PART VIII: VALUATION
In 1Q17 Lumos Networks was acquired by EQT Infrastructure. Lumos had three business segments: Data, R&SB, and RLEC Access. Roughly, their Data is “strategic” assets, while R&SB is closer to “legacy” DSL technology including PRI, long distance and analog lines. RLEC is something in between, some valuable, some not so much. One approximate way to categorize and normalize its assets mix is as such:
Above, Lumos’ Data segment is renamed Strategic, R&SB renamed Legacy, and RLEC split between the two. The blue values are inputs while the black font are calculations. We start by using the acquisition price of approx. $900mm and assume an EV/EBITDA multiple of 4x on Legacy assets. The goal is to calculate the implied EBITDA and Sales multiples of Lumos’ Strategic and Legacy assets. By assuming a 4x EBITDA multiple on Legacy, it implies a 12x EBITDA multiple on Strategic assets. Lowering the 4x EV/EBITDA multiple on Legacy would increase the multiple on Strategic, and vice versa. Next, we will look at additional wireline peer multiples to validate our Lumos analysis, in addition to getting a better sense of the rest of the wireline carriers.
Before thinking about the current multiples, we will categorize the types of wireline carriers as seen above. For example, it is worthwhile separating wireline carriers with a cable assets versus copper assets. The EV/EBITDA of 4x for Lumos’ Legacy is lower than the average as we believe copper DSL will continue to come under heavy pressure in the next few years. Directionally, it should come down and not up, however, feel free to adjust as you see fit. We used peer multiples and chose a ‘base multiple’ representing what we feel would be conservative. For example, Frontier trades around 5x EBITDA but we feel 4x is more reasonable. These base multiples will then be applied to Cincinnati Bell as comparison. As a sanity check, we looked at recent wireline acquisitions such as CenturyLink’s acquisition of Level 3 (13x+ EBITDA), Windstream’s acquisition of Earthlink (~5x EBITDA), and Consolidated Communication’s acquisition of Fairpoint (~6x EBITDA).
For Cincinnati Bell, we applied our base multiples of 12x EV/EBITDA on Strategic and 4x EV/EBITDA on Legacy. The results imply a price per share of $22.38. However, there are a few other observations,
- Both Strategic and Legacy use a multiple we think are conservative.
- EV/Sales of Legacy imply DSL sales may cut in half. We don’t think it will be that extreme but we will use this in a separate valuation model below.
- 3.6x EV/Sales of Strategic assets is lower than our conservative ‘base multiple’ of 4x.
Additionally, we should discuss how we are approximating Strategic and Legacy sales for Cincinnati Bell.
- CBB currently reports approx. $660mm of “strategic” revenue in the last 12 months
- What is defined “strategic” by wireline carriers is based on speed capabilities. This definition unfortunately changes. The trend is faster speeds which is why the definition changes. Given that a number of wireline firms re-categorize “strategic”, we don’t think it’s fair to trust this definition.
- We will instead define CBB’s strategic assets as only: Fioptics, Unified Communication, and a small portion (5%) of their DSL network. These totals $360mm which is almost half of the reported $660mm. $240mm to Fioptics (excluding Voice), $80mm to Unified Communication, and $40mm to DSL.
Finally, the EBITDA Margin can be approximated in a few ways. We consider CBB’s current margins, peer margins, its relative strength versus technologies like cable long-term, etc. The below table shows historical margins. What isn’t shown below is the implied EBITDA margin in the terminal years based on current valuations. This terminal average margin for cable and fiber carriers is around 40%.
This analysis point to nice downside protection from the current price. Next, we will look at a 10yr unlevered free cash flow.
Assumptions in the above model include,
- Discount rate of 6%
- 0-1% top line growth until maturity
- -1% maturity growth rate at year 10 and on
- Minimal gross margin improvement. This is conservative considering the cost structure of a fiber network is lower than a DSL network and meaningfully lower than managing a DSL and fiber network.
- Terminal EBITDA margin of 30% which we think represents a meaningful amount of conservativism relative to cable peers.
As a quick sanity check of the Discounted Cash Flow,
This valuation also arrives at the same conclusion that there is upside at the current price while applied to what we think are conservative assumptions. We however feel this traditional method of valuation is not appropriate given the industry is in a consolidation phase. As discussed in Appendix E: Revisiting the Computer Industry, we suspect a continued pattern of natural consolidation and inorganic growth. This makes modeling based on historic growth quite unrealistic. We believe CBB will either grow through acquisitions or be acquired in the long-run. It therefore makes more sense to only model for the next few years.
Over the next few years, we believe fiber demand will remain strong and likely accelerate. However, it is Cincinnati Bell’s cash availability that will limit their fiber investment. We estimate Cash Flow from Operations to remain around $150-200mm over the next few years. This assumes around $20-25mm annual restructuring and $40mm working capital. At this level of cash generation, we anticipate new fiber buildout will slow relative to the past few years. Legacy DSL will continue accelerate downwards while Unified Communication and IT Services will grow. Three year from now, the thesis is essentially an asset-mix swap from legacy to fiber. The below model follows our above ‘legacy’ definition and margin assumptions. We think there is safety even using conservative assumptions such as,
- Fioptics EBITDA multiple and margins remain at current levels although it continues to grow
- Unified Communication EBITDA multiple and margin comes down as growth slows
- Legacy EBITDA multiple and margin continues to come down