Description

I believe shares of Mitel Networks (MITL) are materially undervalued today. Under a reasonable sum-of-the-parts valuation approach, I believe shares are worth at least $10, which represents more than 42% upside compared to the recent close. This valuation gives no credit to acquisition-related value creation from the company’s M&A strategy, which is a key feature for further upside.

Mitel Networks was written up ~15 months ago by Freestate. The story has changed a fair amount since then but I’ll refer you to that write-up (which explains the business and the power of the acquisition model in particular) along with a detailed write-up on Vonage last month by Lukai – both write-ups will provide more detail on the unified communications (“UC”) business, which is the predominant space that Mitel operates in.

Mitel has 3 segments. Segment 1 is a traditional on-premise unified communications business serving mid-market enterprise customers. Mitel provides enterprises with phone hardware (including actual handsets) and related software (virtual PBXs, auto-attendant, four-digit dialing across HQ and branch offices, call-forwarding, etc.). Mitel is a top 3 player in the U.S. and the top player in Europe. This business is a secular decliner as enterprises shift to cloud-based UC but is being managed for cash. Key assumptions (which are laid out rather clearly in a November 2015 investor day) are for a -5% annual revenue decline and ebitda margins of 20 – 25%.   

Segment 2 is basically the same as Segment 1 – enterprise unified communications – but using a cloud deployment rather than an on-premise deployment. Pure-play competitors in this space would be RingCentral and 8x8, although Mitel is generally further up-market in terms of enterprise sizes (though the competitors are headed that way also). Mitel offers a pure public cloud offering (common infrastructure for multiple clients, which is what RNG and EGHT offer) as well as a private cloud offering (which virtualizes a unique customer’s on-premise system). Note that this segment isn’t a pure match for RNG or EGHT because there are some non-recurring product and other service revenue lumped into the segment, which together with a partially wholesale approach depresses gross margins from those peers’ levels. MITL is transparent and breaks out these various streams in their financials and also breaks out the recurring cloud revenue and seats in their investor materials for comparability. Like many peers in the cloud UC space, MITL’s cloud business is still subscale but is growing rapidly. The segment is guided to a 20% growth rate but I believe it will do better, as evidenced by FX-adjusted 3Q results of +34% growth and a strong 4Q pre-announcement that while not singling out cloud revenue growth may imply an even faster rate. As revenue grows and the data centers are filled and R&D is leveraged, this segment should get to double-digit ebitda margins but perhaps not for another couple of years.

I should note one important factor here – as the industry switches from on-premise deployments to cloud deployments, this plays very well into Mitel’s favor. Not only should the company receive a higher market valuation but the actual economics are actually much better and both MITL and competitor SHOR have slides that brag about how quickly a cloud customer who pays monthly becomes more valuable on a lifetime value basis as compared to an on-premise customer who pays in a lump-sum, up-front (it’s often as early as year-2 when the cloud customer becomes more valuable, while the overall lifetime value may become a multiple of on-premise customers). In fact, a well-capitalized enterprise with a capable IT department should most likely continue to prefer on-premise deployments, and many do. The takeaway here is that there’s a really valuable business model transition underway at Mitel, albeit one that may not be immediately seen as aggregate revenue growth is dampened by the decline in on-premise revenues.

The final Mitel segment is “Mitel Mobile” or what was “Mavenir”, prior to Mitel’s acquisition of that company in early 2015 (I’ll refer to the segment by its former name “Mavenir” for this write-up). This segment is probably still poorly understood and the acquisition was the trigger for the painful stock trajectory in much of 2015 as analysts didn’t understand why Mitel strayed from a cost-takeout driven UC acquisition strategy (i.e., in the mold of the Aastra acquisition) to acquire a high growth mobile infrastructure player with limited synergy. Despite being a deviation from the company’s core business, I believe Mavenir is a very valuable asset and another source of hidden value within the overall Mitel business. I’ll allow you to read the company’s ample material for full detail but Mavenir is best described as a software driven mobile infrastructure provider who is enabling the build out of 4G networks, VoLTE calling, and VoWiFi calling. T-Mobile is Mitel’s “lighthouse” customer but the company has >30 footprint wins including large cable companies. Just yesterday, Mitel announced a deal to power VoLTE services in Indonesia. VoLTE and VoWiFi are highly strategic projects for these customers and have fairly well-defined growth trajectories (as telecom companies are still early in their penetration of the 4G TAM). To be certain, serving the telecom industry and going up against their long-time suppliers is no simple task but Mavenir has impressive customer wins (which have accelerated after Mitel’s acquisition) and has generally delivered strong growth thus far. The segment is guided to 20% growth and a margin ramp from low-single digits to 20+% over the next few years as the company gets past the lab testing / hardware rollout launch phases and hits steady-state deployment mode with software margins (70+% gross margins). One final note here is that while this may be perceived as an undisciplined acquisition, Mitel’s CEO Rich McBee (an alumnus of Danaher Corp.) prides himself on running an extremely disciplined acquisition process and had been scouting Mavenir for years prior to the deal. While this was a growth deal (rather than a cost synergy deal), it does not represent an undisciplined process, which bears mentioning as many investors will ultimately be attracted to Mitel for its deal-making potential. I believe Mavenir is a genuinely innovative company and I wouldn’t be surprised if this acquisition is ultimately looked at very fondly, despite the initial share reaction in 2015.

So, from the above, we are able to see that Mitel has a few pieces: a large, cash-producing but top-line-declining on-premise segment and then two fast-growing but currently sub-scale segments. What’s really nice about the story (and distinguishes MITL from virtually all other UC companies) is that the aggregate business still produces cash flow and is expected to be at a ~16% (non-gaap) ebitda margin in 2016.

Onto my valuation, below I will lay out a simple sum-of-the-parts valuation approach. Everyone is, of course, entitled to pick their own multiples and estimates but I hope the margin of safety will come through here. I will use 2017 metrics to inform a YE 2016 valuation timeframe.

Premise segment
- 4x 2017 EBITDA of ~$185 mm = ~$740 mm of value
- I think 4x EBITDA is amply conservative here. The segment was guided to only a -5% revenue decline (while management hopes to do better) and it makes sense that there be a long revenue tail here given the cost-effectiveness of an on-premise deployment (from the enterprise’s perspective) that I detailed above.

Cloud segment
- 2x 2017 revenue of ~$230 mm = ~$460 mm of value
- The business features 75% recurring revenue and features strong customer lifetime values as described above.
- RNG and EGHT (after some price declines over the past month) are trading at ~2.5x – 3.25x their 2016/2017 revenue estimates and so using 2x represents a meaningful discount to those levels owing not necessarily to a slower growth rate (MITL is adding more cloud seats than those players) but to the lower margin profile detailed earlier.
- If you’re a staunch opponent of revenue multiples then you can adjust accordingly. EBITDA will become material in 2018 as the growth phase matures.

Mavenir (Mitel Mobile) segment
-2.5x 2017 revenue of ~$243 mm = ~$606 mm of value
- This is a slightly higher value than the $560 mm Mitel paid for the business in early 2015. Since that time, Mitel has nicely expanded the customer base and integrated operations.
- Ultimately, upon scale, this should be a 70+% gross margin business and will operate on a perpetual fee license model
- EBITDA for this segment will really ramp not until 2018 and this valuation translates to a ~9x EBITDA valuation on that metric.

Summing up the above segments, and subtracting ~$515 mm of YE 2016 net debt (estimate) gives me nearly $1.3 bn of YE 2016 equity value and >$10 of per-share value (>40% upside). Each $50 mm of value translates to ~40 cents of share price for sensitivity purposes. As I’ve alluded to, I have not included any upside from M&A in my valuation despite this being a material source of further potential upside (the Aastra deal ultimately had more than $80 mm of synergy).

I believe the valuation upside shines through on a consolidated basis as well; a $10 target price would still be <10x 2017’s EPS. The current share price and consensus estimates have MITL trading at <7x on both an EV/EBITDA and P/E basis (for 2017). I think these multiples are far too punitive given the business transition, tucked-away growth businesses, and a disciplined management team.

Further, even if growth isn’t quite as strong as projected, the combination of the company’s free cash flow and deleveraging will help support equity value.

Catalyst

- Continued execution. The company will report 4Q and FY 2015 on 2/25..
- Validation of the Mavenir business through further revenue growth and margin accretion
- Debt paydown. Leverage is currently near 4x (not a good thing in this market) but management plans to get under 3x next year.
- Some turnover of the shareholder base. Elliot Management has amassed a stake in the MITL stock and, in a letter directed to Polycom (Elliot also holds PLCM shares), encouraged consolidation in the space and suggested Mitel as a potential deal-partner for Polycom). This deal likely attracted some fast money into the stock and, as a deal has not yet materialized, MITL shares may have suffered as some investors may now be exiting for other opportunities.
- Actual M&A. Mitel takes M&A very seriously and is constantly searching for targets, of which there are many – UC is still very fragmented with lots of smaller players scattered throughout the world. Deal synergies are meaningful and a deal announcement could reinvigorate interest here.