Description
Disclosure Statement: This is not a recommendation to buy or sell the stock. We own shares of the company, and we may buy more shares or sell shares at any time without notification.
Summary
180 Connect (NCT.U) is a value play with an unusual problem – too much success with their core customer. As a result of DIRECTV significantly consolidating its outsourced installer base, 180 Connect is experiencing a massive growth in revenues from just over $100M in revenues in 2003 to an estimated $280M in 2005, with an expectation of a $400M run rate by the end of 2007. Having been unprepared for this level of growth, EBITDA margins collapsed from almost 12% in 4Q 2003 to 4% in 1Q 2005 due to significant cost increases related to higher overtime payments and the extensive use of more expensive subcontractors to keep up with growth.
Add to this the fact that the company is a recent IPO, traded in Canada (though it’s a US company), a management change resulting from the Q304 disappointment, Q404 results not being filed until May 10, and you have a company that’s been left for dead, down 40% from its (already reduced) IPO price. In such circumstances are great value opportunities found. The company trades at a big discount to its peers, at roughly 9.4x 2005 FCF (which is at depressed levels), and 7.3x 2006 FCF.
Many of the issues have already been fixed. In addition, there are many catalysts over the next few quarters that will only make it more attractive. We believe that the stock could easily double or better from these levels (more on valuation below). Highlights include:
-New CEO is in place since Q1, who actually came over from DIRECTV, where he managed the NCT.U relationship. That seems like a big vote of confidence in the business.
-New CFO in place.
-Q4 and Q1 numbers filed on May 10.
-Immediate policy/financing changes to reduce overhead and operating costs, leading to 8-9% EBITDA margins by year end.
-Company intends to list on a US exchange within the next 12 months.
-Further operating improvements (detailed below) over the next couple of years to get to 10-12% EBITDA margin.
-Continued growth of DIRECTV business.
-Leveraging the existing infrastructure to expand into parallel installation and service markets.
-Opportunity to leverage conservative balance sheet.
-Significant insider ownership.
-Management incentives that kick in above the current stock price
-Low capital expenditure requirements for maintenance and growth.
-Company repurchased shares in current quarter (2Q 2005).
-By our estimates, trading at 2006 and 2007 EBITDA multiples of 5.4x and 3.8x, and 2006 and 2007 FCF multiples of 7.3x and 6.4x.
180 Connect Inc.
180 Connect is one of the largest providers of installation and upgrade services to the direct broadcast satellite, media, and communications industries. Roughly 80% of sales come from one customer, DIRECTV, with most of the remaining 20% of sales coming from various cable companies. 180 Connect is the exclusive supplier to DIRECTV in 22 states. The company trades on the Toronto Stock Exchange under the symbol NCT.U (NCT/U CN on Bloomberg), but the stock price and all financial disclosures are given in US dollars, and the company is headquartered in Ft. Lauderdale. Approximately 98% of business is done in the US with the remaining 2% in Canada.
Background and History
180 Connect was formed in September 2000 with an initial operation in North Carolina and was augmented through four acquisitions. Operations expanded substantially in April 2002 when the company acquired the assets of Viasource Communications for approximately $50M. In January 2004, 180 Connect acquired Mountain Center (LTM $50M revenues) for about $9M.
180 Connect completed its initial public offering on April 23, 2004 at $8.00, reduced from $12.00 as the market environment for IPO’s in Canada had deteriorated. On the roadshow prior to the IPO, the company told investors to expect EBITDA margins of roughly 10-12%, but ultimately failed to deliver on that promise, as the company could not keep up with the growth that DIRECTV was giving them. As a result of the surprising level of growth, the company could not hire quickly enough and had to hire a significant amount of subcontractors (which cost roughly 20% higher rates) and pay significant amounts of overtime (presumably at 50% higher). As a result, EBITDA margins for the 2nd and 3rd quarter of 2004 came in at 6.5%-7% vs. the 10%-12% expectations. Subsequently, the stock dropped from the $8.00 IPO in April 2004 price to as low as $2.80 in November 2004, and has since stabilized at around $5.00.
In February 2005, CEO Barry Simons realized that the company needed a more experienced operator and stepped down as CEO of the company after hiring Peter Giacalone. Prior to joining 180 Connect, Giacalone served as EVP of Customer Satisfaction at DIRECTV and had primary responsibility for all of DIRECTV operations relating to home services, call center and supply chain operations. Prior to that, he served as VP Finance for The News Corporation supporting global merger and acquisition-related activity. We believe that his experience gives him unique insight into Direct TV, the current and future economics of the installation business, and potential growth opportunities.
New initiatives
After joining the company in March 2005, Giacalone immediately implemented plan to improve margins, including the following initiatives. The company discussed many of these initiatives on its May 10th conference call when they announced 4Q 2004 and 1Q 2005 earnings (See Appendix A for discussion of these results).
-Reduce reliance on subcontractors from 25% to 10%
-Improve fleet by providing company owned cars (leasing costs less then driver reimbursement)
-Reduce hourly fees paid for subcontractors
-Improve inventory management and reduce shrinkage
-Improve hiring to reduce overtime
-Address call center costs
-Improve sourcing of consumables
-Increase direct sales of additional services from on site technicians
-Implement better safety and training initiatives to reduce insurance costs
The company believes that through the applications of these initiatives, along with the benefit of slowing growth, that the company should be able to reach 8-9% EBITDA margins by 4th quarter of 2005 and approach 10-12% margins by 2007. Furthermore, Giacalone believes that most of these initiatives have very little execution risk (reducing fees to subcontractors or leasing cars rather then reimbursing drivers is simply a policy change). Eventually, the company believes that it can reach $400M of sales just through incremental DIRECTV business. Peter has specifically said that he will only take on profitable sales, and sees margin improvement as his primary focus.
Giacalone also has appointed a new CFO, Steven Amato to the position of Senior Vice President and Chief Financial Officer. Amato is a CPA and has more than 17 years of senior experience in accounting and financial management. He most recently served as a partner at Ernst & Young in New York, and worked with Peter extensively at News Corp.
Valuation (All is US$)
With the current $127M market cap (and $154M of EV with capital leases), we estimate that NCT.U is trading at 2006 and 2007 EBITDA multiples of 5.4x and 3.8x, and 2006 and 2007 FCF multiples of 7.4x and 6.4x (not a capital intensive business). Even at depressed 2005 margin levels, the stock trades at roughly 9.4x 2005 FCF. Even if EBITDA margins were to never improve above 5- 6%, the company is still very cheap at current prices.
Price: $5.00
Shares: 25.4
Market Cap: $127.0
Debt: $50.8
Cap leases: $25.2 (will be booked in 2Q and 3Q of 2005)
Cash $48.9 (includes roughly $6M of restricted cash)
EV $154.1
MM$ 2003A 2004A 2005E 2006E 2007E
Revenue* $104 $213 $280 $320 $370
EBITDA $7 $12** $16 $29 $40
FCF*** -$1.4 $10 $13 $17 $20
EBITDA % 6.6% 5.6% 5.7% 8.9% 10.8%
EV/EBITDA 9.6x 5.4x 3.8x
P/FCF 9.4x 7.4x 6.4x
* Does not include any revenue from additional initiatives such as structured home wiring
**$12M excludes $7M of one time charges
***Assumes no interest income or other ROI from cumulative FCF generation. See Appendix B for calculation of EBITDA conversion to FCF
Composition and growth of revenues
The company estimates that in 2005, roughly 80% of revenues will come from DIRECTV, with the remaining 20% of revenues mostly from various cable companies.
2004 2005 2006 2007
DIRECTV $148 $224 $260 $306
Cable/Other $65 $56* $60 $64
Total $213 $280 $320 $370
*Cable revenues likely declined in 2005 vs. 2004 because NCT.U decided to not renew a cable contract in New York City that was highly unprofitable.
Growth in DIRECTV revenues for 180 Connect is driven by increased usage by DIRECTV of the Home Service Provider (HSP) network. This is a network of national providers for DIRECTV that, in 2004, performed 40% of all DIRECTV’s installations and 100% of all service requests. More specifically, any time you order DIRECTV through their toll free phone number or through their website, you will get an HSP provider. NCT.U currently is the exclusive HSP provider for DIRECTV in 22 states, including California. NCT.U represents 25% of the HSP network.
To improve service levels, DIRECTV decided to increase the installation work they provide through the HSP network from 40% to 80% over the next several years, which implies a doubling of installation business for NCT.U, without needing to open any new branches to support the growth.
The growth will come from increased business from retailers such as Best Buy and Circuit City, who currently hire mom and pop subcontractors. From DIRECTV’s perspective, the desire to increase the use of the HSP network is specifically related to better customer service (92% customer satisfaction score with the HSP network vs. about 10% outside of the HSP network), and lower cost (less administrative cost if they deal with less contractors.) Customer satisfaction is the key, since it leads to lower churn and significant savings on subscriber acquisition costs.
Additionally, the company will get some growth in upgrade and service revenue because they will now have the ability to take on some additional business that they had previously ceded to overflow networks of installers.
Installations reflect roughly 45% of all work orders and 60-65% of all revenues generated from Direct TV with the remaining 35%-40% coming from service calls and upgrades. The company generates roughly $210 per installation call vs. $115-$120 per upgrade, and $80 per service call, and tends to prefer installation calls because they are higher margin. See Appendix C for a revenue breakout.
Additional Opportunities
Giacalone believes that the value of the company lies in its operating locations and technicians. From my conversations with industry sources, the most significant opportunity for the HSP’s (other than to improve volumes and margins with DIRECTV) is to use the existing infrastructure to generate new sources of revenue in related installation and service businesses. Given his M&A background at NewsCorp, Giacalone is open to making small tuck-in acquisitions that would leverage NCT.U’s existing infrastructure, but only at the right price.
Several days after joining the company, Giacalone bought Digital Interiors, a home structured wiring company, for $350K and 2.5% of installation revenues over the next 18 months. The acquisition provides them with 6 new contracts with builders in the Southwest, for approximately 38,000 homes, with installation beginning in the fourth quarter. If they can install 3,800 homes per year @ $1,000 per home, and upsell 40% of the customers @ $2,700 per home, then the company could generate $10M per year of revenues in the future. Given that they can take on this business using their existing infrastructure, this new business should some strong incremental margins (15% EBITDA margins is not unreasonable). I have not included revenue from the acquisition or the new contracts in the assumptions of my model.
The company has expressed interest in similar opportunities, giving the example that Conoco has 26,000 gas stations, which use 446 different contractors to implement satellite delivered data upgrades that are required every few years. Maybe Conoco could benefit from a consolidated installer base.
Intelligent Capital Allocation
The company intends to use its ample cash flow to pay down debt, make selective acquisitions, and repurchase shares. As of May 3rd, the company repurchased 108K shares in the 2nd quarter, or roughly 0.5% of shares outstanding. We would like to be a little more aggressive with repurchasing shares. The CEO does understand the importance of being very selective with acquisitions, only making ones that are accretive and meet strict ROIC requirements on a risk-adjusted basis.
They also have some opportunities to improve their capital structure, understanding that having $49M in cash and $51M in debt is not optimal. They need to have some cash reserves available to fund insurance collateralization requirements over the next three years (transfer from cash to restricted cash), but they are working on a plan to relax the requirements (obtain LOC through the credit agreements). My model conservatively assumes that the company continues to have an inefficient capital structure.
Capital requirements are minimal because the 100 operating locations have already been built out, and ongoing capital requirements are not more than $2.0M-$2.5M per year.
Competition
Historically, there have been relatively few barriers to entry to serve this market. As a result, any organization that had adequate financial resources could enter the market and bid for contracts. As technology has becomes more complex and DIRECTV has been more focused on providing superior customer service to cable, having a scale is becoming an increasingly powerful barrier. DTV wants consistent customer service implemented by fewer installation partners
The key competitors within the HSP network are MasTec (MTZ) and Direct Tech (private roll-up of 4 HSP’s), which are each roughly the same size as 180 Connect (25% each). The remaining 25% of the HSP are regional players. Each company is assigned exclusive DIRECTV markets so they do not compete directly with each other. In terms of customer service, 180 Connect is in the middle of the pack ranking at roughly 6th out of 14, but still maintains a customer service score of over 90%. 180 Connect believes that they provide the best customer service of the three major HSP’s, and the key reason why they receive inferior scores to some of the regional HSP’s is that those HSP’s have easier markets. 180 Connect believes that its customer service scores are significantly higher then either MTZ or Direct Tech. It is of some comfort that MTZ appears to be going through some of the same issues as NCT.U, evidenced by lower then expected gross margins in 1Q as a results of internal staffing issues related to DIRECTV work.
The key competitors outside of the HSP’s are the local mom and pops. Although these mom and pops may have some cost advantage over the HSP’s (due to lower overhead and the potentially shady treatment of employees as independent contractors), DIRECTV is focused on providing better customer service and is clearly shifting business toward the HSP network.
NCT.U’s commitment to leasing their automobiles (which have the DIRECTV logo on them), as well as having uniformed drivers is a significant investment in customer service (as well as a cost savings) that mom and pops as well as regional HSP’s may be unwilling to make.
Cheap based on Comparable multiples
There are no pure play competitors, but it is clear that 180 Connect trades at a clear discount to some of the closest comparables.
2005 EV/Sales EV/EBITDA P/FCF*
NCT.U 0.55x 9.67x 9.45x
MTZ 0.60x 12.99x 27.96x
DY 0.90x 7.05x 30.47x
PWR 0.70x 11.00x 13.57x
2006 EV//Sales EV/EBITDA P/FCF*
NCT.U 0.48x 5.38x 7.37x
MTZ 0.55x 7.34x *
DY 0.80x 5.80x *
PWR 0.70x 8.00x *
*2005 FCF multiples for competition are for LTM 3/31/2005 vs. 12/31/05 estimates for NCT.U. The point of the P/FCF comparison is to show that 180 Connect is much cheaper on a free cash flow basis because the business does not require a lot of capital expenditures.
MTZ and DY focus more on construction and infrastructure, rather then installation. As a result, capital requirements are somewhat higher, but the barriers to entry might be a bit higher as well due to the complexity of the work (although they compete significantly with mom and pops as well). Additionally, each company has a more diversified customer base.
MTZ gets 27% of its business from phone companies, 37% from cable, satellite, and high speed internet (including DIRECTV), 20% from energy, and 16% from government. DIRECTV (at 29% of sales) is their biggest customer with most of the work performed for them related to installation.
DY generates 88% of its revenues from the telecommunications industry with roughly 24% of its business from Comcast and its top 5 customers contributing to 60% of the company’s revenue. Interestingly enough, DY is able to generate a 13% EBITDA margin even though it must deal with the some of the same difficult competitive and customer dynamics that NCT.U is currently facing (lack of cost advantage, mom and pop competition, strong customer power).
Insider Ownership
The company has strong base of insider ownership as well as early stage investors. 9% of the company is owned by Chairman Byron Osing with 8% owned by other officers and directors. Roughly 59% of the company is owned by early stage investors who understand the long term story. The remaining 24% of shares were sold as a part of the IPO. Although the locked up shares became available for sale in October 2004, the company believes that most, if not all, of the selling since the IPO came from investors who participated in the IPO, but were disappointed by the company not hitting their near term margin targets, immediately after the offering.
Risks
1. Price cuts: After cutting prices in 1Q 2004, DIRECTV has committed to not implementing any further price cuts in 2005. Although they have not discussed their plans beyond this year, Giacalone has indicated that DIRECTV recognizes the significant investment that NCT.U and other HSP’s have made toward improving customer service and understands that industry margins are at the point where any further price cuts could lead to erosion in service quality. The risk that DIRECTV takes away any margin improvement by NCT.U is partially mitigated by the fact price cuts would only occur if all HSP’s, not just NCT.U, had improved margins. In a sense, NCT.U is protected by the performance of the weakest competitor. Given that NCT.U has a better balance sheet and higher margins then MTZ, stronger access to the public markets than privately held HSP’s such as Direct Tech, and the ability to make significant investments to reduce cost, it is difficult to imagine that other HSP’s could survive a price cut at this point. With DIRECTV’s focus on reducing churn and improving customer service, having an HSP reduce service quality or exit the business would not be consistent with the goals of the organization.
2. DIRECTV takes installation in-house similar to EchoStar: We believe this is very unlikely. First, DIRECTV does not have the infrastructure to do this type of work, and has found that some experimental attempts to build this infrastructure have failed. Second, with the rather low margins in this industry, it is not as if DIRECTV will save a lot of money by doing it themselves. Third, former DIRECTV executives do not appear to see this as a major risk. I doubt Giacalone would have joined the company if this was concern. Also, Tom Beaudreau, formerly of DIRECTV, left to run DirecTECH, one of the three large HSP’s.
3. Decline in new installations: By 2007, many analysts expect that DIRECTV will not be able to grow its subscriber base beyond 17M or 18M (vs. 14M at the end of 2004). Fortunately, 180 Connect still gets the benefit of high churn due to competitive dynamics between satellite and cable, and existing customers who move to a new residence but want to keep DIRECTV. With both stable gross additions due to churn and recurring service revenues, the company expects revenues from DIRECTV to flatten out around 2007, but not to decline after that.
Catalyst
1. Margin improvement which should begin to impact results in 3Q 2005
2. List on the AMEX or Nasdaq by the end of the year
3. Potentially accretive acquisitions which utilize existing infrastructure but diversify customer base.