Description

Like many investors we are usually wary of M&A but we think Mitel’s (MITL) proposed acquisition of Shoretel (SHOR) is the exception to the rule. Mitel/ Shoretel will be the second largest company behind RingCentral in worldwide Unified Communications as a Service  (UCAAS) which is a sticky and growing niche. It’s debatable to what extent UCAAS is a commodity but it’s well understood that basic business telephony is an essential need and there’s a huge annoyance factor involved with switching providers. Bottom line: Not only are Mitel and Shoretel identical companies but Shoretel was wildly overspending.  We think Mitel will blow away their proposed $60mm in synergies which will unleash substantial free cash flow for rapid deleveraging. At the same time we are buying Mitel at a low point as relates to revenue growth in its recurring cloud business which can only get better with the addition of Shoretel which was growing much faster in cloud.  Mitel might not be as sexy as RingCentral, 8x8 or Vonage but on a risk adjusted basis we think it’s the best name in the space.

History / Background

By way of background, Shoretel grew rapidly between 2004-2012 to emerge as a leading provider of business communications services for small businesses in North America. The business model was a capital sale of a premise based phone system called a Phone Branch Exchanges (PBXs) followed by a maintenance and service revenue stream . Shoretel generated a decent gross margin on its hardware in the low 60%’s and even higher gross margin on maintenance and service contracts which have averaged in the mid 70%’s.

While the rest of the industry was racing towards the cloud and offering hosted PBXs and charging customers a monthly recurring service fee instead of a one time capital charge,  Shoretel was late to the game and only entered the cloud market in 2012 with the purchase of M5. TTM revenues for consolidated Shoretel were $357mm with 40%  coming from hardware, 20% from service, and 40% from recurring cloud. While Shoretel has managed to grow its cloud revenue  at a high double digit rate for the last several years and keep  service revenue flat, product revenue has been declining at a double digit rate.

   Mitel made a run at Shoretel in November of 2014 and offered $8.50/share but Shoretel’s board rebuffed the offer:

http://investor.mitel.com/releasedetail.cfm?ReleaseID=881718

Fast forward to July 27, 2017  and Mitel offered to purchase Shoretel at $7.50/ share and this time the board accepted the offer.  The transaction is expected to close in the third quarter of 2017.

http://investor.mitel.com/releasedetail.cfm?ReleaseID=1034670

A little under a  year ago Shoretel announced they were forming a Strategic Advisory Committee to review strategic alternatives. It’s a fair question to ask why after a year of shopping the company around no one else was interested in the asset  and why Shoretel was willing to settle for a lower price even though they had demonstrated meaningful growth in their hosted cloud business.  We think the answer to this question speaks to  Mitel’s unique position within UCAAS and why Mitel is likely to grow its market share in the future.

Within UCAAS there are two basic go-to-market strategies. On the one hand, there are pure hosted cloud players like RingCentral, 8x8, Vonage, Broadview, West, and Fuze. There are slight variations among the different providers,i.e., some run off Broadsoft software and some offer enhanced MPLS connectivity but the basic ideas is the same: a pure over the top service where all the hardware sits in the cloud. On the other hand, there are hybrid players like Mitel, Shoretel, Cisco that sell a combination of hardware and hosted solutions depending primarily on the size of the client (for the purpose of simplification we are excluding Avaya  which primarily offers legacy PBXs).  While Wall Street has embraced the sizzle of the pure cloud story and believes it will take over the world, for many companies, especially those with greater than 1000 seats, it’s much cheaper to buy a traditional PBX for their headquarters  and service branch offices with cloud offerings . It’s a rent/ buy decision and the answer depends on numerous factors but the basic idea is the hybrid guys can sell both systems depending on the customer need but the pure cloud guys can only sell the “rental. “ The point is that Mitel’s legacy premise business, which is forecasted to decline -2% to 0%, is ultimately a strategic asset insofar as it enables Mitel to address the entire UCAAS market. It also gives Mitel a huge lead over the competition given the existing relationship and the power of inertia that makes switching undesirable.

It’s for this reason that the natural home for Shoretel would necessarily be with another hybrid player because all the synergies on the premise side would be lost to a pure cloud player. It’s also significant that relative to the paltry free cash flow generation at RingCentral and 8x8, Mitel has always been free cash flow positive. It’s the combination of a strong balance sheet supported by free cash flow and a huge installed base that enables Mitel to be a strong consolidator. Fortunately Mitel played their hand wisely and was able to get Shoretel at a discount to their original offer.

The Deal /Synergies

Even if Mitel only achieves their stated goal of $60mm in synergies by 2019 we think Mitel equity is attractive but we think the the $60mm number is conservative.  We have several data points to back up our hypothesis:

1. Mitel has a long and successful M&A track record and has consistently exceeded their targeted synergy number, most notably in the case of Aastra which management says is the most analogous to Shoretel given the significant overlap.

2. There is no question about it: Shoretel was overspending in a meaningful way.  Operating expenses  as a % of revenue at Mitel are 42% versus  62% at Shoretel. This is not just a case of eliminating overlap but also rationalizing the out of control spending at Shoretel.

3. Management has expressed supreme confidence in their ability to hit their synergy target going so far as calling the Shoretel integration “wildly easier” than Aastra (Aastra had European operations whereas Shoretel is primarily NA focused).

4. This is purely reading the tea leaves but our conversation with top shareholders indicate they are in favor of the deal so there was no incentive for management to overplay the synergy number to sway shareholders who are on the fence.

So what do we think the actual synergy number could be? We don’t see any reason why it can’t approach close to double their estimate, like they were able to achieve in the case of Aastra where they projected $50mm in synergies and achieved $100mm.  But for the sake of conservatism we have arrived  at an estimate of  ~$100mm. In FY 2017 Shoretel generated $357mm in revenue and spent $238mm in operating expenses (67% of revenue). Mitel spends 42% of revenue on Opex. Normalizing Shoretel’s spend for Mitel’s saves $88mm in Opex. Before announcing the Shoretel deal, Mitel  had already initiated a 10% reduction in its workforce for a projected savings of $30mm on an annual basis. So we take roughly half of that savings and add it to the $88mm and we get to our $100mm number.

Valuation

We present below  our projection for what the combined company will look like in 2019. We assume 15% organic growth for cloud revenue, 5% decline in product and service revenue. All other assumptions are based upon management’s guidance outlined in the presentation announcing the deal:

http://files.shareholder.com/downloads/MITL/4882439501x0x950955/CD348EC1-2852-4969-8C67-3E128DC4B445/FINAL_-_2017_07_27_-_Mitel_Q2_and_ShorTel_Aquisition_-_FINAL.pdf

(Non -GAAP for TTM for period ended June 2017):

As Mitel continues to play the long game and transition their huge installed base of 60mm end users to either the cloud or hybrid solutions, it’s likely the market will realize that Mitel is more similar than different to it’s high flying peers which trade at an average multiple of 3-5x cloud revenues. At 3x  run rate of 2019 cloud revenue of $348mm, the cloud stream would be worth $1.0bil by 2019. We value the product and service business at 1x 2019 revenue (assuming 5% decline) and give credit for 2 years of deleveraging to arrive at a stock price of $14/share.

Conclusion

There’s another angle to the story we like which we mentioned in the intro....In the most recent quarter, concurrent with announcing the Shoretel deal,  Mitel reported recurring cloud revenue growth of only 10% which basically places them dead last in organic cloud growth compared to their peer group. Management was quick to point out that bookings have grown 32% in the trailing twelve months and the disconnect between revenue and bookings relates to capacity issues which have been resolved.   The point is that there’s a margin of safety here and we think the combined company will easily grow its cloud business at least 15% organically.

As UCAAS matures and top line growth  rates invariably come down, we think investors will begin to place more value on profitable growth.  Recently, for example, 8x8 which is one of the leaders in UCAAS,  announced it was taking down it operating margin guidance for 2018 from 7-9% to 3% and the stock was hammered:

http://investors.8x8.com/releasedetail.cfm?ReleaseID=1034813

Before pursuing Shoretel, Mitel was already generating a >10% EBITDA margin. We’re confident that Mitel/ Shoretel will increasingly pull away from the pack given their inherently lower customer acquisition costs that come from having an enormous legacy installed  base that can easily be transitioned to hybrid or cloud only solutions. Already trading at a greater than >10% free cash flow yield adjusting for synergies, Mitel appears safe should the growth strategy sputter or take longer to materialize. But if Mitel can just get back to growing in line with the overall UCASS market, we think Mitel equity has substantial upside.

Catalyst

-Deal Closes in Q3

-Deleveraging

-Recurring cloud growth improves