Description

Mitel Networks (NYSE: MITL / TSX: MNW)                                                                 

Target price: $16 / Current Price: $8.52 / Return: ~90%

Cash producing machine that’s consolidating the industry

Mitel Networks is transitioning from a hardware vendor with long upgrade cycles that competed in a fragmented industry to a consolidator with scale selling software-based solutions. A recent major acquisition, a fiscal year change, and new reporting metrics have made the situation difficult to analyze. The Company’s partial revenue transition from a capital sale to a recurring / cloud model ultimately increases the lifetime value of customers, but optically appears like a drag on top-line growth in the near term. The thoughtful investor is presented with an opportunity to buy a Company that is rapidly growing cash flow and is transitioning customers to a more profitable business model before the business begins to inflect in the coming quarters.

With strong cash flow and multiple ways to win I think Mitel will nearly double in over the next 2 years. I believe Mitel will achieve at least $1.20 in cash earnings for 2016 (including $15mm cash restructuring) which I believe can be valued 13x – reasonable given the GDP growth industry, Mitel has organically been gaining share, and Mitel is consolidating the industry. Long term I believe the Company’s cash EPS will growth to $1.50+ Bears contend that Mitel’s on-premise business, which largely consists of endpoints (desktop phones) is declining and they discredit management’s synergy targets given the takeout price. The biggest reason for the valuation, however, is the lack of awareness and a hesitation to get into a hardware business with a long upgrade cycle – the analysts I’ve spoken with indicate that most buysiders are new to the name and generally surprised by the Company.

First Aastra now ShoreTel

In 2013 Mitel announced the acquisition of Aastra Technologies (completed in 2014) doubling the size of the Company and target large synergies. So far, it appears the acquisition was a huge success with the synergy target raised from $50mm to $75mm on a <$500mm deal. In Oct 2014 Mitel announced it had made an offer to acquire ShoreTel (SHOR) for $8.10 / share or just under $500. On Oct 27, SHORs board announced they had rejected the offer. I believe the deal would be accretive and Mitel’s management will likely raise the offer price but will be disciplined with respect to price. That said, an acquisition is not needed for MITL to work and this writeup assumes the ShoreTel deal does not go through – although I believe it could represent additional upside.

What they do

Mitel Networks is a Canadian provider of enterprise IP (internet protocol) telephony equipment and software solutions as well as managed services like call centers. Mitel targets small and medium sized enterprises and offers on-premise, cloud and hybrid solutions under one unified platform. Most products are sold directly to end customers through a partner network and in some cases, Mitel provides service provides a “wholesale,” white label, product that they repackage and sell to customers. Mitel originally gained traction selling private branch exchange (PBX) solutions that effectively enabled enterprises to route inter-company calls and have other phone services managed on an internal network cutting down the cost of telephone service providers.

What has the Company been through

Founding (70s – 2000s): Mitel was founded in the 70s by Michael Cowpland and Terry Matthews (current Chairman of the board) and grew out of a product that enabled enterprise inter-office phone communications. From its early success the Company extended its telecom product line and grew to $100mm revenue by 1981. In the 80s a controlling interest was sold to British Telecom who later sold the interest to European private equity firm Parmira. In 2001 the Company was broken up into several pieces: Terry Matthews purchased 90% of the PBX business, Mitel Networks – the Mitel of today. The manufacturing arm (Brecon Ridge) and the IP portfolio (Mitel Knowledge Corp) were both spun out and the original company, renamed Zarlink, held a 10% stake in Mitel Networks and an acquired semi business. The Mitel of today initially filed to IPO in 2006 but withdrew its filing after it acquired Inter-TEL for $743mm – the deal was financed with $430mm of debt and the remained funds raised from equity funded by Francisco Partners and others. The Company ended up going public in 2010 raising ~$150mm at $14 to pay down debt. The stock immediately disappointed and traded below $5 a year later and would not exceed the $5 value until late 2013.

Present day: In early 2011, current CEO Rich McBee was brought in to run / turn around the Company. McBee was previously the President of the Communications & Enterprise group at Danaher Corp. Before that, he was President of Tektronix which Danaher acquired the Company in late 2007. In November 2013 Mitel announced the acquisition of Aastra Technologies, the 3^rd largest player in Europe and Mitel’s closest comparable by size. The merger was roughly a merger of equals and created the 4^th largest player IP telephony provider globally (Mitel TTM Rev ending Oct ’13 - $592mm USD vs. Aastra TTM Rev ending Sept ’13 - $590mm USD). The stock reacted favorably to the announcement running from ~$6 before the announcement to nearly $9 within a month. Mitel gave the holders of ~12mm Aastra shares $80mm cash and just under 50mm shares of Mitel stock (~44mm shares + some level retention shares) and assumed ~40mm of Aastra debt. In all, Mitel paid ~$470mm (after factoring Aastra’s $89mm of cash on the balance sheet) for a predominantly European company that did $590mm in Revenue and $40mm in EBITDA in the 12 months before being acquired. In May 2014 insiders including Francisco Partners, Terry Matthews and Aastra’s former CEO sold 7.4mm shares at $12.30. Francisco Partners, Terry Matthews and Francis Shen (Aastra’s CEO) currently hold 16.0mm, 9.8mm and 1.5mm shares out of approximately 103.7mm fully diluted shares. Today, after a $25mm debt repayment immediately after quarter close, Mitel has a market cap of $935bn, $109mm in cash and debt and pension obligations of $413mm.

Enterprise Telephony Industry

According to Gartner, Mitel is currently the fourth largest telephony with 8.1% of the market revenue provider behind Cisco (18.1% market share), Avaya (13.7% share) and NEC (9.9%) and has been organically gaining share. The industry took off in the 70s and 80s when automated private branch exchanges (PBX) took the place of corporate telephone switchboard operators that would manually route calls. The industry developed further in the 90s as networking advanced and the internet became widespread. This led to the emergence of internet telephone systems or IP-PBX, particularly Voice over IP (VoIP). Recently, Microsoft Lync has been gaining share as a low cost alternative that’s bundled with other Microsoft products. Microsoft does not provide endpoints though and relies on partners to enable its technology on existing voice networks - Mitel is a Lync partner.

Current Opportunity / What’s Misunderstood

Mitel was initially a difficult investment for me to stomach because the stock had already run from $5 to $10 within the span of a year (which too often stops me from investing in good situations). Additionally, investing in a business that gets half of its revenue from hardware like telephone endpoints with hardware pricing pressure initially had me skeptical but I later came to realize the business model is shifting and has a number of change agents.

1) Deal synergies: Before Mitel acquired Aastra their gross margins were near 56% and their target EBITDA margin was 19-21%. The Aastra business they acquired had gross margins closer to 43% and its EBITDA margin had decline to 6-8%. Initially Mitel announced a $50mm synergies target by 2016 later raising this target to $75mm annually (run rated expected by June 2016). Mitel expects to realize a run rate of $20mm in synergies by the end of 2014, a $50mm run rate by the end of 2015 and the full run rate of $75mm in June of 2016 with roughly half the savings from COGS reduction and half the savings from OpEx. The Company expects to incur cash costs of $83 million to realize these synergies with ~$40mm coming in 2014 (over $24mm was spent in the first half of the year). In speaking with management they indicate that this $75mm is very achievable and, although I do not model it, there may be the opportunity for cost cuts above their stated number. One point that gives me comfort on their synergy target is CEO Rich McBee’s history: Danaher is known as being one of the best M&A integrators and McBee has already expanded Mitel’s gross margin by nearly 800bps since taking over. To summarize the impact of deal synergies Mitel has announced $75mm of annual savings to be achieved in two years – this equates to 6.3% of the total enterprise value or 8.5% of FD market cap of the Company annually. With respect to a potential ShoreTel deal I think Mitel could extract at least $40mm of cost synergies over a 2 year 

2) Cash generating ability: The amount of cash flow the combined business is able to generate is impressive. In the last 4 reporting periods before the announced acquisition Mitel did $93mm of EBITDA while Aastra did $40mm of EBITDA. Using the most recent filings since the companies have been combined it appears that the combined Mitel did $134mm of EBITDA in the TTM period ending 6/30/14 and in a recent investor presentation the Company listed $163mm of LTM EBITDA (inclusive of $13mm synergies). After adjusting for debt expense which is LIBOR + 4.25% on the $304 of term loan with a 1.00% LIBOR floor and other pension and capital lease expenses I estimate cash interest will be no more than $5.5mm per quarter or $22mm annually. The Company’s target tax rate is 20% although they have deferred tax assets and will likely pay less than this rate in the near future. Mitel is well run from a working capital and CapEx perspective. I estimate working capital will consumer $10mm of cash flow annually while CapEx will be at most $25mm – likely something lower. In all this is $75mm of annual cash expenditures subtracted from EBITDA. On the $140mm of base 2016 EBITDA (excluding synergies and accounting for $20mm additional OpEx) I forecast Mitel to produce at least $65mm of cash flow. Add to this whatever synergy level you believe the Company can realize – although I think they have a good chance of exceeding $75mm but $50mm is more conservative. $50mm taxed at 20% leads to an incremental cash flow of $40mm of total FCF of $105. This is 8.8% of today’s EV (including pension liabilities) and 11.9% of the current market cap. I think there is considerable upside to this number if CapEx is lower than I anticipate, growth is higher than my 4.0% annual for 2 years, OpEx creep is less than my $20mm or they do in fact hit their synergy target.

3) Transition to recurring and higher margin revenue model:

- Historical capital sales have long upgrade cycles (how many companies were replacing $80 - $200 phones in 2008 unless they had to) and maintenance was costly - units were often sold with a hardware maintenance contract and in the event of a device failure Mitel or a partner would send an employee to fix or replace the device

- Recurring cloud model give business the choice to “rent” what would be a one-time purchase for many organizations. This is particularly popular for small businesses that don’t have the expertise or the up-front money to deploy company-wide phone systems

- Like renting a car the recurring model is more profitable over time but at first it can appear that the business is decline as illustrated in the example below

- The software based model allows Mitel to remotely diagnose problems and eliminate many of the “boot on the ground” historically required to service failures

4) Growth prospects: Overall, the enterprise IP telephony business is likely a GDP grower over the next several years and will probably decline at some point. I think Mitel is well positioned to grow faster than the market over the next few years for a few reasons. First, Mitel offers and open architecture allowing it to integrate with other IP architectures and, very importantly, Microsoft Lync. I personally believe Lync will be the way of the future and over time most enterprises will transition to phone systems that integrate with Office products and Outlook contacts. Until that day comes though, Mitel offers enterprises solutions to link their legacy architecture to Lync and other cloud systems. This hybrid solution preserves the large investment many companies have made while transitioning them to a less capital intensive infrastructure. It should be noted that Mitel’s main competition offering cloud VoIP solutions to SMB customers does not sell premise and hybrid solutions that leverage existing business infrastructure. Second, Mitel (along with the other largest phone providers) give businesses the choice to have premise, full cloud or hybrid phone solutions – this allows companies to leverage their existing infrastructure. Contrast this with smaller cloud only providers like EGHT and RNG that don’t provide the same level of flexibility.

5) Deleveraging: The Company has indicated that the current $300mm in debt is higher than they’d like. In both announced quarters since Mitel has acquired Aastra they’ve voluntarily prepaid $50mm of debt - $25mm announced after Q1 and paid in Q2 and the same in Q2/Q3. I believe management will continue to reduce debt and only undertake acquisitions that have the ability to deleverage quickly – I wish they could buy back stock at these levels but unfortunately they have the opposite problem with a small float.

6) Management: I’ve had the pleasure to meet CEO Rich McBee in person and I’ve spoken with a few others about him. Consistent with most managers I’ve met with a Danaher pedigree, I believe he is an excellent operator as demonstrated by his ability to improve operations / cost structure of the historic Mitel business, transition the business model to higher growth cloud and recurring revenue model and acquire Aastra for what appears to be a great price – 6x EBITDA if only half the synergies are realized. As the Company delevers and cash flow grows I expect Mitel to do more acquisitions and consolidate the space further – when I met management they indicated there were still good opportunities in the space.

What is it worth?

Above I describe how Mitel is an inexpensive business that will produce a lot of cash and is taking share and growing faster than the GDP growth industry. I model $0.82 of cash EPS in 2015 (inclusive of $20mm cash restructuring costs and $30mm in synergies) and $1.20 of cash earnings in 2016 ($15mm rest. / $55mm synergies). After restructuring costs roll off and some level of synergies are realized I think the business can earn more than $1.50 in cash. I estimate this business will do ~$120mm of FCF to equity in 2016 and will produce more than $100mm in cash from now until the end of 2015. Given the business shifting to a more recurring and higher margin base and the additional tailwinds I think this business should trade at least 13x 2016 earnings. This is more than a 90% premium to today’s price and equates to a 9% cash flow yield in 2015 and 14% cash flow yield in 2016. I’m looking for a $15 - $17 price in the next two years with multiple ways to realize greater upside and am alright waiting given I expect the  business to pull in $100mm (11% of the market cap) while I wait.

What could go wrong – Key considerations

The current market price assumes MITL’s revenue streams and earnings erode

• A significant amount of Mitel’s business comes from one-time phone hardware sales – if low priced competitors begin gaining share in the Western world it will negatively affect Mitel
• Synergy realization is key to the story – without synergies Mitel trades ~11x 2015 earnings
• Additional M&A may not be successful – the Aastra transaction was unique for many reason from limited personnel overlap to synergies as a % of deal price: a deal this cheap will not come again
• Float / volume is relatively small – Mitel trades 220k shares a day, a $50mm position is greater than 5% of outstanding shares
• Private equity overhang – private equity and insiders still own more than 25% of the outstanding shares and given the tenure of the PE investment, they will likely be looking to monetize again in the near future

Catalyst