Description

Allstream—formerly known as AT&T Canada—is an undervalued post-reorganization equity currently trading at an EV/EBITDA multiple of 1.7x. This translates into a fully-taxed run-rate free cash flow yield to equity of 22%. As the largest competitive local exchange provider or CLEC in Canada, Allstream provides telecom services exclusively to businesses. The Company is the #2 service provider to blue-chip customers in all major Canadian metropolitan areas. This report will argue that Allstream’s inexplicably low valuation can be attributed to three reasons: (1) Investors’ misunderstanding of Canadian tax laws and inability to properly value Allstream’s CDN $1.8 billion net operating loss carry-forward. (2) Management’s over-conservatism and history of “sandbagging” estimates. (3) The Street’s incorrect assumption that Allstream’s free cash flow is certain to plummet over the long-run. All dollar amounts are Canadian unless stated otherwise. Allstream has 19 million Class B limited voting shares and 1 million Class A non-voting shares that are traded on the NASDAQ and Toronto Stock Exchange under ALLSA, ALLSB, ALR/A, ALR/B, respectively.

Unavoidable Bankruptcy: After spending $3.5 billion to develop a national network, Allstream entered CCAA protection on October 15, 2002. In particular, Allstream’s bankruptcy was solely due to a poor business plan that was doomed for failure from Day One. An inappropriate capital structure resulting from the “build it and they will come” mantra of the 1990s provided little room for error. Once Allstream was overleveraged, there was literally nothing any manager could have done to prevent the Company from filing for bankruptcy. Simply put, Allstream needed to lay fiber across Canada to compete with the incumbents or else the Company did not have a business. Unlike other high-profile bankruptcies such as Spiegel Group and K-Mart which resulted from negative EBITDA results for a sustained period of time, Allstream’s core operations were performing quite well—as the Company’s EBITDA soared from $58 million in FY2000 to $223 million in FY2002.

Moreover, our conservations with several CIOs of Allstream’s clients confirmed the solid progress shown in the financial statements—that Allstream’s CCAA filing was by no means due to inadequate technology, poor customer service or any other major problems. On April 1, 2003, Allstream consequently emerged from bankruptcy in less than 6 months with no debt and $140 million in unrestricted cash after a restructuring led by Cerberus. Now, Allstream offers investors the alluring opportunity to reap all of the benefits from the old AT&T Canada’s $4.7 billion in accumulated debt without having to service a penny of corresponding interest. Allstream now has an unnatural, but advantageous cost advantage that will be discussed later in this report.

Decent Business: Allstream has several appealing attributes which are not apparent to most investors. Allstream operates under a low-churn, recurring-revenue model in which 80% of the revenue comes from 4,000 customers—many of which are blue-chip customers including American Express, Government of Canada, IBM, Disney, Ford, and Wal-Mart. A list of Allstream’s customers can be found by referring to Page 11 on the Company’s recent PowerPoint presentation—which can be found on Allstream’s comprehensive Investor Relations site at www.allstream.com/pdf/ financial/AllstreamInvestorPPT.pdf.

In the Canadian enterprise market, many large customers need two different telecom providers for backup purposes—known as “redundancy.” Many of these chief information officers use Allstream along with incumbents or ILECs Telus and Bell Canada in Western Canada and Eastern Canada, respectively. These customers cannot afford to see Allstream fail and actively want the Company succeed in the interests of competition.

Many people are concerned about the threat of Telus and Bell Canada emerging as serious competitors outside of their incumbent areas. Currently, Bell and Telus serve customers outside of their incumbent areas. But, we believe the risk of Allstream being adversely affected is minimal. Our research checks suggest Bell and Telus are weak when not in their incumbent regions. In addition, neither non-ILEC operation has generated any positive EBITDA since inception. On the other hand, Allstream will have earned consistently positive EBITDA for four years in a row by the end of 2003.

Furthermore, enterprise telecom customers are extremely “sticky” because there is tremendous implementation risk associated with changing telecom providers. In some circumstances, it can take several months to convert a large company, install new systems and train employees. Accordingly, most customers will be hesitant to leave unless they are extremely disgruntled with the customer service. This compares very favorably with the consumer long-distance market—in which pricing wars are common because all it takes is a phone-call and the switch of a button to convert a residential subscriber.

AT&T Relationship: Before Allstream filed for bankruptcy in 2002, it generated approximately 20% of its revenue from AT&T. Thus, many critics were bearish about Allstream’s potential as an independent company. Nonetheless, an analysis of the relationship between the two companies shows that the “AT&T business will disappear, so Allstream’s business will decline” argument is untrue and illogical. In particular, the AT&T-related business constitutes three separate revenue streams.

Northbound Traffic: This revenue stream results in $50 million of northbound traffic from AT&T’s US customers into Canada. According to management, this part of the business is declining between “slightly and substantially” due to decreased volume of phone traffic—primarily due to a weak economy. While one cannot be absolutely certain, management emphasized that none of this business is going to competitors.

AT&T Informal Referrals: This $120 million annual revenue stream is earned from referenced accounts and is the single most misunderstood aspect of the AT&T—Allstream relationship. In simple terms, Allstream has earned this business because AT&T gave them a stamp of approval and provided a “recommendation.” This is not direct billing between AT&T and Allstream. According to management, this part of the business is relatively unchanged and Allstream has not lost one single “big” client.

Actual AT&T Clients in Canada: This $110 million annual revenue stream from US AT&T’s clients who have operations in Canada and are making phone calls out of Canada. Allstream invoices AT&T for these clients. According to management, this part of the business “is growing healthily.” Allstream recently signed a new agreement with AT&T—perhaps because both companies have proprietary Lucent 4E switching platforms that are not made anymore, so competitors cannot steal this business away. As a result, it would be difficult to fathom this business disappearing.

Customer Retention and Expansion: For the reasons stated above, Allstream surprised many critics when during CCAA protection, virtually none of their customers switched providers despite the Company’s financial woes and perceived uncertainty. Even better, Allstream actually signed up many new high-profile customers such as Cisco, Toys R US, and 7-11 and renewed and expanded agreements with Best Buy, Starbucks, and National Car Rental. At the time, these customers were fully aware of Allstream’s future without AT&T as a partner and the looming bankruptcy.

We asked CIOs what matters when choosing a telecom provider. Every single CIO stated quality of service is the most important part of the equation, followed by pricing, with brand recognition being the least important of the three factors in choosing a telecom provider. At the end of the day, maybe half of the $50 million of the AT&T business is at risk of dropping. Hence, this $25 million downside is small peanuts to a Company that generates $1.3 billion per year of revenue.

Insider Buying: Allstream insiders have been buyers of the stock, albeit at lower levels, but nonetheless a very positive sign. For example, the CEO, COO, and CFO purchased 10,000, 2,550, and 2,000 shares at the $38 level. In addition, Purdy Crawford, a Director appointed in November 2002, purchased 15,000 shares of the stock. This information is generally unknown to most investors and does not appear in any sell-side reports. However, one can access the new SEDI online insider database at www.sedi.ca to get a full list of insider transactions.

$1.8 Billion Net Operating Loss Carryforward: Allstream was able to preserve a $1.8 billion net operating loss carry-forward through the CCAA process. These NOLs are usable for seven years according to management. There is also a key difference between the United States and Canada that quite a few investors who follow Allstream are aware of. An acquirer in a related business can purchase Allstream and take full advantage of the NOLs and apply them to offset the pretax income of the combined entity—making Allstream a valuable acquisition candidate. This fact has attracted a laundry-list of prominent hedge funds to the stock. Cerberus, Omega Advisors, and Chilton Investment Partners all have filed 13G forms with the SEC and are 5% plus owners of Allstream.

Now, without any acquisition and assuming a run-rate EBITDA – Capex number with capital expenditures roughly equal to depreciation, Allstream’s NOL should be worth between $371 million to $469 million using a 12% discount rate.

The difference depends on Allstream’s ability to use an obscure Canadian loophole, which according to management allows corporations to use the NOL to absorb the entire EBITDA and postpone the depreciation tax shield until the NOL has been used. The way this would work is as follows: Allstream would generate $279 million in EBITDA and instead of using the depreciation shield for the extra $100 million and only use the NOL to shield pretax income of $179 million, Allstream would NOT use the depreciation shield and instead use the NOL to offset the $279 million in EBITDA. This trick allows Allstream to use the entire NOL AND also save $100 million in depreciation expense for use a later point—presumably 7 years down the road when Allstream’s NOL’s expire. This trick assuming management is adhering with Canadian tax laws—adds an extra $98 million of value to the enterprise—not particularly large, but definitely material and important. In spite of this possibility, the valuation analysis below assumes a conservative NOL value of $379 million or $18.04 per share. Furthermore, if Allstream can grow its EBITDA, the NOL has a higher present value.

Sandbagging Management Team: An analysis of the financial results and projections suggests that Allstream managers are sandbagging guidance. There are understandable reasons why Allstream has an incentive to be conservative when giving guidance to the Street and discussing current business trends. They are very intelligent and seasoned executives who have been around long enough to realize too many momentum investors will sell any stock that misses earnings without any regard to valuation; they do not want to take a chance. They would rather be conservative, let the future free cash flow speak for itself, and have the last laugh. Below is a table of past and projected financial results.

Q1 2002 Q2 2002 Q3 2002 Q4 2002 Q1 2002 Q2 2003

Revenue 383,830 384,857 359,861 359,597 353,325 336,582

EBITDA 38,025 50,483 54,280 80,404 66,294 73,502

EBITDA 9.9% 13.1% 15.1% 22.4% 18.8% 21.8%
Margin

Capex 54,843 19,265 10,844 58,733 33,227 15,794

(Q2 2003 adds back one-time $4.4 mm re-branding expense because the projected expense is already added to EV)

According to the information circular, Allstream expected between $200 million and $220 million of EBITDA for FY2003 and $140 million of capex. In the first six months of FY2003, Allstream earned $140 million of EBITDA and spent only $48.9 million of capex. In order for Allstream to generate $220 million of EBITDA, Allstream will have to operate under an unthinkably low 11.9% EBITDA margin on Q2 run-rate sales compared to the recent 21.8% EBITDA margin in Q2 2003. The original capex guidance, as we expected, turned out to be $40 million too high and now has been adjusted to $100 mm for the year. Before management lowered capex guidance, they provided the following breakdown of the $140 mm figure: $56 million or 40% was for success-based or growth, $56 million and 60% or $84 million was for back-office and maintenance. If sales happen to be lower than forecasted, one should expect Allstream to spend even less capex going forward—thereby preserving free cash flow.

Another critical comment occurred at the NYC investor luncheon which suggested management is hiding a trick under their sleeve. When asked about an appropriate capital structure, management suggested that it intends to have a more standard capital structure going forward by levering up the Company in the near future. One manager laughed and commented along the lines about how he had taken a business class before and understood finance basics. This comment does not appear to support arguments that Allstream’s business is going away soon.

Valuation: The cheap valuation is the critical part of this report. While Allstream may turn out to be a good growth story, the attractive part of the story is the downside protection. A review of the enterprise value suggests that Allstream’s value is very static and has considerable downside protection because of the NOL and large cash position that grows every quarter. One can also analyze this situation as a relatively risk-free investment with a free call option on any future success of Allstream and/or a Telus acquisition at a higher price.

In this analysis, it is assumed that Allstream will have $339 million of cash by the end of 2003--$250 million as of the end of Q2 added to the 6 months ended June 2003 run-rate EBITDA – Capex. The Company confirmed that the pension assets consist of a typical equity portfolio levered to the performance of the stock markets. Allstream management may elect to reduce the pension liability—which by the way might decline naturally because of the strong global equity markets or tweaked assumptions. Also, there are no working capital issues that would inhibit cash collection. There are 20.0 million common shares and 1 million additional shares were assumed to be dilutive for management options.

Once the value of the cash and NOL is subtracted from the enterprise value of Allstream, we calculate very attractive multiples for equity as well as for the enterprise value. To determine the equity market capitalization, the cash and NOL are subtracted and a pro-forma 40% tax is applied to the EBITDA – Capex calculation to avoid double-counting the NOL.

Equity Market Capitalization 1,058,800
Less Cash At Jan 1, 2004 (339,099)
Add Approx. Pension Liability 100,000
Long-Term Debt 0
Add Capital Leases 17,000
Add One-Time Branding Expense 20,000
Less Present Value of NOL (371,190)
Total Enterprise Value 485,511
EV / EBITDA 1.7x
Equity Market Cap less NOL and Cash 4.5x
/ After-Tax FCF
Free Cash Flow Yield to Equity 22%

The fact that Allstream is cheap hopefully is obvious by now, but many people will argue over the multiple that Allstream deserves. For this reason, a simple sensitivity table is presented for both EV / EBITDA and FCF to equity fans so fellow VIC members can decide for themselves.

USD / CDN Exchange Rate Assumption
0.746x

FCF Mult. Trading Value Implied Equity Allstream CDN $ Allstream US

3.0x 900,079 900,079 $42.86 $31.97
4.0x 1,009,009 1,009,009 $48.05 $35.84
5.0x 1,117,939 1,117,939 $53.24 $39.71
6.0x 1,226,869 1,226,869 $58.42 $43.58
7.0x 1,335,799 1,335,799 $63.61 $47.45
8.0x 1,444,729 1,444,729 $68.80 $51.32
9.0x 1,553,659 1,553,659 $73.98 $55.19
10.0x 1,662,589 1,662,589 $79.17 $59.06
11.0x 1,771,519 1,771,519 $84.36 $62.93
12.0x 1,880,449 1,880,449 $89.55 $66.80

EBITDA Mult. EV Implied Equity Allstream CDN $ Allstream US

0.5x 139,796 713,085 $33.96 $25.33
1.0x 279,592 852,881 $40.61 $30.30
2.0x 559,184 1,132,473 $53.93 $40.23
3.0x 838,776 1,412,065 $67.24 $50.16
4.0x 1,118,368 1,691,657 $80.56 $60.09
5.0x 1,397,960 1,971,249 $93.87 $70.03
6.0x 1,677,552 2,250,841 $107.18 $79.96
7.0x 1,957,144 2,530,433 $120.50 $89.89

We believe a 10x multiple of free cash flow and/or a 4x to 5x EBITDA multiple is not an unreasonable valuation for Allstream. This would yield an equity value in 6 to 12 months for the Allstream Class B ALLSB symbol (the most liquid) of between USD $60.00 and USD $70.00 or CDN $79.00 to CDN $93.00 without much downside—around a 50% to 80% increase from today’s trading prices. Despite the cheap valuation, Allstream does have substantial upside due to several factors discussed below.

Telus Acquisition: Since Allstream filed for bankruptcy in 2002, there has been much speculation in the Canadian newspapers and among analysts that the Company would be acquired by Telus—the ILEC in Western Canada. There are two primary reasons for this speculation. First, Allstream management has made it abundantly clear in conversations, media interviews, conference calls, etc that they want to sell the business at the right price; If you refer to Page 5 of Allstream’s recent investor presentation mentioned earlier in this write-up—which if any VIC members are ex-investment bankers will remind you of a pitch-book, you will see Shareholder Value Drivers 3. “Participate in further consolidation of telecom industry;” it is very rare that one finds such an unmistakable desire by executives to sell their Company and unlock shareholder value.

An acquisition of Allstream by Telus makes a lot of sense intuitively. Telus is notoriously weak in Eastern Canada outside of its incumbent area and could benefit from Allstream’s corporate customer base and state-of-the-art network. Second, although Telus will not be a cash taxpayer until 2006 because of its acquisition of cell-phone provider Clearnet, Telus is a large corporation that will likely generate over $1 billion in EBITDA – Capex in 2003 and could consequently utilize Allstream’s NOL in a shorter timeframe. Finally, Telus could eliminate enormous overhead in SG&A and earn high incremental margins on new business—not to mention eliminating a competitor and thus alleviating price competition.

For these reasons, Telus attempted a takeover of the old AT&T Canada in 1998, but discussions supposedly fizzled due to Allstream’s high debt load and various other factors. Nonetheless, the CEO of Telus has denied any interest in Allstream. "We are not looking at that asset and it is a cold file in this organization," he said. "If you are a Telus shareholder and find out that I am devoting intellectual effort to Allstream, you should spank me," he said. Many observers believe Telus will wait to acquire Allstream to reduce its debt load, solve its union problems, and integrate the Clearnet merger. While no specific probability can be assigned to an acquisition, we partly consider owning Allstream stock receiving a free call option on a potential Telus acquisition.

Foreign Acquisition: Another potential catalyst for Allstream is the lifting of foreign ownership rules for Canadian telecom and media companies. Currently, foreigners can own 20% of an operating company and 33% of a holding company—creating a maximum point of 46.7%. This acts as a natural barrier to industry consolidation. If rules are changed, one might expect some interest from foreign acquirers such as Deutsche Telecom. In the spring of 2003, Industry Minister Allan Rock recommended the removal of foreign ownership restrictions, but was not approved by Heritage Minister Sheila Copps.

However, Allstream COO John McDonald has indicated on the record that the lifting is “not a question of if but when.” After the current Prime Minster and his cabinet meet for the final time in December, progress is expected to begin and many experts believe the rules will be changed by the end of 2004. Another possible benefit is that foreign interest prompts Telus to act sooner rather than later.

Regulatory Front: As an alternative carrier, Allstream owns fiber covering 80% of its target market but must pay exorbitant access fees to the incumbents when serving customers on the remaining 20%. When bidding for contracts predominantly on Allstream’s own network, it is the natural low-cost leader because it has no interest expense—whereas Bell and Telus are far more levered and have to support the cost of their networks. This is a key advantage for Allstream and has allowed them to maintain a competitive advantage over Bell and Telus outside of their incumbent areas. However, the cost savings Allstream has from its new lean capital structure are dwarfed by the $400 million of annual access fees it must pay to the incumbents. There are two types of services that cost Allstream differing amounts of money. Certain services are cost-plus services which allow Allstream to pay Bell and Telus a standard markup and end up being a reasonably fair wholesale rate for Allstream.

However, a little known fact is that Allstream must pay 2/3 of its access fees or $266 million to purchase access at RETAIL RATES that are sometimes higher than what Bell and Telus can charge its own customers. Management estimates that it is overcharged 60% relative to cost-based access. As one might expect, this phenomenon sometimes forces Allstream to lose money on parts of many large contracts if it can stomach the losses and/or prevents Allstream from bidding on certain contracts if the contract is uneconomic. In FY2002, Allstream paid $445 million in access fees and Allstream expects to pay around $400 million in fees this year. That is $45 million in incremental EBITDA right there. It is precisely these cost savings that provide a margin of safety for Allstream’s EBITDA and give us assurance that the business can be valued on a run-rate.

Fortunately for Allstream, there are several recent actions by the regulator to increase competition in telecom. In May 2002, the Canadian Telecom Regulatory Commission or CTRC reduced the payments Allstream makes to ILECs by 8% to 10% on cost-plus services. This reduction constituted a majority of the $45 million in access fee reduction. In December 2002, the CTRC changed certain services from retail to cost-based. Allstream recently filed an application for access to gigabit-ethernet on a cost-plus based access structure. In addition, management stated that Bell and Telus have overcharged them for years on access fees and the regulators are now sending auditors for the first time to ensure fair billing practices. While it is difficult to quantify the potential benefit from regulatory relief, we believe the trends are clear and that the wind is behind Allstream’s back. If Allstream were ever able to convince regulators that paying retail for $266 million worth of fees is unfair, Allstream would save 60% of $266 million and generate $160 million of incremental EBITDA. IF THIS BENEFIT IS FULLY REALIZED, A 4X MULTIPLE OF THIS INCREMENTAL EBITDA ADDS AN EXTRA $30.47 PER SHARE TO ALLSTREAM.

Also, Allstream’s top-line would benefit because it could start bidding for contracts that were previously unprofitable on the margin.
Finally, Allstream management has remarked about disruptive technologies such as fixed wireless on several conference calls. This is interesting because there might be a point in the future in which fixed wireless is ready for prime time and could prevent Allstream from having to pay a huge amount of access fees to Bell and Telus. We are not worried that management will spend capital unless it is convinced the fixed wireless technology will save Allstream money. Obviously, fixed wireless has an awful reputation because of Winstar and Teligent, but this may end up surprising a few people down the road. We view this $400 million in access fees as a huge opportunity for Allstream to reduce its cost structure and with only 20 million shares outstanding, the potential is enormous.

Catalyst

1) Management On the Road: Allstream executives hosted an investor luncheon in New York City a couple of weeks ago and have attended two conferences in the past week to articulate the story to prospective investors. Previously, they were rather quiet which is typical of post-reorganization companies.

2) Solid Financial Results: Once Allstream continues to beat its sandbagged estimates, the Street will realize the numbers are sustainable and reward the Company with a real multiple of cash flow.

3) Acquisition: Any bid of the Company by Telus or a foreign acquirer once and if foreign ownership rules are relaxed should provide upside.

4) Regulatory Relief: CTRC decisions could result in a more favorable cost structure going forward.