Description

CBeyond

Ticker: CBEY

Stock Price: $16

Market Cap: $475 mm

Cbeyond ("CBEY") is an IP based telecom provider focusing on small business clients that is trading over 200x earnings.  The market mistakenly views this as a growth company as it has been growing revenue by opening up new markets.  However, without any unique assets, intellectual property, or service offering, I find it hard to justify such a rich valuation for a business caught in the competitive cross hairs between cable and telco companies. As this seems like a recipe for disaster in my book, I recommend a short of this equity.

Business

CBeyond is an IP based telecommunications company whose existence is based on the ability to lease T-1 lines at a wholesale rate from the local exchange carrier and re-lease them with services to their clients.  In 2000, the company launched what was at the time a unique offering targeting small businesses with 5-249 employees.  CBEY launched originally in three markets, and was able to gain share by offering a cheap alternative to the local exchange carriers for a businesses' telecom needs.  

With this initial success, CBEY took themselves public in 2006 and gained the capital necessary to launch new markets.  Their target market is defined as the top 25 MSA's, where they believe there are 1.4 mm businesses.  The company currently serves 12 markets and its stated goal is to open up 2-3 new markets per year.  The company believes that by concentrating on small-businesses, they face limited competition as this customer base has been historically under-served.  According to CBEY, this customer base appreciates their high-touch sales force.  In theory, they also appreciate the fixed monthly payment structure of one to three years, allowing for budgeting simplicity. 

Unfortunately for CBEY, since 2000, the world has changed.  Today, instead of being underserved, small businesses are focus customers for both the cable companies and telco companies.  A bundled offering is now standard, vs unique, and the small business customer has limited access to credit and therefore may balk at a long term commitment, especially given a declining price environment.  While CBEY only admits to the economic effects, the increase in churn is likely due to all the above mentioned reasons.  CBEY's churn sits at 1.5%/month today vs 1% historically. 

Numeric points

While I don't deny the company showed success in its original markets (Atlanta, Dallas and Denver), it is difficult to see comparable success in their newer markets.  The original markets took 17 months to become EBITDA profitable, and today, the markets are taking at least 24 months or more. 

The slowdown of profitability implies a steady increase in competition.  EBITDA margins in the newer markets also remain stubbornly below that of the initial markets ~ a difference of about 1000 bps exists between Houston and Atlanta despite Houston being EBITDA positive for four years.  And this margin gap has remained steady for the last five quarters. 

In terms of quality of earnings, there are a number of significant problems.  There are indications that revenue is under pressure and/or the cost of acquiring customers has increased.  For example, the company showed accelerated customer growth in the 1H, yet they tempered revenue guidance.  In fact, they had the best quarterly gross adds ever, but given their rising churn rate, their overall customer growth rate decelerated.  In addition, the SG&A per market has continued to increase, resulting in the highest level per market ever, and leading to the steady margin decline.  Their cash balance has also been steadily decreasing, demonstrating a significant decrease in FCF while EBITDA has remained suspiciously steady.

The company continues to blame a poor economy, but denies any effect from the new cable entrants.  Yet both CMCSA and TWC mgmt claim both success and substantial growth in this area at GS's annual media/telecom conference at the beginning of September. 

Valuation

The company trades at approximately 10x trailing EBITDA and over 200x next years estimated earnings.  In order to justify the rich valuation, the street has made the blanket assumption that CBEY will achieve 10% market share in all of its markets, despite its inability to reach this market penetration in even its most successful market.  CBEY's market penetration in its best market is only 5%.  And, as you see above, even if CBEY is able to attain this share, it seems probable it is either with lower revenues or higher expenses than expected. 

Catalyst

1)      Earnings ~ potential for a guidance decrease

2)      Realization of the truth: ultimate growth and profitability is impaired given cable competition