Description

Recommendation 

Buy TGO common stock.  TGO is an acquisitive company that owns substandard assets, has a history of chronic underachievement, and is facing a cloudy future in terms of its ability to transform itself and successfully compete in a very crowded marketplace.  The Company went public in 2007 at $11.75/sh and if you look at the financials and the stock chart, it hasn’t done much of anything since then except become a value trap for frustrated investors, including some activists.  The stock today has essentially become orphaned and often trades with very little liquidity for extended periods of time.  Therefore, it’s possible that the Company remains a value trap but I like the set up here for a rerating over the course of this year and next.

In the aftermath of the wild bidding frenzy for Straight Path Communications, investors started to focus on other companies with similar types of spectrum assets that the market may be overlooking in their valuations.  I believe TGO may be one such company given their spectrum holdings and it could draw not only investor interest but also strategic interest from large telcos in search of spectrum assets.  In aggregate, TGO has licenses for 7.5bn MHz-Pops in the 24 and 38 bands that could have strategic value if the spectrum was cleared for mobile use.  Spectrum valuations are complex and often controversial and because I am probably one of the least qualified investors to discuss this subject, I won’t attempt to place a precise value on TGO’s spectrum assets.  My simplistic working theory, based on conversations with professionals more informed in this area, is that the spectrum is worth a bit something to worth quite a lot. 

However, while I am unable to pinpoint what TGO’s spectrum is worth, I am comfortable making the assumption that at today’s levels, the market has placed zero incremental value on this asset.  At the current enterprise value of $98mm, the stock is trading at an EBITDA multiple of 5.9x and at a high single digit FCF yield.  Granted these are not the best telco assets out there but I’d argue that this is not an overpriced stock particularly given the free optionality on the spectrum.  Without making heroic assumptions, I think the operating assets are worth at least $5.50 – 6.00/sh (+17 – 28%) today and valuation could rerate considerably beyond this once the Company gets some attention from the investment community and folks start focusing on the potential value of the spectrum asset.  Mid to longer term, there is very little reason for TGO to exist in its current form.  It should be sold in its entirety or in pieces to another operator(s) that can actually create value out of the assets instead of destroying shareholder value the way the current and past management here have.

Company / Situation Overview

TGO is a Canadian IT services provider for businesses.  It provides small and mid-sized businesses across Canada with network and voice services, data center services and enterprise infrastructure cloud services.  The Company started as an access company that sold Internet access and point-to-point connectivity primarily using fixed wireless microwave technology. Since its foundation however, the Internet access market has become highly competitive, with the Internet moving towards a commodity level of need among users. TGO realized it needed other products to stay competitive in the market, and has since moved into data centers, cloud computing, and voice solutions via a series of acquisitions in recent years.  The Company has over 4,000 customers and manages over 3,000 cloud workloads.  The Company has approximately 60,000 sf of data center capacity in seven facilities across Canada, as well as facilities in the U.S. and the U.K.

While the Company recognized early that the Connectivity business was being disrupted and was therefore going to struggle to grow, the execution to stay relevant by entering new growth areas has been terrible.  There have been many strategic reviews, ill- conceived attempts to get into capital intensive and competitive areas such as building out a fiber-optic delivery platform, and poor capital allocation decisions such as overpaying for data center and cloud assets.  Add to this the revolving door at the CEO position where the Company is now on the 3^rd different CEO in recent years.  It is small miracle that given all these missteps, this Company has been allowed to exist on its own.  Given the competitive nature of the telecom industry, the Company’s small size, and the lack of any proprietary technology, there is zero likelihood that TGO can ever thrive as a standalone.  It is more likely that management will continue to destroy shareholder value by overpaying for more mediocre acquisitions.  I believe that the extremely fatigued investor base recognizes this and unless the operating performance of the business improves (very unlikely), TGO will be forced to put itself up for sale over the course of the next 12 – 18 months.  If the spectrum does hold meaningful value, then that will only accelerate a breakup or sale.

Business Segments

The Company separates its business activities into three segments: Cloud Services, Colocation Services and Connectivity Services.

Cloud Services

TGO provides infrastructure services for compute, storage, disaster recovery cloud solutions and other offerings either on a direct or indirect basis. Like all other cloud solutions, the TGO cloud offers customers access to on-demand computing power without the need to acquire and maintain expensive server equipment. The Company also provides offsite cloud storage for backup and disaster recovery situations. The Company’s partners include Amazon, IBM, Cisco, VMware, Mitel and others. Cloud services revenue is generated from monthly recurring charges based on usage.  Competitors include the major telcos such as Bell Canada, Rogers Communications and Cogeco, and a number of data center providers including CenturyLink, Cologix and Q9 Networks.

Colocation Services

TGO provides data center colocation services to customers who are seeking cost effective, outsourced data center services.  Customers are able to provision computing equipment within shared partial cabinets or full, private cabinets, as well as customized caged space designed for their specific needs. The Company provides connectivity on redundant routes in and out of the facilities. The Company generates hosting and colocation revenue from set-up fees for new installations and monthly recurring charges based on the number of cabinets and/or the quantity of cage space, power requirements, managed services provided and Internet/data bandwidth requirements.  Additional revenue is generated from add-on services such as disaster recovery under custom contractual arrangements.  Competitors include the major telcos such as Bell Canada, Rogers Communications and Cogeco, and a number of data center providers including CenturyLink, Cologix and Q9 Networks.

Connectivity Services

TGO provides businesses with secure access and data connectivity services via its owned and operated carrier-grade MPLS enabled wireline and fixed wireless, IP communications network in Canada.  The Company’s carrier grade IP communication network serves an important and growing demand among Canadian businesses for network access diversity by offering wireless services that are redundant to their existing wireline broadband connections.  TGO targets SMB and select enterprise customers that are located in commercial and industrial areas of metropolitan centers in Canada. Customers include single and multi-site businesses requiring Internet access and data connectivity services, and enterprise customers requiring true redundancy to their wireline solutions. Contracts are typically one to three years in length and services are billed monthly or quarterly over the term of the contract. Competitors include telcos such as Bell Canada, TELUS Communications, Allstream, Rogers Communications, Shaw Communications and Cogeco, who provide wireline services.

Summary Financials

On surface, TGO’s five-year financials don’t look all that bad.  Revenues have grown from $49mm to $58mm and EBITDA has generally been in the $16 – 18mm per annum.  Cash flow has been positive almost every year and solvency has not been an issue.  However, when you factor in the $43mm that the Company has spent on acquisitions do you then recognize the value destruction that has taken place here.  That EBITDA has not grown even after all this investment is quite astonishing and explains why the Company’s stock is trading close to all time lows and the why there has been significant CEO turnover and activist involvement.

Not being able to slow the top line erosion in the Connectivity business has continued to plague the Company.  Contracts are being renewed at lower market rates and usage revenues are lower as customers switch to unlimited usage plans. 

Not surprisingly, 2017 will once again be a “year of investment” where management will look to double marketing spend and increase the size of the sales force in an effort to better compete in the marketplace.  This will obviously be a drag on 2017 profitability and my guess is 2018 will likely not be any different.  I doubt we ever see any meaningful organic growth at TGO. 

Capitalization

The only significant debt in the cap structure is in the form of a $40mm term loan.  Current net leverage is 1.9x EBITDA and this metric should be even lower by the end of the year.  The maturities of the term loan and credit facilities were just recently extended to 2021.  The Company has $9.2mm in cash and should end the year with $12 – 13mm.  Furthermore, the revolver is unfunded and therefore liquidity is very strong. 

Valuation Thoughts (ex Spectrum)

TGO currently trades at an undemanding 5.9x multiple based on my FY17 EBITDA estimate of $16.7mm.  Assuming that the Company generates $5 – 6mm in cash flow during the year, the FCF yield on the current market cap would be 8.2% (and closer to 10.0% on an ex-cash basis). However, given the different growth profiles of the businesses, it makes sense to examine the valuation by segment.

The Connectivity segment appears to be in a secular decline and therefore should command a very low distressed type multiple.  For FY17, I am assuming that the top line shrinks by 8% to $37.6mm.  While the Company does not break out profitability by segment, we can look to older financials prior to them getting into the Cloud & Colocation business to estimate Connectivity margins today.  Based on historicals, I’ve assumed a range of 29 – 31% for EBITDA margin.  To be conservative, I’ve assumed a 4.0 – 5.0x EBITDA multiple to arrive at a valuation range of $44 – 58mm for Connectivity.  It’s possible a large telco competitor could pay a higher multiple for this asset given the potential for synergies on the cost side. 

Based on this valuation for Connectivity, the implied valuation for the Cloud & Colocation business is $40 – 54mm.  This works out to an undemanding implied revenue multiple of 2.0 – 2.7x for a recurring revenue business growing the top line at a high single digit rate.  

Based on the foregoing, I believe that the stock is undervalued and is worth at least $5.50 – 6.00/sh excluding any potential incremental value from other assets such as spectrum or NOLs.

For a sanity check, I am including some trading multiples (from April and so slightly dated) for comparable assets while fully recognizing that TGO’s assets are likely to be inferior in quality relative to many of the companies on this list.

Publicly traded comparables

M&A comparables

Spectrum Overview

In 1999, TGO participated in Industry Canada’s first wireless spectrum auction of 24 GHz and 38 GHz bands where it acquired 70 licenses.  These licenses range in bandwidth from 200 MHz to 600 MHz.  In 2010, the Company purchased an additional six 24 GHz licenses, which included 240 MHz in each of Toronto, Montreal and Ottawa, and 80 MHz in each of Calgary, Vancouver and Edmonton.  Today, the Company owns a portfolio of 24 GHz and 38 GHz wide-area spectrum licenses that cover regions across Canada, including 1,160 MHz in Canada’s 6 largest cities.  The Company delivers broadband services to its customers using radios operating in 24 GHz and 38 GHz spectrum. The licensed spectrum connects the Company’s core hubs together to create a wireless backbone to avoid any points of failure. The licensed spectrum is also used in the access network or “last mile” to deliver high capacity Ethernet-based broadband links for business, government and cellular backhaul.

The Company has also applied for and received licenses in the 38 GHz band which it uses for point-to-point deployments. These licenses are issued on an as needed and user defined basis.  Industry Canada uses the spectrum grid concept to define service areas, each with an area of 25 square kilometers. These licenses are issued in paired frequency blocks, each with a bandwidth of 50 MHz.

In addition to 24 GHz and 38 GHz wide-area licenses, the Company also holds licenses on a site-by-site basis for point-to-point spectrum in the 11, 18 and 23 GHz bands.  In 2010, the Company applied for and received 16 licenses in the 3.65 GHz band provided on a shared use basis. Each license consists of 50 MHz of spectrum that is available for the entire serving area and enables the Company to provide services up to 10 Mbps using point-to-point and point-to-multipoint deployments.

So, is all this spectrum actually valuable?  And what is it worth?  The honest answer to both is I don’t know.  What I do believe is that TGO’s spectrum is similar to what U.S. telcos have been targeting ahead of potential 5G deployment.  In addition to the widely followed Straight Path (which owns spectrum in the 28 GHz and 39 GHz bands) transaction, other notable recent M&A activity includes AT&T’s acquisition of FiberTower, which owns spectrum in the 24 GHz and 39 GHz bands, and Verizon’s buyout of XO Communications, which also owns spectrum in the 24 GHz and 39 GHz bands.  I presume all this activity is driven by the speculation that the FCC will soon open up new bands for wireless applications.  If Canada’s Innovation, Science and Economic Development Canada (ISED) does eventually consider clearing the way for TGO’s spectrum to be used for mobile applications, then it would not be unreasonable to assume that Canadian telcos may have an interest in acquiring TGO's spectrum much in the same way AT&T and Verizon have in the U.S. 

However, this is not a clean spectrum-only story like Straight Path.  While the majority of existing customers operate on unlicensed spectrum and would be unaffected, TGO does use some of the spectrum for its fixed wireless operations and therefore, there would be some business interruption from re-farming spectrum for mobile applications.  There should be workaround for these issues particularly if a large telco is the buyer.

There’s some sellside research out there that attempts to value on TGO’s spectrum but I don’t feel comfortable referencing it.  There are just way too many assumptions embedded in these valuations given the differences between TGO's spectrum versus the assets that have recently traded in the U.S.  For me, as a spectrum tourist, the attraction here is owning what I believe to be an undervalued security where I am potentially getting significant upside optionality without having to pay a cent for it.

Catalyst

- From an operational perspective, any stability in the top line of the Connectivity business would be viewed as a big positive

- If the TGO continues to post poor/lackluster operating performance, fatigued investors with board presence could finally force a sale of the entire company

- From a spectrum standpoint, any announcements from the FCC and/or ISED that clears the way for TGO's spectrum to be used for wireless applications would be a catalyst for a rerating