Description

Cbeyond Inc. (“CBEY”) is a very inexpensive unlevered business in the midst of a product transition and a likely re-rating by the market, resulting in significant appreciation.   CBEY currently trades at < 3x EV/EBITDA, and a 12% FCF yield, even after high capex spending that should start to decrease next year as CBEY completes its fiber buildout for its SME customer base throughout all 14 MSA’s in which they operate.  With a 67% gross margin and 18% EBITDA margin, a large customer base, and an attractive cloud based product offering, CBEY is far too cheap at current levels and is a possible acquisition candidate.  I believe the stock is worth as much as 5x EBITDA as FCF improves next year, yielding over $12/share.

Business

Based in Atlanta, CBEY focuses on the SME market, offering bundled telecommunication services with a goal of providing excellent 24/7/365 customer care.  CBEY serves over 58,000 customers across 14 markets:  

Atlanta, Chicago, Houston, Dallas, Denver, Seattle, Minneapolis, Detroit, Miami, D.C., Boston, San Diego, LA and San Francisco.

CBEY offers the traditional, basic service offerings of network services, voice and data.  This category of product offering, labeled 1.0, is still a large majority of its revenue and customer base.  As it has embarked the last few years to convert to an all IP based, Metro Ethernet speed (>10MB) network in all 14 markets, it also has built a suite of cloud based services, and a more comprehensive technology centric product offering called 2.0.   Services include online voice or cloud PBX, virtual servers, managed firewall hosting of Microsoft products, and mobility.   Its Cloud PBX product especially is getting terrific traction.  2.0 based revenues were up 21% YoY in the 2Q, while 1.0 traditional was down 6%.  Those rates should continue according to management and hopefully 2.0 accelerates as they optimize sales productivity and the salesforce into next year.

Their customer focus is on the sub 250 employee company, but their average typically has been well under 30 employees.  The 1.0 product resonated with the sub 30 very well based on price and great customer service.  Cable and ILEC competition remains intense and some customers leave on price alone, regardless of poor customer service.  This is the main contributor to churn, which has been steady at 1.5-1.7% monthly.   The 2.0 product offering is doing well in the 30-100 employee base as typically these companies have more complex needs, more employees mobile and security and managed hosting services are more in demand.  This is the focal point of upgrading existing customers and targeting new ones, especially those already in the building of current customers.  

Company capex to date on its new cloud services and fiber/MetroE buildout is extensive - over $150mm.  Metro Ethernet is available to over 190,000 buildings, with dark fiber to 1000 buildings by end of 2014 (currently 350).  20 year leases with Zayo and FiberLight for this dark fiber rollout.  ARPU on new 2.0 product offering is much higher than exiting ARPU, roughly 80% higher as of last quarter.  2.0 offering is now up to 14.2% of total revenue, double last year’s 6%, and on just 6.9% of customer base.  

Of the currently lit buildings with dark fiber, 80% of customers are committing to fiber.  Should help margin as well as customer churn given higher speeds.  

Reason for stock weakness recently

On July 31, CBEY lowered 2013 revenue guidance from $475-485mm to $464-471mm.  Importantly, EBITDA guidance was kept flat, and FCF guidance actually increased on lower capex requirements.  The revenue guidance implies 2H13 revenues to be slightly down (.5-2%) from 1H13.  This spooked analysts and I think they have it wrong.  

The transition for a SME business to 2.0 often requires education and the sales cycle can be long as the overall monthly bill is likely to double.  CBEY has been focused on upgrading the likely 2.0 prospects, especially those in their current 350 lit buildings.  That is a long list and they are just beginning to understand the salesforce requirements as well as optimizing the more senior sales people to drive this push.  This renewed focus usually forces a portion of the current customer base to be neglected on purpose to improve ARPU and margins - exactly the case here as the legacy lower price tier 1.0 customers aren’t receiving a lot of attention.  This is a major component of churn and management seems fine with it, as early indications are 2.0 churn will be much lower, and margins in the 2Q uptake certainly reflect that 2.0 is more than offsetting 1.0 customer losses.  Importantly, management said on 2Q call that they expect the 1.0 legacy losses to stabilize going into 2014.  ARPU was up $6 from 1Q to 2Q to $662, even though 1.0 revenue was down 6% YoY.

I believe CBEY stock is washed out here, stabilized and an excellent value proposition as the new product offering permeates through the customer base resulting in higher ARPU, higher margins, and ultimately much more FCF as the IRR from its huge investments begin to payoff.  Shareholder and analyst fatigue, coupled with a $20mm share repurchase over next 2 years, offers a great opportunity to accumulate CBEY.  

Balance sheet/Liquidity

CBEY is very underlevered vs its peer group.  Cash was $27mm as of 6/30, $2mm of debt, $75mm credit facility untapped and $14mm of capital lease obligations, mainly fiber leases.  

Company did $7mm of FCF in the 2Q (adjusted EBITDA - cash capex) and expects $18-22mm of FCF for the year, on $76-80mm of adjusted EBITDA.  The company broke into FCF+ territory in 2010 and has done a decent job of generating FCF while focusing on new product offerings and fiber buildout.

Capex has been huge since inception as more than $500mm has been invested in the business. $20mm in capex alone in 2Q ($15mm of it cash capex rest is lease loans from fiber rollout).  Company expects $60-65mm of cash capex for the year.

Shares outstanding:  30.6mm

Price:  $6.4

Market cap: $196mm

Net Cash:  $12mm (includes capital lease obligations)

Enterprise Value: $184mm

2012 EBITDA:  $79mm

2013 EBITDA:  $78mm

2014 EBITDA:  $80mm

2012-14 EV/EBITDA: 2.3x

Estimated 2013 FCF of $20mm offers a 10% FCF yield on market, and 11% on EV.  My 2014 estimate could prove conservative as cash capex will decline $10mm once fiber project complete in 2014.  $30mm of steady FCF should not be valued at 6x.  

Stock was $9 prior to 2Q revenue guidance change.  I expect it to at least return to that level as 3Q/4Q results come inline with that guidance and management supports stock with the buyback.

Catalyst