Description

Eschelon Telecom is an inexpensive (4.2x 2007 EV/EBITDA), fast growing (30+% EBITDA growth) and well run Competitive Local Exchange Carrier (CLEC), headquartered in Minneapolis, Minnesota, and operating primarily in Qwest territories. Eschelon went public in August, 2005, is financial sponsor backed by Bain Capital & Windpoint, and trades at a significant discount to other comparable CLECs. There is no fundamental reason why ESCH has been given such a sharp discount to its non-fiber rich peers, and there are several catalysts ahead which should increase investor interest in the company and drive shareholder value. These include driving synergies out of the recent Oregon Telecom (OTI) acquisition, further accretive acquisition opportunities, increased liquidity due to a recent stock offering, leveraging a clean balance sheet and an acceleration in line sales and collocation build-outs. ESCH has seen its revenues grow from $60 million in 2000 to over $225 million in 2005, with margins expanding from deep in the red, to Q1 2005 margins north of 21%. Continued margin expansion through scale, effective cost controls, network optimization and synergistic acquisition growth should drive the company’s valuation going forward.

Eschelon is a facilities-based provider of communication services to over 50,000 small and medium businesses, typically with fewer than 100 employees. As of March 31, it has 427,521 access lines in service, 87% of which are “on switch”. The remainder were categorized under the old UNE-P regime, and are now negotiated rates mostly with Qwest under the QPP plan. Where the company owns their own collocations and switches, they do not own most of the fiber (unlike fiber-rich CLECs such as TWTC or Broadwing which do and should garner higher multiples), and lease it under primarily UNE-L arrangements with Qwest. The company has demonstrated a mix of organic growth as well as successful acquisitions of other regional CLECs, done to gain access to a larger customer base and drive significant operational synergies out of the combined business.


Overview & Strategy
ESCH provides telephone and data services in Arizona, Utah, Washington, Oregon, Colorado, Nevada and California. The Company’s strategy is to target small and medium sized business that are often overlooked and relatively unimportant to the RBOC in their territory, Qwest. They have been successful in taking away customers from Qwest by working with potential customers in a consultative manner, and offering a comprehensive data & voice solution to small businesses. They have over 50,000 customers, with an average of 9 lines / customer. Many of their customers are locations of national chains. On the pricing side, Eschelon does not attempt to win customers by undercutting RBOC pricing significantly, and may price only a few % less than the RBOC, yet 10-20% higher than other CLECs. The company considers its competitive advantage, the level of care and customer service that the customer receives. Customer satisfaction shows up in their low churn number of 1.3%-1.5% per month, which has trended down from a high of 1.8% and stabilized around this level. The company manages its salesforce by targeting strict profitability measures for each new sales proposal, and incentivizing salespeople on selling on-net solutions, which have significantly higher margins.

Over 87% of ESCH’s lines are “on-switch”, and in Q1 2006 and in 2005, over 97% of new total new access lines installed were installed on-net. ESCH has constructed a network of owned switching and collocation equipment collocated in RBOC central offices or carrier hotels and interconnected using primarily leased transport and leased metropolitan loops. ESCH purchases the last mile connection to the customer directly from Qwest in most instances. The company actually did acquire some metro fiber transport with its recent acquisition of ATI, which I will talk about later on. ESCH’s leased metro fiber and long-haul backbone network is fully redundant, and is serviced by the company’s own ATM switches.

The larger fiber based CLECs like TWTC, BWNG and Cogent that serve the enterprise markets stress their focus on success-based capex, meaning that they build fiber to the premises, avoiding the RBOC last mile only when they have a customer contract signed. ESCH makes a clear distinction to differentiate its target market, given that the average size of the ESCH target customer (~9 lines, $350 / month in services), the economics don’t work to service this market while owning the last mile to the customer. Also, contrary to fiber-rich CLECs, ESCH does not have any interexchange, carrier, ISP or wholesale revenue, which has seen a sharp decline over the past few years in pricing, and has harmed the bottom line of these companies. The tradeoff in not owning your own fiber, is having a less capex intensive business but with lower EBITDA margins (20+% for ESCH vs. 30+% for TWTC) Similarly, targeting a larger base of customers make ESCH less susceptible to changes brought upon by carrier consolidation. For ESCH, no customer accounted for more than 0.5% of revenues, for TWTC, the top ten customers accounted for 32% of revenues. I am not commenting on the TWTC business model here, which I do like very much, just trying to stress the level of differentiation between these two types of CLECs.

Eschelon has been successful at growing its business organically, but recently in the past 2 years has also been active in the M&A market, picking up regional CLECs within Qwest markets, where the potential for synergies was high. In October, 2004, Eschelon purchased Advanced TelCom (ATI) for $46 million. Pre synergy EBITDA in the business was $7 million, equating to a trailing multiple of 6.6x. Through line migration, moving customers to Eschelon switches, as well as utilizing several Sonet fiber networks in various markets that ATI had, run-rate EBITDA as of 12/31/05 for ATI was $22 million. This equates to a post-synergy EBITDA multiple of 2.1x. The integration was completed during Q4, 2005, and all of the synergies have now been realized going forward. ATI added 125,000 access lines, and 18,000 business customers. They operate in 6 of ESCHs existing markets, and add 6 adjacent markets and 1 new market, mostly in Washington, Oregon, Nevada and Santa Rosa, California.

Similarly, in January, 2006, Eschelon announced the acquisition of Oregon Telecom (OTI), which closed in April. OTI operates in existing and adjacent ESCH markets in Oregon and has a similar small business customer. OTI added 45,000 access lines, and 6,000 additional business customers to ESCH. The consideration paid was for $20 million, on $3 million of pre-synergy EBITDA, a 6.7x multiple. After all synergies are realized, run-rate EBITDA is expected to be $6 million, equating to a 3.3x multiple, and the company is ahead of schedule in realizing these. ESCH has already begun ringing out cost savings with OTI, by scaling down personnel overhead, shifting HR systems to ESCHs, standardizing pricing, and migrating lines on-switch and expects that its target of 24 months for full synergies will be shortened by a year or so.

As demonstrated by the past two acquisitions, ESCH has shown solid M&A discipline, purchasing assets for reasonable valuations, where significant operating synergies could be realized, creating highly accretive acquisitions. The past two acquisitions will add $28 mm of run-rate EBITDA, for a purchase price of $66 mm, or 2.4x EBITDA.

In terms of additional acquisitions, ESCH commented prior to the OTI acquisition that they have between 6 and 8 companies that they have their eye on to choose from. They were hoping to add $100 mm of Revenue, which is about $76 mm after the OTI acquisition. Their M&A filter requires that the company be within their existing territories, targeting small and medium sized businesses, and the company needs to be EBITDA positive immediately and cash flow positive within 12-24 months.

They have paid for previous acquisitions primarily through the debt markets, and have commented that they would feel comfortable with leverage up to 3.0x (currently at 0.5x). However, on May 15, a day after their Q1 earnings call, they announced the completion of an overnight equity offering through Jeffries, raising $50 million on 2.3 mm shares. I was not necessarily happy with them doing an equity offering, while being underlevered, and trading at a 4.3x EBITDA multiple. Their rationale after following up them was that they felt it necessary to increase their float (which is only about 8 mm shares – this offering increases it by almost 20%). Additionally, they postured that in the medium term, there could be a larger acquisition that they would be interested in, and would need to do an additional debt offering anyway to raise more capital. Integra Telecom (owned by Bank of America Capital Investors, Boston Ventures, Nautic Partners and Shaw Ventures) is a perfect fit within their markets for them, and they would be able to realize more than $50 mm in annual synergies from this type of transforming deal. I do not think a deal is imminent, but scale in this business along with the ability to drive significant cost savings would definitely drive shareholder value.

Products & Regulatory
ESCH sells analog and DSL lines, in addition to T1 products – which generate higher gross margin and have significantly lower churn characteristics. During Q1, 64% of new lines were T systems, vs. 59% in Q4, and 56% in Q1 2005, while churn on these lines is below 1%. Eschelon offers its flex pack T-System products to its customers so they can purchase capacity in byte increments, and can incrementally increase their utilization at modest incremental costs for the customer, but with 60-70% incremental gross margins to ESCH. For typical analog lines, ESCH leases mostly Unbundled Network Elements (UNE-L). Smaller customers are more likely to be served by this, than by T-1 lines. On-switch T-1 and analog lines have gross margins that are between 55-70%. ESCH has about 40,000 lines that are off-switch, meaning they need to lease all Network Elements (UNE-P, which was deregulated by the FCC) and is now known as Qwest Platform Plus (QPP). These lines are characterized by lower gross margins in the range of 45-50% and are only sold by ESCH only to accommodate larger companies attempting to connect more than one branch, of which some may not be in ESCH territories. Off-switch lines generally also have higher churn rates.

ESCH was slightly affected by the FCCs Triennial Review on bundle network element costs, which effectively increased access costs in 2005, much of which was passed onto consumers through price increases. This FCC change had to do with the removal of UNE-P, and renegotiation with the RBOCs negotiated rates. ESCH realized gross margin declines of $600,000 in 2005 because of this, and no further price increases are expected. The original guidance for the 2005 impact was closer to $2 million, so the company was able to pass on more costs than initially expected. In addition, UNE-L pricing, which is still regulated, has stabilized, and is not expected to move one way or another. In order for these costs to increase, the RBOCs would need to file rate cases with individual state Public Utility commissions, and in the past when this action was initiated, costs were actually lowered for ESCH. Additionally, they addressed recent concerns on their Q1 call that because of recent CLEC mergers, metro fiber pricing would be increasing. The CEO commented that this was not the trend they were seeing, and in many instances were renegotiating lower metro fiber rates. The average rate a few years ago for metro fiber leases was $1,500, which they are paying now around $500, and the going market rate is closer to $400, so decreases were still available to them. They also were benefiting from their ATI acquisition (discussed below) which also included several metro fiber SONET rings.

Competition
The markets that Eschelon competes are highly competitive. The typical customer win (over 60% of the time), is at the expense of Qwest not other CLECs. In each market that the company competes, they are the #1 or #2 CLEC. According to the company, the following lists the competitors by key ESCH market:

Denver Minneapolis Phoenix Portland SLC Seattle
1)ESCH ESCH ESCH ESCH Integra ESCH
2)AT&T Integra AT&T Integra ESCH AT&T
3)Cbeyond Popp Cox AT&T AT&T XO

In all of these markets, Qwest is the ILEC, except for a Verizon presence in Portland. RBOCs seem more satisfied at this stage with the current regulatory environment, and see the wholesale revenue they are generating from deals with CLECs as an inexpensive way to participate in this small business marketplace, without spending heavily. In addition, with RBOC focus shifting towards cable competition, net neutrality and video franchising, they are not focused on competing for the small and medium sized business with an extensive team of feet on the street. The company has commented that the competitive landscape remains stable, as it tracks it by its win/loss ratio, which stands at 3:1x (3 lines won vs. 1 line lost) with competitive churn declining to 0.55% / month.

The management team is very strong, with significant history in the telecom and CLEC sectors. They are extremely forward with investors, and are good at defining their operating goals on a quarterly basis, and then focusing the investor community on them. They are incentivized through stock and option ownership, although recently they have been selling through a 10b-5 plan. Management discussed this on the call, that the entire management team together was selling 150k shares, in order to diversify their holdings. While the valuation is extremely cheap, the stock has moved in the past few months, although I think there is a long way to go. (FYI, they will be at the Lehman telco conference next wk)

Private equity funds own about 45% - Bain owns 26% and Windpoint owns 20%. They are active on the board and management believes that they are in the companies for the long run, and have no incentive to sell their stakes until significantly more value is realized. There was a third PE firm, Stolberg Partners which owned a 1.5 mm share position, which was distributed to its LPs back in February.

Financials & Performance
The company has grown revenues organically over the past 5 years at a CAGR of 24%. On a more recent and practical view, over the past 3 years, organic growth has averaged about between 9-12%, with acquisitions increasing this growth rate significantly. Over the past 3 years EBITDA margins have expanded from -2% in 2002 to Q1 EBITDA margins north of 21%. I expect these to continue ramping, as the company completes its OTI acquisition, drives the business organically and gains the benefits of scale. The company has been firm in its cost controls, driving SG&A growth at a much slower rate than revenue growth. Also, the additional capex being spent in the next 2 years to build out additional collocations, should drive higher margins, while signing new customers up “on switch” and shifting older customers onto owned colos.

Operational metrics have also shown solid growth and improvement over the past few years. As mentioned earlier, line churn has moved generally in the right direction, although they did have a seasonal uptick to 1.56% / month in Q1 2006, up from 1.29% in Q4 due to continued integration of ATI (10bps) and seasonality (15bps). Similarly, the percentage of lines on switch has improved from around 75% in Q1 2004 to 87% currently.

On the Q1 call, they announced that they were going to accelerate their hiring of salespeople in new adjacent territories, faster than their planned build-out of collocations. The company now expects to hire 35 sales associates through Q2 and an additional 25 to a total of 265 by Q3 2006. This is 2 years ahead of their previous plan. In addition, they had previously announced the build-out of 60 colocations by 2008, they have also accelerated this plan to finish the build-out by 2007. 20 new collocations will be built out this year by September 2006, increasing the company’s addressable market by 80,000 lines to small and medium sized businesses. Currently, the company has 130 colocations. Because of the acceleration in the build-out and to incorporate OTI, they raised their full year guidance, including a 30% increase in monthly sales run rate and higher capital expenditures due to the accelerated build-out and hiring, and $3.6 mm to integrate OTI. The company now expects to sell 12,000 to 14,000 lines per month vs. 2005 sales / month of 9,000. The company, while FCF positive in Q1 will be slightly FCF negative in the next 2 to 3 quarters before peak capital expenditures subside and FCF growth continues. Below are my estimates, breaking out acquisitions along with the valuation for the company.

($s in mms)
2003 2004 2005 2006 2007
Revenue 141 158 228 270 300
%Growth 15.8% 12.1% 44.0% 18.4% 11.1%
%Org Growth 16.9% 13.1% 6.1% 9.8% 11.3%

GrossProfit $80.3 $84.4 $121 $143 $165
GM 56.9% 59.9% 57.3% 58.7% 61.8%

EBITDA $15 $26 $41 $57 $74.4
EBITDA Margin 10% 17% 18% 21% 25%
EBITDA Growth NA 76% 61% 39% 30%
Op Leverage 65% 22% 39% 57%

Capitalization
Stock Price $16
PF FD Shares Out 17.9
Market Cap $286 mm
Debt $143
Cash $114
Enterprise Val $315 mm

Valuation
2006 2007
EV/EBITDA 5.5x 4.2x

Comps
Broadwing (BWNG) 35x 18x
Cbeyond (CBEY) 15x 11x
Cogent (CCOI) 27x 16x
Covad (DVW) 53x 10x
TW Telco (TWTC) 10x 9x
US Lec (CLEC) 7.5x 6.4x
All CLEC Average 25x 12x
Non Fiber CLEC 26x 11x

ESCH is actually trading roughly inline w/ the RBOCs, VZ & AT&T – both trading around 4.3x, although the RBOCs are growing EBITDA sub-10%, while ESCH is growing EBITDA at an almost 35% CAGR from 2005 to 2007.

In addition to continued execution from management, there are several catalysts which should drive the stock north, with potential upside of at least 50%. Given the strong track record and quality of the management team, the competitive position in the markets, and the demonstrated strength of the company’s operating leverage, I believe the company should be trading for a multiple more comparable to its peers, - north of 6.0x 2007 EBITDA, which gets me to a value above $24 / share. I think as growth accelerates a price higher than this is reasonable. In addition, the downside is limited at this point by an extremely reasonable valuation and managements continued successful execution.

First, the company has already proven that it can drive synergies from the ATI acquisition. It has now turned its attention to driving synergies out of OTI, which has been going well so far. Continued migration from off-switch OTI lines to on-switch lines should reduce costs, while also allowing the company to expand faster in adjacent markets.

Second, the company has other acquisition candidates in the pipeline which, if history repeats itself, will be highly accretive to ESCH. The company is highly disciplined when looking at synergies, and I do not expect that they would acquire something far fetched, or something that could not fit their cash flow and profitability expectations in the same demographic markets they serve. Continuing to acquire companies at post-synergy multiples of around 3.0x, will continue to drive value to the bottom line, and increase the operating leverage of the company. In addition, considering that there is at least one large transformational acquisition out there for ESCH to do, it seems like a matter of time before Integra and ESCH get their differences sorted out and merge. Management has stated that over $50 million of synergies / year could be realized from this combination. Integra competes in many of the same territories, serving the same customer base that ESCH does.

Along with the previous point, ESCH will drive equity value to the company by increasing its leverage as it may need to raise more capital in the future to complete any acquisitions. Especially, given the recent equity offering, the company is very much underlevered, and does not have the most efficient capital structure. The company is levered at about 0.5x, PF for its recent equity offering, while comps on average in the sector are significantly above this. CCOI is levered around 3.0x, as is XO, CLEC is overlevered at 6.0x+, although the industry average is closer to 2.5, according to HY Jeffries report.

The recent stock offering was an important event for ESCH, albeit maybe not the most efficient way to raise capital, when trading at this multiple. The float is around 8 mm shares, and the company trades less than 100,000 shares per day, so increased liquidity and the ability for some larger institutions to take positions, will definitely help the way the stock trades.

As I talked about before, the increased confidence in the business management has shown by accelerating their investment process in salespeople and collocations, will begin producing benefits in 2007, and will have the benefit not only of selling more lines, especially T1 data lines, but the increased network effect will also be in play. Many of the company’s clients are larger corporations that have branches throughout ESCHs coverage universe, so the ability to add locations to ESCH will help accelerate line growth. The management team has been very good at managing street expectations, and beating and raising guidance over the past several quarters.

Lastly, ESCH has little visibility on the street, only 3 sellside firms cover it – Wachovia, Jeffries & Lehman. As the company gets more research coverage, institutional interest should also increase.

Catalyst

1)Synergies realized from Oregon Telecom (OTI) acquisition
2)Further accretive acquisition opportunities
3)Continued margin expansion
3)Increased liquidity due to a recent stock offering
4)Increased leverage driving value to shareholders
5)Acceleration in line sales and collocation build-outs
6)Sellside coverage