Description

Summary

We seek asset-rich and/or recurring cash flow generative companies going through corporate transition (such as bankruptcy, restructuring, consolidation) and take a multi-year perspective for that structural change to manifest itself in the price of the securities. A long investment in the Syniverse (SVR) 9.125% Senior Notes ‘19 at ~76c (12% CY, 22.9% YTM) is an example of our approach. The bonds currently trade at 7.4x EBITDA/9.8x unlevered FCF (net of cash) and offer +40% upside.

SVR is a processor of roaming transactions between wireless telecom carriers globally. The company’s business model is driven by multi-year customer contracts which provides for a predictable revenue and recurring cash flow stream. The industry has a generally favorable long-term secular backdrop given the increasing usage of mobile data. SVR was acquired in January 2011 by Carlyle for ~$2.6bn (with $1.2bn equity contribution) or +10x 2010 EBITDA.

So why does the opportunity exist?

Since mid-2014, the company has been in the process of de-emphasizing its legacy US-based CDMA platform and focusing on its next gen global Long Term Evolution (LTE) architecture, and has experienced some bumps along the way:

1. Permanent: higher than expected step-down in its 3G GSM contract re-pricing

2. Permanent: the loss of a MVNO (virtual network contract, ~$22MM revenue/yr.) in Q3-2015

3. Temporary: management subsequently guided to another year of declining revenue in 2016. The structural shift in the company’s revenue base (declining CDMA, growing LTE) is taking longer than expected, and the growing business has, thus far, been insufficient to offset the decline in legacy revenue. I view this as a temporary delay.

 The market views SVR as an overleveraged or “restructuring in waiting” credit given the risk associated with the runoff in CDMA revenue. SVR is ultimately a story of “revenue headwinds vs revenue tailwinds”, and I believe the impact of shifting technologies and latent demand in next-gen LTE has led to false pessimism that is causing the market to overlook the company’s underlying business quality, attractive cash flow characteristics and secular growth prospects.

Capital Structure

Situation Overview

In Q1-2016, the company responded to the evolving industry landscape and company-specific setbacks by announcing an aggressive restructuring plan to streamline expenses. In Q2-2016 SVR reported results that provide some data points that a “revenue inflection point” is possible in the next 12-18 months. As such, I have become bullish on the company’s prospects. The key elements of the thesis include:

1. Good business

2. Evidence of cost rationalization

3. Signs of revenue stabilization

4. Healthy cash flow generation (despite revenue pressure) and solid liquidity profile

5. Good credit protection for the bondholders

6. Attractive valuation

The main risk continues to be a prolonged delay in the ramp in next-gen LTE revenue.

Company Description

SVR was founded in 1987 by GTE Communications (now Verizon post its merger with Bell Atlantic in 2000) and operated as a wholly-owned subsidiary until 2002 when it was sold in management buyout. Today, the company is the largest independent transaction processor of roaming traffic connecting mobile network carriers and enterprises globally. SVR has a diverse customer base of +1,000 Mobile Network Operators (MNOs) in +200 countries. SVR provides a suite of essential services that enables customers of globally disparate carriers to roam seamlessly (voice and data sessions) across wireless networks. These “mission-critical” functions that facilitate network connectivity between wireless operators include billing clearinghouse and financial settlement services, authentication and authorization of end-users on roaming partner networks (‘signaling’), IP data transport, fraud control and detection applications.

In 2015, the company generated $832MM in revenue, $260MM in EBITDA and $57MM in pre-tax FCF. The company has made two acquisitions and one minority investment in recent years – MACH, a primarily European-based processing and signaling platform, in 2013 for $590MM; Aicent, a bolt-on to the US business, in 2014 for $290MM; and 40% equity stake in Vibes, a US mobile engagement company, for $45MM in 2016. 

The Thesis

1. Good business: At the outset, the company meets my criteria of a good fundamental business in a growing industry:

• Recurring revenue and predictable cash flow stream – customers sign multi-year (usually three years) contracts with SVR to utilize its platform and suite of services. The company derives its revenue primarily from recurring monthly fees that are contractual in nature and based on the number of roaming transactions SVR processes for its customers. While SVR has experienced revenue headwinds in recent years, the “glide path” is predetermined and predictable, and enables management to react accordingly.

• Margins, capital intensity and FCF conversion – while revenue and EBITDA have been under pressure in recent years, SVR’s +30% EBITDA margins and low capex model (7-8% of revenue) have enabled it to generate healthy unlevered FCF with a conversion rate of ~70-75%.

• Resilient business model during periods of economic recession – the business has proven to be relatively stable during cyclical periods. SVR’s transaction-driven revenue model provides for contract-tiered pricing and consistent (and growing) unit volume based on global roaming dynamics. The company is, however, not completely immune to economic shocks and did experience a 4.5% pullback in revenue/~7% decline in EBITDA during the 2008/09 financial crisis. It is worthwhile noting that during the 2008/09 period, even consumer staple companies like P&G suffered a 3-4% hit to topline. Importantly, SVR’s business is much more global today and increasingly insulated from local economic shocks. In 2009, 26% of revenues were generated outside North America; today it is closer to 45%, and expected to grow as CDMA (US) continues to decline while LTE (global) gains traction.  

• Growth opportunities – data usage in the mobile industry is experiencing positive secular trends as evidenced by the growing number of mobile subscribers, devices and traffic. This has translated into strong GSM roaming volumes which have grown ~17% per annum for the last several years. To put the LTE opportunity set in context, of the 1,200 MNOs or so worldwide, only ~200 have deployed LTE to date. Thus far, less than 1,000 LTE roaming agreements have been signed between these carriers compared to over 60,000 GSM and CDMA contracts currently on record. Hence, for the LTE opportunity to fully coalesce: (i) more carriers need to deploy LTE networks, (ii) more handsets need to be LTE-enabled; and (iii) more carriers need to sign LTE roaming agreements. So, while LTE has been accepted as the global standard for the next stage in the evolution to 4G (and beyond), the industry is currently at an early stage in the transition.

• A necessary part of the supply chain - 99 of the top 100 global MNOs, including Verizon, America Movil, Vodafone, Telefonica, China Unicom and Reliance Communications, use SVR’s platform. Based on discussions with management and some of SVR’s competitors, it seems that the company commands a +80% market share in GSM roaming. As the global mobile ecosystem becomes increasingly complex (2G, 3G, 4G, LTE, Wi-Fi across broad geographies), there is a growing need for an independent intermediary to connect subscribers across partner networks. While some of the very large carriers manage their roaming transaction clearing and related activities in-house, the cost/benefit of insourcing is generally not very attractive (lack of scale) for the smaller tier 1 carriers, tier 2s and tier 3s. In this context, SVR has not lost any business to in-sourcing over the last +5 years, and has, in fact, seen growth from existing customers looking to augment their use of SVR’s service.

2. Evidence of cost rationalization: While it is early innings of the restructuring plan, the company’s actions are beginning to show signs of operational improvement – for the first time in two years SVR generated a year-on-year EBITDA margin increase (of 80bps to 31.2%) in Q2-2016 despite continued revenue pressure. Management is aiming to reduce annualized cash costs (Cash COGS and opex) to $500MM over the next few years, down from $600M in 2015 and $545MM annualized in Q2-2016. This incremental $45MM reduction in the cost base would add +550bps to EBITDA margins (to 36-37% range) on the current revenue base.

3. Signs of revenue stabilization: The company’s revenue trajectory over the last two years has clearly been disappointing – revenue is down 8.5% year-on-year and -13.5% since Q2-2014 (essentially when the transition started) – as aforementioned, this is a story of “revenue headwinds vs revenue tailwinds”, and a few recent data points suggest that revenue stabilization and growth are possible in 2017 and 2018, respectively:

• 80% of the GSM contract repricing will behind them by the end of 2016 – despite their dominant position in GSM roaming, SVR experienced ~$9MM in pricing pressure during the first year of the contract renewal period which started in 2015 (40%) and should continue in 2016 (40%) and 2017 (20%); I am modelling in ~$10MM and ~$5MM revenue hit in 2016 and 2017, respectively, based on current volume trends. It is important to understand the multi-dimensional drivers for the recent price compression, from both competitors and customers, to derive confidence on the path to stabilization: (1) Competitors – SVR’s primary competitors such as Belgacom, Comfone and Starhome, have been aggressive in the recent RFP processes which has pressured SVR to offer some discount to remain competitive. SVR still commands premium pricing based on its incumbency position, scale and service reliability. With roaming volume growing 15-20% per annum in recent years, at a cursory level it seems surprising that roaming service providers are “pricing down” their service to win business. Upon closer inspection, it appears that SVR’s competitors are aggressively trying to capture GSM market share in order to position themselves as the incumbent to benefit from LTE evolution which is still in its early stages of growth; and (2) Customers – in recent years the MNO revenue model has experienced a “step function” change: until recently, roaming was largely a variable “pay as you go” feature of subscriber price plans where roaming revenues and costs were essentially tied to variable roaming traffic and wholesale rates that MNOs paid each other for subscribers roaming on partner wireless networks. The roaming business has evolved to an “all you can eat” model which has more of a fixed revenue component but higher roaming transaction costs (given increased roaming traffic). This dynamic has put pressure on margins and MNOs are looking to match their cost structure with the evolving revenue model.  

• The CDMA revenue glide path is visible and should slow by 2019 – CDMA clearing, settlement and signaling revenue, which accounted for ~20% of revenue (~$190MM) in 2015, is expected to decline to ~$90MM in 2019. CDMA revenue, which dropped ~$40MM in 2015, is expected to drop another $40MM in 2016 based on management guidance and experience a linear decline thereafter until 2019. While the loss of this historically consistent revenue base is clearly a negative, the path is visible and slowing.

• While still in its infancy, LTE revenue is gaining traction – in the most recent quarter, the company reported “Diameter Signaling” revenue (part of LTE) of 2x what it was in Q2 last year. While Diameter Signaling contributes less than 5% of the SVR’s total revenue base today, the rate of growth is noteworthy as the industry uses it as a proxy for the velocity of the evolution from 3G to 4G (LTE).

   

  My estimate of the net impact of major revenue headwinds and tailwinds: 2015A – 2019E:

   

($MM)                               2015A              2016E              2017E              2018E              2019E

Major Headwinds:            (63.6)               (72.0)               (35.0)               (20.0)               (10.0)

Major Tailwinds:                 17.5                  25.0                 40.0                  65.0                 70.0

Net Impact                          (46.1)               (47.0)                  5.0                  45.0                60.0   

4. Healthy cash flow generation and solid liquidity profile: As aforementioned, SVR’s business model has an attractive cash flow conversion profile given its +30% EBITDA margins and relatively low capex. As such, despite the near-term revenue headwinds, the company generated pre-tax operating FCF of ~$57MM in 2015. I expect 2016 to be a trough year for the company for both revenue and EBITDA but anticipate positive pre-tax operating FCF of +$20MM, and +$50MM by 2017. SVR is also in good shape from a liquidity perspective (with $76MM cash on hand plus $150MM undrawn RCF) and +2 years of runway before the maturity/refinancing cycle kicks in for the notes and the bank debt. Even at this depressed level of EBITDA, I believe the company has sufficient liquidity and FCF generation capacity to roll-out its expense reduction plan (pay severance and right size its cost structure) and outlast the revenue storm.

5. Good credit protection for the unsecureds:

• Secured Leverage: Secured book leverage (at par) is high at 6.3x LTM EBITDA and 6x net of cash. I expect this to drop to sub 5x by 2018 owing to the benefits of cost savings and revenue inflection. Both the credit agreement and bond indenture have a 4x net secured leverage cap and use LTM “Adjusted EBITDA” (which includes ~$35MM in addbacks such as fees Carlyle and stock-based comp) for covenant compliance purposes. At 5.2x LTM Adjusted EBITDA, SVR is currently in violation of the net secured leverage test. Based on the RCF and general lien carveouts, SVR does have incremental secured bank debt capacity of ~$250MM, which would prime the bonds by about one turn of leverage. This amount essentially caps out the company’s undrawn RCF. The company also has some (less than 1x) capital lease and foreign sub secured carveout capacity if necessary.

• Total Leverage: The bonds, which also benefit from a blanket subsidiary guarantee, contain a total FCCR covenant of 2x. In reality, however, while the company is in compliance, at +20% yields, SVR is essentially shut out of the unsecured market.

• Other: There is a “springing lien” feature in the credit agreement whereby if the RCF draw is greater than 25%, the company is required to maintain a secured debt ratio of 5x or less. It is also worth noting that SVR has significant (+$600MM) restricted payment capacity to potentially retire the 9.125% bonds at a discount.

6. Attractive Valuation using multiple methodologies:

• Yield: On a yield basis, the 9.125% notes trade at 12% CY and 22.9% YTM (~300bps/turn of leverage). This appears too wide to the bank debt which is 5.6x levered (gross) at market (at 88-90c) and trades ~5% CY and 9% YTM (~160bps/turn of leverage) - so for ~2x incremental leverage, the market is offering an additional +700bps in CY and +1,500bps in YTM – appears significantly mispriced to me. While the bonds may ultimately be impaired and the 9.125% may prove to be the fulcrum security in the capital structure, I believe the spread to the bank debt presents an attractive risk/reward for SVR’s bondholders.

• Multiple: in the mid-high 70s context, the 9.125% bonds trade at 7.4x (net of cash) LTM EBITDA of $247MM (“Adjusted” EBITDA is $284MM as reconciled by the company) and 9.8x LTM unlevered FCF. Assuming the bonds are the fulcrum, I view the current market context as an attractive entry point multiple for this quality business - dominant competitive position, predictable contract-based revenue, recurring cash flow, low capex - and relative to peer group companies (no direct public comps but similar companies in the industry) such as Verint (also facing headwinds) which trades at ~10x Adjusted EBITDA. Put another way, and understandably simplistically, assuming the 9.125% bonds are the reorganized equity, and the bank debt is unimpaired, the FCF yield to the “new equity” is ~18% at the current market price:

I appreciate the “new equity” would be a levered stub in the capital structure and the bank debt covenants would have to be renegotiated, but I believe this business could support 5-6x leverage given its FCF generation capacity and the prospect of significant deleveraging over the next few years.

• Guarantor vs Non-Guarantor: post the European-based MACH transaction in June 2013 and given the expected growth in global LTE roaming traffic, it is also informative to evaluate recoveries using a guarantor (bank debt is senior to bonds) and non-guarantor (bank and bonds are pari) framework:

SYNIVERSE HOLDINGS, INC.
Corporate Structure
($MM)
	Carlyle Group
	(Private Equity)
	100%
	Buccaneer Hldgs Inc.			100%		SYNIVERSE HOLDINGS, INC. (SVR)
	(Merger Sub)			(merged into)		(HoldCo, Delaware corp.)
						L+300 Secured Bank Debt			$     1,554
						9.125% Unsecured Bonds			$        475
									$     2,029
								2015	LTM
						Cash Interest		(109)	$      (109)
						Sub. gtee
				100%					100%
	NON-GUARANTOR SUBSIDIARIES					GUARANTOR SUBSIDIARIES
			2015	LTM				2015	LTM
	Revenue		191	181		Revenue		670	646
	EBITDA		80	82		EBITDA		180	165
	% Margin		42%	45%		% Margin		27%	26%
	Capex		(16)	(17)		Capex		(52)	(50)
	Unlevered FCF		64	65		Unlevered FCF		128	115
	Cash	51	87	47		Cash	39	80	29

Main Risks

• Further pressure on GSM contract repricing – as 40% of the GSM contract repricing occurred in 2015, we have a framework for the remaining 60% and management is “confident” that future step-downs will be in context of recent deals. Having said that, there is some risk of unfavorable repricing beyond expectations.

• More dramatic CDMA decline – a lot of the decline in SVR’s CDMA roaming revenue in 2015/16 is a result of Softbank’s investment in Sprint in 2013. Sotfbank’s support gave Sprint the financial resources to fill out the geographic dark spots in its network and offer nationwide coverage plans on its own network. Sprint has already spent multiple billions in enhancing their network and most of the investment now appears to be behind them. As such, I believe management has a long tail of CDMA roaming revenue, albeit attriting at a predictable pace. Further disruption, consolidation, change etc… in the US wireless landscape is certainly feasible which could alter the rate of CDMA attrition for SVR.

• Slower ramp in LTE – I believe the move to LTE is a question of when not if. Nevertheless, risk clearly exists that global carriers may not deploy LTE networks or execute LTE roaming agreements as quickly or efficiently as demand may warrant. In my view this is the main risk facing SVR in its ability to grow into its capital structure and refinance its bank/bonds in 2019. Having said that, at 7.4x “trough” EBITDA (in my view), I think there is significant downside protection / upside optionality for the bonds.

Catalyst

•  Futher progress on cost cutting plan
• Continued ramp in LTE roaming traffic
• Exchange/deleveraging transactions