Description

MPower Communications (MPE) is an excellent post bankruptcy value play in one of the most despised sectors of telecommunications – Competitive Local Exchange Carriers (CLEC’s). MPE is growing EBITDA at a rate near 100% a year with a fully diluted enterprise value (adjusted for a just announced acquisition) of $120 million. The company has given guidance for EBITDA of $16 to $18 million in 2005 and $35 to $39 million for 2006, giving the company an EBITDA multiple 3.2X 2006 projected EBITDA. Don’t spit out your coffee after reading the next line… this is a CLEC with a FREE cash flow yield of 22% based on managements 2006 projections. Better yet this yield is achieved with a leverage free balance sheet.

Is there room for CLEC’s to compete against the RBOC’s. The RBOC’s still produce tremendous levels of operating cash flow with less than great service. Just try calling a RBOC service line then compare the wait with MPE’s line. A well run CLEC such as MPE with the right facility based operating mode, I believe, can carve out a good business over the next few years.

Background

MPE emerged from bankruptcy in late 2002 with the elimination of over $600 million in debt. The company now has a very strong balance sheet with no debt and $34 million of cash.

As part of the BK and post BK restructuring and rationalization they reduced headcount and expenses, sold cash burning and non strategic markets and become a focused company with services in markets that they could grow in profitably. These markets are the following: Los Angeles, San Diego, Northern California (Bay Area), Las Vegas and Chicago. In the second quarter of 2003 they posted their first EBITDA positive quarter and have been EBITDA positive since. The cost of the build out, for the markets listed above, was approximately $400 million at cost. The enterprise value today (pre acquisition of ICG -- less cash) is approximately $112 million, so you are paying roughly 28 cents on the dollar for these assets.

I have spent time getting to know the management and believe the company, despite being a smaller player, is one of the best managed publicily traded CLEC’s. For those interested, they have some very good materials on their web site that gives background on the company, their strategy, management bios etc. I would also recommend listening to the web-cast of their conference call last week that discussed the acquisition of IBG and 3rd quarter results. Their strategy is pretty simple:

• Grow the business organically by capitalizing on the large opportunities within existing markets.

• Seek acquisitions (at the right price) that fit well within MPE’s markets to become a larger “regional system”.

• Create higher margins and cash flow by leveraging their underutilized network infrastructure and reducing redundant G&A overhead.

• Participate in industry consolidation that will occur first on a
regional and then national basis. To this end, they see MPE eventually being sold to a larger “national” player.

Acquisition of ICG:

Last week, MPE announced a transforming acquisition that positions them as a leading CLEC in California. MPE will acquire the California assets of Denver based ICG, which include retail and wholesale customers in MPE’s existing markets in California (San Diego, LA, and Northern California) plus a statewide SONET based fiber network that now compliments MPE’s existing deep collocation and switching infrastructure. The acquisition will allow MPE to offer new products such as private line, increases their IP Centrex capabilities, positions them as a strong player in the wholesale market, and reduces their reliance on the ILEC’s.

MPE will pay for the acquisition by issuing 10.7 million shares and assuming $24 million of equipment leases for a total purchase price of approximately $38 million (using the price of MPE stock ($1.35) at the time of the announcement). This acquisition is expected to add $8 to $10 million of EBITDA in 2006. I think the acquisition is further demonstration that the management team is continuing to execute its plan.

Operating Numbers and Projections:

(the projections are guidance given by MPE management and include the acquisition of ICG for the years 2005 and 2006)

Proj Proj
2003 2004 2005 2006

(MILLIONS)

SALES $148 $151 $204 $225
EBITDA ($3.4) $ 9 $ 20 $ 37
CAPX ($ 9) ($ 11) ($ 11)
ICG Integration $ 8)

Free Cash Flow $0 $ 1 $ 26

EV as % Sales 73% 57% 52%


Monthly Churn* 2.25% 1.56%

* Business lines.

Valuation

The valuation is based on 2006 operating projections and end of 2006 fully diluted enterprise value.

First let’s look at cash:

Current cash: $34.1
Stock Sale: $ 2.5
(as part of ICG acquisition stock is being sold to Columbia Capital and M/C Venture Partners venture capital firms that are selling ICG to MPE.

2004 4th qtr. EBITDA $ 1.0
2004 4th qtr. CAPX ($ 3.5)
2005 EBITDA $ 19.5
2005 CAPX $(11.0)
ICG transition costs ($7.5)
ICG fiber lease payments ($4.0)

Ending 2005 cash $31.1
=====

2006 EBITDA $37.0
2006 CAPX ($11.0)

23.5 million options @ .90 $20.7
Restricted Cash $ 9.7

Ending 2006 cash $87.5
=====
Fully diluted 2006 shares

114 million * $1.65 $188.1
Plus:
LT liabilities (fiber leases) $ 18.0
Less:
Cash $ 87.5

Enterprise value $118.5
2006 EBITDA $ 37.0

EV / EBITDA 3.2

2006 free cash flow $ 26.0

2006 free cash flow yield 22.0%


Comps:

Comparable publicly traded CLEC’s are trading at EBITDA multiples of 7X to 12X EBITDA. Some comps include:, US LEC (CLEC), ITC Deltacomm (ITCD), and XO Communications (XOCM). Putting a 7X multiple on MPE’s 2006 EBITDA gets you to $260 million of value; adding net cash after accounting for the fiber leases ($69 million) gets you to an EV of $329 million. If you then divide the EV by 114 million fully diluted shares you arrive at a share price of $2.97 an 80% increase from $1.67. Keep in mind this 80% upside is achieved with no leverage.



EV EBITDA EV/EBITDA EV/Sales

2004 Numbers (millions)

CLEC $502 $40 12.5X 150%

ITCD $570 $80 7.1X 118%

XOCM $920 $100 (proforma) 9.2X 55%


Risks

MPE is subject to unbundled network element rates for competitive access to the RBOC’s. These rates are set by the state public utility commissions. The rates in Illinois have recently been changed as have the rates in California, so the near and medium term uncertainty is now mitigated. DSO loop pricing has gone up by 25% to 30% in each market while DS-1 loop pricing has gone down by about the same amount. This has a slightly negative effect in short term, as more loops are DS0. However, most of MPE’s growth and new business is on in DS-1loops. The new pricing will become a net positive within a couple years because about 80% of new business is DS-1 based. The new prices are reflected in MPE’s guidance.

Catalyst

MPE is a medium to long term contrarian investment. Some catalysts include:


• Further industry consolidation.
• Improved operating margins through elimination of redundant costs and better leverage of existing infrastructure.
• Future awareness by Wall Street and mainstream investors of the cheap valuation relative to assets, cash flow and growth.