Description

Boingo (WIFI) is a short because the business will never generate margins or cash flow that are anywhere near high enough to justify its equity valuation, and something will almost inevitably go wrong to crush the bulls' "jam-tomorrow" expectations.  It is possible that they never report a GAAP operating profit again.  My bullish scenario for the business, if everything goes as management hopes, yields an $8 DCF valuation for the stock, 20% downside.  I think it more likely that something goes wrong and fair value is closer to $5, 50% downside.  This downside could come quickly if something bad happens to the business, or, if everything goes well for the business, it could come through years of alpha as the stock stagnates while the S&P 500 pays dividends and marches higher.  The likely result is somewhere in the middle: The stock will probably present good trading opportunities from the short side, bouncing around such that you can cover lower and re-short higher.  I would not be surprised to pull 100% profits out of this position over the next few years.

This position is likely a longer-term short.  I am posting a recommendation now because it looks like a great entry point.  Boingo just reported earnings, and the stock at $10 is 25% above its low of $8 from six weeks ago and 12% above what had been a three-year high of $9 two months ago.

My thesis depends less on the specific details of what is happening now – no bearish channel checks, no looming specific problem, no “they are going to miss the next quarter” – and more on the structural analysis.  I can’t tell you what the catalyst will be, only that odds are excellent that there will be one.  I have 17 years of experience as a strategy and operations consultant for telecom and technology companies and then as a tech/telecom-focused hedge fund manager.  I have seen this movie before.

My exaggerated and knowingly imprecise description of the average telecom business, from the owner’s perspective, is this:  Dig a hole in the ground, throw tens or hundreds or thousands of millions of dollars into the hole (capex), and pray.  Pray that you can earn back your capital cost before either the technology you just bought becomes obsolete or new entrants pile in and destroy the margins.  In the old days, people literally dug holes in the ground to hold the wires.  Now you might be launching the money into the sky (satellites), hanging it on towers (cellular), hiding it in corners or behind stadium seats (wifi), etc.  To put it in academic terms, telecom businesses tend to have high up-front capital requirements, high technology risk, and low barriers to entry. The big boys like VZ and T have enough structural advantages, technology diversification, government help, and cash flows such that their risks end up being fairly low.  For almost everyone else, owning the equity of a telecom business, on average, sucks.  For an obvious example, see my saga with magicJack (CALL), especially message board my post #206 upon recommending exit.  I knew I was getting into an inherently bad business but played for a short term win, won big, then overstayed my welcome and lost all my profits when it went obsolete surprisingly quickly.

Another important pattern-recognition overlay is the usual management behavior when faced with declines in their core business.  Managements have an overwhelming imperative to grow their business.  Almost all of them attempt to expand into adjacent or nascent areas so that they can keep growing instead of shrinking.  Most of the time, the new areas will yield lower returns on capital than the legacy business.  Most of the time, management will claim that start-up margins are low or negative but will improve.  That is usually true directionally, but most of the time, management claims (and probably believes) that margins will improve more than they actually will.  A depressing amount of the time, the step-out destroys value; it fails to return its cost of capital or even loses money on a cumulative basis.

The combination of these two factors is toxic for an equity owner.  Telecom management teams, more than most others, will spend the up-front capital  on loss-making growth that either never earns a profit or never earns nearly enough to pay for the capital and up-front losses.  One prominent example that springs to mind is Earthlink, whose management I met with ten years ago.  They had an extremely profitable but slowly-dying dial-up internet access business, and their answer then was to sink several hundred $million into building outdoor public wifi networks for municipalities and try to charge people for access.  It seemed obviously dumb at the time.  After that, they tried their hand at pretty much anything and everything a small telecom network operator might plausibly try.  Here is how they describe themselves today:

EarthLink (EarthLink Holdings Corp.,NASDAQ: ELNK) provides managed network, security and cloud solutions for multi-location businesses. We help thousands of specialty retailers, restaurants, financial institutions, healthcare providers, professional service firms and local governments deliver a reliable and engaging customer experience in their stores and branch offices. We do so by building and managing MPLS WAN networks, by providing virtualized infrastructure, security, hosted voice, secure WiFi and compliance solutions, and by offering exceptional customer care. We operate a nationwide network spanning more than 28,000 fiber route miles, with 90 metro fiber rings and secure data centers that provide ubiquitous data and voice IP service coverage. Our EarthLink Carrier™ division sells facilities-based wholesale telecommunications to other providers and our award-winning Internet services connect hundreds of thousands of residential customers across the U.S. For more, www.earthlink.com and follow @earthlink, LinkedIn and Google+.

And here is how that has worked out for their shareholders, compared to the S&P 500.  Even after doubling in the last six months, the stock is trailing the S&P 500 by roughly 120 percentage points of returns including dividends.

Which brings us to Boingo.  If you have never looked at the business, you probably know it only as the company that sells you wifi access in airports, either for a fee or subsidized by the airport authority and advertisements.  That is their legacy business, and it is dying.  Just like with CALL, cellular broadband and smartphones have eliminated the demand.

They also have three newer businesses:

1. Distributed Antenna Systems (DAS).  Boingo builds small-cell cellular networks in high-traffic venues like airports, stadiums, hotels, and university campuses to supplement the mobile carriers’ own networks.  Carriers pay Boingo a fee to offload their traffic onto the Boingo network.
2. Wifi offload.  Led by T-Mobile and Sprint, mobile carriers are now enabling the offloading of voice calls from the cellular network to wifi.  Earlier this year, Sprint and Boingo announced a deal for Sprint to offload calls to Boingo’s wifi network.  (This is why I now think CALL has no chance of success.)  The Sprint deal alone should create some nice revenue growth.
3. Military.  Boingo struck a deal with the Department of Defense to build wifi networks on most U.S. military bases.  Military personnel must pay for their own subscription.  Boingo just started this business in late 2013 and started reporting revenue numbers for it in 4Q14.  It is growing like a weed.  They had 100,000 “covered beds” (resident military personnel) in 3Q14 and 160,000 in 2Q15.  Subscriber penetration has grown from 7% in 3Q14 (7,000 subs) to 25% in 2Q15 (40,000 subs).  These numbers translate to 500% year-over-year revenue growth.  Management forecasts 225,000 covered beds by year-end and up to 300,000 by the end of 2016.  After that, the covered beds growth stops and further growth would need to be through increased penetration.

Here are the revenue numbers by reported segment, cobbled together from a combination of 10-Qs and earnings calls.  Management did not begin splitting out DAS and military until 4Q14, so the revenue numbers for periods before that are derived using the year-later growth percentage numbers given by management.  The new 3Q14 splits will not be available until next quarter.  DAS, retail, and military line up cleanly with their product offerings.  “Wholesale” includes both the traditional wholesale wifi revenue paid by, e.g., airport authorities, as well as the new call-offloading revenue from mobile carriers.  “Advertising & other” revenue comes from the same wifi installations from which Boingo generates retail and wholesale revenues.

The new business lines have kept total revenue growth nicely positive, despite the increasingly severe decline in retail wifi.  Total revenue growth dipped to 4% in 2013 but rebounded to 12% in 2014 and should be 15-17% in 2015 and 2016.

All these new businesses are probably a much better idea than Earthlink’s municipal wifi networks.  Even so, all the new revenue may be value-destroying.  Here is Boingo’s annual EBIT and EBIT margin:

Cash flow is much worse because, to enter these new areas, they are pouring capex into the big metaphorical hole.  In 2014, D&A was $31m, 26% of revenues, while capex was $71m, 59% of revenues.  Thus with net losses of -20m and 5m of net working capital usage, they had negative free cash flow to equity of -$64m (on a current market cap of $365m).  Management has not yet provided a 2Q cash flow statement, but they forecast  $40m of “non-reimbursed” capex in 2015, which should still be more than D&A.

These numbers will improve.  The newly-built networks will fill up with more revenue at high incremental margins.  (But remember, retail wifi is declining at high negative incremental margins.)  The capex will slow.  At least for a while, capex could drop below D&A.  But that is not enough.  In Boingo’s best year, 2011 EBIT margin was 12%, EBITDA margin was 27%, and capex still was greater than D&A by 3% of sales.  Management claims their new businesses can eventually get to 30% EBITDA margins.  For me to get to an $8 DCF value, I need to assume:

• Revenue grows double-digits for several years and slowly tails off to 5% in year 10
• EBIT margins climb to 13%, above their all-time high
• EBITDA margins climb to 31%, above management’s hope
• D&A/sales drops from 26% to 18% over time
• Capex/sales drops even lower, from ~30% this year to 16%, below D&A for many years, even though their capex has never been less than D&A.  (So free cash flow to equity is better than GAAP earnings.)
• Capex and D&A converge in the terminal year
• 10% WACC, 3.5% terminal growth rate

Meanwhile my model has them burning through $60m between now and when they turn cash-flow positive in 2019.  They currently have $21m in cash and $13m debt, $7m net cash.  They recently initiated a revolver loan with $50m capacity.

And that is if everything goes right.  This is telecom.  Something always goes wrong.  I cannot tell you what precisely will, but some combination of operational difficulties, customer delays, disappointing subscriber take-up, new competition, new technology, or “unforeseen” capex needs (e.g. for increased throughput) will disappoint.  The rule is, don’t short merely on valuation.  I do not view this as a pure valuation short.  It is overvalued even on an overly-optimistic scenario, but my most likely scenario is in the medium term there is some hiccup, or two or three, or something seriously wrong, and shorts enjoy a very quick 20-30% whoosh down.  If the whoosh takes a while, I am happy to have this stock stagnate as a true hedge to my longs.

Catalyst

I don't know what the catalyst will be, but the field of candidates is rich; see the last paragraph.