are legitimate addbacks), so ex-SBC, ZAYO would have burned $43 million LTM

      • If ZAYO can grow Revenues 8% over the next 3 years (to $1.542 billion) and that they can achieve a 30% EBITDA-CAPEX margin (aggressive, as explained, but perhaps achievable if you buy into adding back SBC), then they will generate $463 million. Assuming they can lower interest expense by $30 million (to $140 million run rate) and they don’t pay taxes (large NOL), then free cash flow should be around $320 million at the end of 2017, which means that they are now trading at 20x an aggressive 2017 estimated free cash flow number. If you consider SBC to be an actual expense, then real cash flow will obviously be much lower

  • Valuation:

    • Private Market Values

    • Values among CLEC's are at multi-year highs, primarily due to recent consolidation, where assets have been purchased for over 10.0x EBITDA;

    • Most recently, LVLT purchased TWTC for 14.4x LTM EBITDA and 14.2x E. 2014 EBITDA

    • Prior to Zayo’s 2012 purchase of ABVT, non-Zayo CLEC M&A deals (as outlined in the ABVT proxy) ranged between 5.1x-12.2x LTM EBITDA (averaging 7.3x; median 6.65x)

    • Non-Zayo CLEC M&A, as outlined in the recent LVLT-TWTC proxy, ranged between 6.5x-11x (averaging 7.9x; median 7.3x)

    • Zayo’s 29 acquisitions (as outlined in their presentations), averaged 9.44x LQA EBITDA. Its largest, ABVT was purchased for 9.1x LQA EBITDA and 9.4x LTM EBITDA

    • Public Market Values (all EBITDA numbers do not add back SBC)

    • Prior to the June 2014 acquisition announcement from LVLT, TWTC was trading at high 11.7.x LTM EBITDA and 11.5x 2014 EBITDA and 10.21x 2015 EBITDA

    • LVLT, trades at 10.3x E. 2015 EBITDA and 9.2x 2016 EBITDA

    • CCOI trades at 15.2x 2014 EBITDA, 12.9x 2015 EBITDA and 11.0x 2016 EBITDA

    • Most other public Telco’s including CLEC’s trade 6.5x-7.5x E. 2014 EBITDA

    • In order to justify their multiples most “sell-side” analysts used Tower companies and DataCenters into their comps

    • ZAYO Valuation:

    • It is my opinion, that all of the mentioned comparable CLEC’s (LVLT & CCOI) are overvalued

    • Even so, it is hard to say that Zayo deserves a premium valuation, especially considering it isn’t growing on a secular basis faster than CCOI

    • M&A opportunities are dwindling, Zayo has even said that there shouldn’t be much expectation of M&A (at least here in the US)

    • Base case - Zayo trades at 11.0x E. 2016 EBITDA (I am using calendar year, which is an average of 2014 and 2017) comparable to CCOI (of course not adding back SBC), then it would trade at $21.25 or 20% lower than today. This would be an astounding 35.5x E. 2017 Free Cash Flow and 42.3x Earnings (this free cash flow does add back SBC)

    • Bear Case – Zayo trades at 9.2x 2016 EBITDA, comparable to LVLT, then it would trade at $15.85 or 40% lower than today. This would be an 26x E. 2017 Free Cash Flow and 31.5x Earnings

 

 

Why Does This Opportunity Exist?

 

  • Frothy Valuations of CLEC’s, much of it created by Zayo’s own aggressive M&A

  • Excitement around fiber and the growth of broadband. This is a real secular trend that will provide growth for years.

  • Lack of focus on CAPEX, which is the major driver of secular growth and the lack cash flow generation. Like other CLEC's, Zayo claims that 85% of its capex is success based and that maintenance is a small sliver of total capex. Reality is that Capex expense is recurring. Anytime a CLEC has cut back on CAPEX spending they have seen a dropoff in revenues

  • Strong “headline” Revenue & EBITDA Growth rates – Since 2008, Zayo has achieved an amazing 61% Revenue CAGR and 86% EBITDA CAGR

    • While these growth rates are impressive, it came from a very small base – Revenue grew from $64.6 million EBITDA grew from $15.6 million in 2008

    • Most of the growth has been driven by M&A, which the company admits will be much slower going forward

  • Confusion in the market how to deal with Stock Based Comp

  • Sell-side using Tower Companies & Datacenters as comps

    • While dark fiber leasing is very profitable, and under long term leases, it doesn’t deserve the valuation of Tower REITS that actually pay dividends and have the high multiples due to their dividend yields

    • Zayo’s trading multiple, is actually higher than many of the data centers / interconnection companies

 

 

Risks

 

  • Continued M&A that is rewarded by the market

    • There are some large private fiber CLEC’s still around including Icahn’s XO Communications and Sidera Netwoks (old RCN)

    • Some phone companies have Metro Fiber divisions, including WIN, ELNK, LMOS and SHEN

  • Company get purchased by a large well capitalized Telecom Company (ATT, WIN, CTL or Verizon)

  • Investors ignore all that is mentioned here, the company continues to perform and trades to Sell-side targets of $30 (11.5% increase)

 

 

 

 

Catalysts

 

  • Quarterly Earnings – The company now breaks out pro-forma prior quarters so we can see real growth rates

  • Secondary – expected in 6 months from the IPO when the lockup expires

 

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Quarterly Earnings – The company now breaks out pro-forma prior quarters so we can see real growth rates

  • Secondary – expected in 6 months from the IPO when the lockup expires

    sort by    

    Description

     

     

     

     

    Company Description

     

    Zayo Group LLC provides high bandwidth infrastructure and carrier neutral colocation. The Company offers services including dark fiber, wavelengths, private line, ethernet, and custom solutions. Zayo Group serves carrier, enterprise, school, hospital, and government customers throughout the United States.

     

    Investment Summary

    Short equity at 26.90. Aggressive accounting, minimal earnings or free cash flow, high valuation, high leverage, constant M&A, confusing financials and lack of real comps and make Zayo a compelling short opportunity

     

    Capital Structure & Relevant Financial Metrics

     

     

    Coupon

    Maturity

    9/30/14

     

     

    $250 Million Revolver (L+275)

    2.985%

    3/18/2017

    0.0

     

     

    Term B (L+300; 100 Floor)

     

    4.000%

    3/18/2019

    1,990.1

     

     

    Secured Bonds

     

    8.125%

    12/31/2019

    675.0

     

     

    Cap Leases & Other

     

    8.500%

     

    25.3

     

     

    Total Senior Secured Debt

     

     

    2,690.4

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    Senior Bonds

     

    10.125%

    6/30/2020

    325.6

     

     

    Total Debt

     

     

     

    3,016.0

     

     

    Cash

     

     

     

    175.5

     

     

    Net Debt

     

     

     

    $2,840.5

     

     

     

     

    Shares

    Price

     

     

     

    Equity Cap Class A

     

    239.009

    $26.90

    6,429.3

     

     

    Total Equity Value

     

     

     

    $6,429.3

     

     

     

     

     

     

     

     

     

    Total Enterprise Value

     

     

     

    $9,269.8

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

     

    2013

    2014

    LTM

    E. 2015

    E. 2016

    E. 2017

    Revenues

    $1,004.4

    $1,224.1

    $1,245.7

    $1,321.4

    $1,427.1

    $1,541.3

    PF Reported EBITDA

    $540.0

    $681.3

    $694.1

    $748.4

    $806.3

    $901.6

    Adj. EBITDA Margin

    53.8%

    55.7%

    55.7%

    56.6%

    56.5%

    58.5%

    PF Adj. EBITDA

    $343.7

    $571.1

    $582.0

    $629.5

    $677.9

    $762.9

    EBITDA Margin

    34.2%

    46.7%

    46.7%

    47.6%

    47.5%

    49.5%

    CAPEX

    $332.5

    $360.8

    $389.1

    $455.3

    $499.5

    $539.4

    Interest Expense

    $202.5

    $203.5

    $198.9

    $174.4

    $170.0

    $170.0

    Taxes

    ($24.2)

    $37.3

    $37.4

    $17.6

    $16.1

    $26.3

    FCF

    $29.2

    $79.7

    $68.7

    $101.1

    $120.8

    $165.9

    OCF-CAPEX

    $60.8

    $199.5

    $171.2

    $101.1

    $120.8

    $165.9

    Earnings

    ($145.6)

    ($181.6)

    ($190.9)

    ($63.9)

    $91.0

    $149.2

    EV/ PF Reported EBITDA

    17.2x

    13.6x

    13.4x

    12.4x

    11.5x

    10.3x

    EV/ PF Adj. EBITDA

    27.0x

    16.2x

    15.9x

    14.7x

    13.7x

    12.2x

    P/E

    (44.2x)

    (35.4x)

    (33.7x)

    (100.7x)

    70.6x

    43.1x

    Price / FCF

    220.4x

    80.7x

    93.6x

    63.6x

    53.2x

    38.8x

    Price / (OCF-CAPEX)

    105.7x

    32.2x

    37.5x

    63.6x

    53.2x

    38.8x

     

     

    Current Situation

     

     

    Investment Thesis

     

     

     

    Why Does This Opportunity Exist?

     

     

     

    Risks

     

     

     

     

     

    Catalysts

     

     

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Messages


    SubjectRe: Beginning of the end?
    Entry05/15/2015 11:43 AM
    MemberFletch

    From my perspective nothing really has changed, in fact i am not really sure why the stock is down so much (although i am still short and happy).  In my opinion, it is more of the same. I can't stress enough the metric of (EBITDA-CAPEX) / Revenues.  To me this tells the real story.  

     

    LVLT completed their takeover of TWTC.....EBITDA margins went up but so did CAPEX.  Historically they were talking about CAPEX being at 12% of revenues now they are up at 15% of revenues and as a result the metric of (EBITDA-CAPEX) / Revenues DOES NOT CHANGE.  the only time it will change is when CAPEX slows down and unfortunately, a slowing capex = slowing revenues which will destroy the multiple

     

    CCOI had a pretty bad quarter - Their (EBITDA-CAPEX) margin has been crashing down to earth from 27.5% in 2010 to 16% today (which is in the range that all these companies consistently end up in).  To me, i have been thinking that CCOI could be the best short in the sector as its multiple is really high, like these other clowns they have never generated any significant cash flow, it is a hedge fund hotel (over 30% of holders) and the Coup de grâce is that they are borrowing money to buy back stock and to pay out a huge dividend (and even increasing the dividend payout every quarter).  In 2014, their buybacks and dividends were $100 million more than their free cash flow - it is completely reckless.  Even using analyst estimates for this year (which assumes that the EBITDA-CAPEX margin increases back to 20%), the dividend payout is greater than their cashflow

     

    Finally, to your question, Zayo - I believe that the whole company is smoke and mirrors.  Even putting aside the Non-cash Comp issue, this is a company that does not generate any significant cash flow and in my opinion never will.  The analyst community valuation is bordering on ridiculous.  They now use valuation comps from the Tower and DataCenter sector (ironically, Zayo's valuation is higher than most data centers).  I admire the aggressiveness of management in which they continue to buy assets to goose revenue (and continue to confuse investors) and use the cheap debt markets to pay for their buying binge.  On the conference calls, they inundate people with massive amounts of information but most of it is not helpful in any analysis.  The bottom line for me is cashflow and with ZAYO it is close to non-existent.  Sellside community thinks that their EBITDA-CAPEX margin (using the companys hokey definition of EBITDA) is better than the other guys, but even going out 5 years to 2019 estimates where they are expecting this margin to expand to 29%, they are only expecting free cash flow of $225 million, so at todays price the stock is trading at over 25x 2019 earnings.  This company is not a high-flying startup.  By the company's own admission their "secular" growth is high single digits.  The valuation continues to be completely ridiculous 

     

    So to sum up - in my eyes nothing has changed, i continue to be bearish.  I don't know why the stock has sold off - I wasn't as spooked about the comment about the chunkiness of new orders and therefore a slower growth in the 2Q.

     


    SubjectIRR
    Entry08/18/2016 04:15 PM
    MemberFlashdance

    Hi Fletch, I was wondering if you're still short Zayo and if you had any updated thoughts. I have been trying like hell to figure this thing out and none of it makes any sense.

     

    Quick scorecard on Zayo:

    • GAAP losses? Check.
    • Massive SBC? Check.
    • Ham-handed EBITDA adjustments for SBC? Check.
    • Ultra-acquisitive? Check.
    • Capital intense? Check.
    • Commodity product? Check.
    • Organic growth vague? Check.
    • Maintenance capex misportrayed? Check. (Think E&P MLP's)
    • Custom definitions/jargon? Check. (What company needs a 12 page glossary to accompany earnings???)
    • Industry known for capital destruction? Check.
    • Utterly incomprehensible earnings decks? Check.

    Did you see their most recent slide deck from the Cowen conference? I'm guessing Dan Caruso has gotten so tired of answering questions about what the returns on capital are for this business, so he tried to frame it a different way:

     

     

    I've gone through this about a dozen times and I still am not sure if this is an honest way to look at it. The real question here is what's the natural decline rate of ebitda. Do you know? I don't. What Dan is saying is that the increase in ebitda creates value in excess of the cost to create that ebitda. But the problem here is that ebitda is (I'm pretty sure) front-end loaded, so much like an E&P company, if you keep increasing spending, you'll keep showing improvements in returns. I ran Dan's analysis out for FY16 and FY17 (using street estimates of ebitda, cash flow, and capex) and sure enough, the IRR declines unless they do big deals. (Side bet: Zayo makes at least $400 million of acquisitions in FY17 - that's the amount that puts them above FY16). The real question though is what happens to ebitda if they spend $0. Would it fall by 5%? 10%? By Dan's own methodology, if it fell by 6%, the IRR drops to 0%.

     

    Does anyone have any idea what the actual returns are for Zayo? They appear to be low-to-nonexistent without some serious mental gymnastics. It all seems to depend on the natural decline curve of ebitda. Anyone have any ideas? Thanks.

     


    SubjectRe: Re: Re: IRR
    Entry08/20/2016 09:52 AM
    MemberFlashdance

    dkepesh, thanks for chiming in. I think we’re speaking past each other a bit. You’re mostly talking about the multiple, something I didn’t mention nor do I care about for now. 14x, 10x…it’s not relevant to my question. I’m asking what the IRR of Zayo’s cash flows are over a longer period of time. The time period and trailing capex are critical to this question (which imho is the only question about this company) because the IRR can be materially misrepresented in the short-term. You and management say the IRR is 20% and I’m saying that figure is likely being arrived at by using flawed analysis since the ebitda declines over time. Given the cash flow profile of their assets, yes, it can appear like they’re generating a 20% IRR as long as they continually outspend cash flow

     

    Furthermore, it’s concerning to me that Zayo outspends cash flow by so much, and has other various business merits (e.g. pricing escalators, low churn, unlit fiber coming online, etc) but still can’t generate more than about 5-8% organic ebitda growth. I realize this is a common issue among people covering the stock, so you can add my name to the list, but seriously, why isn’t this company growing more? Is it the case that they’re spending a disproportionate amount of capex on dark fiber and other things that aren’t cash flowing today but have value nonetheless? Or are there other parts of the business that naturally decline faster, perhaps customers on certain networks/equipment that’s rapidly becoming obsolete? If you could help me understand I would sincerely appreciate it.

     

    Lastly, I disagree that these new IRR slides were for the benefit of employee comp. These slides were presented at an investor conference, to investors, for the benefit of investors. I know that the company is continually fielding questions about what their return on capital is, and this was a response to that since modeling Zayo is difficult if not impossible. This was Dan’s attempt at dumbing-down the analysis for investors which is something that frankly, the company desperately needed to do. At least E&P companies give you decline curves and other assumptions so that you can build a model and actually see the relationship between capex and ebitda, and understand the capital intensity and what kind of organic growth is sustainable. I’ve spoken to a number of Zayo bulls whom I respect and surprisingly, I still haven’t seen anyone been able to properly articulate any of this, let alone connect the dots on the normalized IRR.

     


    Thanks for any thoughts. I have no position. I thought the “story” was compelling but have obviously gotten tripped up during the analysis. (No idea why most of this is in a red font. I've tried editing to black but it's not taking)


    SubjectRe: Re: Re: Re: Re: IRR
    Entry08/22/2016 08:26 AM
    MemberFlashdance
    dkepesh, I'm somewhat troubled by two major contradictions:
     
    Maintenance capex. I am with Fletch on this…strongly. It is impossible for an asset-heavy company with $4 billion in net PP&E to have $1.2 million in maintenance capex in its last quarter (and $11 million TTM). I find management’s insistence that their maintenance capex (which Dan has defined as nothing more than replacing equipment that breaks) is a mere 1.6% of capex and .25% of gross PP&E absurd. Maintenance capex is a fake, counterfactual figure, whose appearance is usually symptomatic of a flawed business model (ahem MLP’s). It's a number that anyone can pull out of thin air, but no one has any idea what the consequences would be in such a state of operation. No asset-heavy public company other than regulated utilities have ever run in maintenance mode, if such a thing even really exists. And here’s the real problem: if Zayo only spent $11 million per year to fix broken equipment, churn would almost certainly accelerate dramatically. (We’re back to one of Fletch’s main arguments, which is logical) What you’re doing with your ROIC is valuing the business based on this theoretical scenario of maintenance mode on the cost side, but then not making the necessary adjustment to revenue for what would inevitably happen. 
     
    Non-cash NWC/PP&E. You’re saying that Zayo is worth is in excess of its book value…that its balance sheet doesn’t reflect the true worth. The company built an asset that they carry at $X on the balance sheet, but in reality it's worth 5x. That’s fine, I have no qualms with that assertion. But if that’s the case, you cannot exclude the goodwill and intangibles from ROIC, especially considering almost half of Zayo’s EV has come from acquisitions. Much of the capital employed by Zayo was accounted for in goodwill and intangibles. Yes, it’s just an accounting entry, but it exists for a reason, and in this case absolutely represents capital employed. Last year's 10K shows that since May, 2013, Zayo spent $3.7 billion on 15 acquisitions. Intangibles comprised $971 million while goodwill comprised $1.04 billion. Combined, 54% of the capital - real capital employed by Zayo - was accounted for as intangibles and goodwill. Once again, you're trying to have things both ways. Zayo has received the benefits of these acquisitions in the form of materially higher ebitda which you are including in your calculation, but then you’re ignoring the majority of the capital required to get that ebitda. I suppose if Zayo had only acquired companies with $0 PP&E and 100% intangibles and goodwill, you would say the ROIC is infinite. I get it, intangibles is usually a murky topic, but again, the point is that you keep taking all of the company's merits, further adjusting them to be as favorable as possible, then sweeping all the bad stuff under the rug.
     
    After spending more time on this over the weekend I'm still at a loss about what to make of this company. It seems like there's an interesting long-term story in here, with data infrastructure and backhaul. Perhaps some parallels to railroads or other assets. And every single one of these things seems to get acquired. I would also be willing to bet that Zayo does have a lot of high return assets buried in there somewhere. But the number of red flags is overwhelming. They deploy capital in minimum 20% IRR projects. How do we know? Because Dan said so...despite over $500 million in retained earnings deficit...with heavily adjusted non-GAAP numbers...protected by a safe harbor statement...and there's a graphic of a baseball field on the IR deck.

     


    SubjectRe: Re: Re: Re: Re: Re: Re: IRR
    Entry08/23/2016 10:31 AM
    Memberima

    All of the telcos offer commodity services and it hard to see how returns on incremental capital can be all that attractive. And that is the reason why the actual maintenance CapEx is likely to be a lot higher than what these companies claim. We have been short cogent and believe that they have underreported CapEx. We don't have a view on Zayo yet. 


    SubjectRe: Re: Re: Re: Re: Re: Re: Re: IRR
    Entry08/24/2016 08:09 AM
    MemberFlashdance

    ima, how does a company like Cogent underreport capex?


    SubjectRe: Re: Re: Re: Re: Re: Re: Re: Re: IRR
    Entry08/25/2016 09:27 AM
    Memberima

    They define and give guidance to the street on their capex as defined by additions to pp&e (classic capex) + principal repayment on capital leases. By that definition the numbers for the last 3 years have been 60m, 78mm and 56mm respectively for 13-15. They have also guided their definition of capex to be down this yr slightly from last yr (less than 56mm). So the street generally thinks capital intensity is coming down. But when I look at their CF statement where they give more disclosure, I calculate their effective capex as: additions to pp&e + capital leases INCURRED (not principal repaid – a timing difference but sill a reasonably significant difference) + pp&e obtained by installment (started for the first time last yr)  + non-cash equipment in exchange transactions + fair value of equipment acquired in leases (small number) then I get a total of 92mm, 100mm and 92mm for the last 3 yrs. This is quite a significant difference.  Another way to look at the business is incremental EBITDA (over 4 years) divided by capex (as we have defined) over trailing four years. That ratio has been consistent. When we look at street models we see a dramatic increase in capital efficiency, which is unlikely.  


    SubjectMore questions on IRR
    Entry02/06/2017 11:14 AM
    Memberutah1009

    Hi all, I have been looking at Zayo and had one main question that follows up on some of the prior discussion. Can anyone explain the relationship between capex and revenue with some granularity? As far as I can tell, this is 90% of understanding the financial model and returns for the business. I spoke to the company and they could not provide an answer which made sense. 

     

    I want to go back to that IRR slide that Flashdance previously posted. In addition to trying to illustrate the underlying returns of the business, this is the caclculation that determines a huge chunk of incentive compensation for management. However, there is a glaring flaw to this process, which is that it's only considering EBITDA in a single point in time. This is inherently not how IRR works...that's just self evident. IRR is the rate of return for the entire life of the cash flows, not just cherry picking one point a mere 12 months out. I find it at best amateurish that a management team would use this flawed methodology, and at worst it's intentionally deceptive. It also begs the question of whether someone pitching this process can have any credibility to what they're saying in general.

     

    I recreated Caruso's slides from the IR deck on the subject, and this is the simple model I threw together. In order to get mid-20's IRR's, you basically need to assume bare minimum capex and double digit organic growth. The maintenance capex issue has been discussed and honestly I have no idea what to think here. I do know that their own definition of maintenance is simply incorrect. But the organic growth topic is a little more straightforward and management has targeted 10%. However management was downplaying this goal at the Citi conference in early June which is what caused the stock to crack. 

     

     

     

     

     

     

    The entire model that spits out their IRR calculation is hyper-sensitive to the relationship between capex and organic growth. For all intents and purposes, they are the only two inputs. Increase capex a little or reduce organic growth a little and all the sudden Zayo's alleged IRR's (which aren't even being calculated correctly in the first place and is overly generous) fall from ~20% to ~14%. So back to my original question: what is normalized capex per each organic growth scenario? If they want to achieve their target of 10% organic growth, what is capex? This is all very Chesapeakey. By the way, this is holding the EBITDA multiple constant. There is no rule saying multiples don't compress, like in say, oh I dunno, a highly levered company in a rising rate environment?

     

    Saying this all another way, the real issue here is what is happens to EBITDA if they spent virtually nothing in capex. Their nonsensical IRR doesn't account for the fact that EBITDA will decline...their assets have a decline curve, do they not? Their IRR should compare the balance sheet (enterprise value - net debt) which is a single point in time versus a stream of future cash flows which, all things being equal, will decline. They instead make a completely apples and oranges comparison. This is why E&P companies have PV10 reports. For Zayo, if you start modeling in 0% organic growth or declines (but still assuming low capex/EBITDA), the "IRR" goes negative. 

     

    Any thoughts appreciated. Thanks.

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