Description

Company Description

Zayo Group LLC provides high bandwidth infrastructure and carrier neutral colocation. The Company offers services including dark fiber, wavelengths, private line, ethernet, and custom solutions. Zayo Group serves carrier, enterprise, school, hospital, and government customers throughout the United States.

Investment Summary

Short equity at 26.90. Aggressive accounting, minimal earnings or free cash flow, high valuation, high leverage, constant M&A, confusing financials and lack of real comps and make Zayo a compelling short opportunity

Capital Structure & Relevant Financial Metrics

Current Situation

• Zayo was formed in 2007 and has grown mostly through acquisitions

  • Company has made 30 acquisitions since forming for $3.46 billion

  • Top 5 Acquisitions account for $685 million of total revenue and were purchased on average for 9.x LQA EBITDA

  • As a result, Zayo has grown from $125 million in revenues and $36 million in EBITDA in 2009 to YE 2014 Revenues of $1.123 billion and Company Adjusted EBITDA of $648 million (more on this later)

• On October 16, Zayo sold 16 million shares stock in its IPO for $19, raising $282 million. Additionally, some existing shareholders sold 8 million shares in the offering.

  • Proceeds of the transaction are allocated for general corporate purposes, but will most likely be used to pay down high coupon debt at a premium

  • Zayo initially marketed their offering between $21-$24 a share, but due to extreme market volatility during their roadshow they had to lower their range and price the offering at $19. However, on the first day of trading, the stock was up over 15% to 22

  • The stock has now risen over 40% in under 2 months

• Zayo primarily operates in 2 segments Physical Infrastructure and Lit Services

• Physical Infrastructure- This represents 47% of revenues and 53% of EBITDA

  • This segment provides raw bandwidth infrastructure (Dark Fiber) that are leased to customers who light the fiber themselves using their own optronics – This area, representing 70% of this segment and 32% of the entire company, is the crown jewel of Zayo with the highest growth, the best margins and the least competition

  • This segment also has data centers that offer colocation and interconnection services, most of which was acquired in Zayo’s purchase of Fibernet (FTGX) in 2009

• Lit Services – Classic telco services over its fiber network

Investment Thesis

• The business:

  • ZAYO actually tries to give clarity about its business to investors and inundates investors with minutia about its business. (I actually really like companies

  • However, at the end of the day, 60% of Zayo is a Telecom company providing access to its fiber rings. They compete with all the big telco’s, cable companies & CLEC’s

  • Despite being in the same industry CLEC’s have varying metrics and margins……over the last few years…..

    • LVLT EBITDA Margins have ranged between 14.5% and 29% and CAPEX has ranged from 5%-12% of revenues

    • TWTC EBITDA Margins have ranged between 27% and 38% and CAPEX has ranged from 15%-29% of revenues

    • CCOI EBITDA Margins have ranged between 6% and 32.5% and CAPEX has ranged from 11%-21% of revenues

    • ZAYO Adjusted EBITDA Margins have ranged between 32% and 47% and CAPEX has ranged from 32%-39% of revenues

    • Prior to its merger with Zayo, ABVT margins ranged between 18% and 41% and CAPEX has ranged from 30%-36.6% of revenues (ABVT represents over 40% of Zayo’s Revenues and also used SBC to inflate its EBITDA)

  • One metric that is relatively consistent across all of these names is (EBITDA less CAPEX) / Revenues for the last few years, this has averaged:

    • 13% for LVLT

    • Projections in the LVLT 3 Proxy have it going from 16% in 2014 to 20% in 2018

    • 12% for TWTC (range 11%-14%)

    • 17% for CCOI (range 15.5%-17.7%)

    • 17% for ZAYO last year 12% the prior year and 11% in the latest quarter (this assumes EBITDA without adding back SBC as will be explained below)

    • 13% for ABVT,

    • Projections in the ABVT Proxy had it going from 15% in 2012 to 26% in 2018

  • While CLEC’s want everyone to think that most of their CAPEX is “growth” and not “maintenance”, the reality is that when they cut back on CAPEX, revenues do not grow and in fact start to decline (mostly due to the ever declining prices). As a result, the majority of the CAPEX is RECURRING. The only ones that have lowered their CAPEX and as a result achieved 20%+ EBITDA-CAPEX margins are the ILEC’s and they are all suffering from revenue declines

• Growth:

  • The company has been growing nicely, primarily through acquisitions.

  • Secular growth in the last quarter was a little over 7%, which is comparable to comps

    • 8% for TWTC

    • 3.8% for LVLT (LVLT Core communications up 6.1%)

    • 9% for CCOI

• Stock Based Comp (SBC)

  • Like many other companies, Zayo reports EBITDA with adding back Stock Based Comp. However, unlike other companies, Zayo has a tremendous amount of SBC

  • In 2014, ZAYO’s SBC was $253 million, which was 23% of revenues and 39% of their reported EBITDA. EBITDA.

  • SBC in 2014 and 1Q 2015 was an anomaly, and was exaggerated due to a “one-time” bonus related to the IPO. Looking at their 2013 SBC, historical Abovenet SBC, and what the company was saying on its roadshow, more normalized SBC would be closer to $30 million a quarter or 9% of Revenues

    • This amount is still much higher than comp’s which typically pay out 2% of their revenues in SBC

  • Backing out this real SBC (9% of revenues), would lower EBITDA by $110 million (16%) in 2014

  • It is my opinion that SBC should not be added back to EBITDA, because

    • It is a real cost, that the company would have to pay their employees. I.e., if they stopped paying any SBC (and didn’t supplement that amount with cash) the employees would leave

    • it is the equivalent of the company just selling shares into the market every quarter and counting the proceeds as EBITDA

  • while this could be somewhat ok when looking at the debt (since they do not care about dilution), when looking at the equity companies need to be compared without SBC addbacks

    • if LVLT were to have the same level of SBC as ZAYO, their EBITDA (pre TWTC merger) would increase by 23%.

  • SBC is a great method of payment in a high valuation company like ZAYO as the dilutive effect is better than using cash, but it can snowball in a declining stock environment, especially when the decline is more related to declining multiples than declining fundamentals

  • Part of the SBC is actually related to the stock price, so if the stock falls (even if fundamentals are strong and employees are doing their jobs well) employees will get a lower comp

• Cash Flows:

  • Ultimately, value is all about cash flows and this business has very little.

    • After years of promises, LVLT will first be delivering FCF this year and mainly a result of being able to refinance their balance sheet at much lower interest rates

    • TWTC, which had consistent growth for years, and has been FCF positive since 2007, has only produced $500 million of total free cash flow over that 7 year period, a very small amount relative to the $5.9 billion equity value LVLT paid for them

    • Virtually, all of the free cash flow at ZAYO is a result of SBC. PF for all acquisitions, ZAYO had $694 million in reported LTM EBITDA (with all SBC added back), $389 in CAPEX, $198 in Interest and $37 in taxes which totals $69 million in free cash flow. LTM SBC, was $338 million, I estimate the real amount to be $112 (the other amount was one time awards associated with going public, and therefore are legitimate addbacks), so ex-SBC, ZAYO would have burned $43 million LTM

    • If ZAYO can grow Revenues 8% over the next 3 years (to $1.542 billion) and that they can achieve a 30% EBITDA-CAPEX margin (aggressive, as explained, but perhaps achievable if you buy into adding back SBC), then they will generate $463 million. Assuming they can lower interest expense by $30 million (to $140 million run rate) and they don’t pay taxes (large NOL), then free cash flow should be around $320 million at the end of 2017, which means that they are now trading at 20x an aggressive 2017 estimated free cash flow number. If you consider SBC to be an actual expense, then real cash flow will obviously be much lower

• Valuation:

  • Private Market Values

  • Values among CLEC's are at multi-year highs, primarily due to recent consolidation, where assets have been purchased for over 10.0x EBITDA;

  • Most recently, LVLT purchased TWTC for 14.4x LTM EBITDA and 14.2x E. 2014 EBITDA

  • Prior to Zayo’s 2012 purchase of ABVT, non-Zayo CLEC M&A deals (as outlined in the ABVT proxy) ranged between 5.1x-12.2x LTM EBITDA (averaging 7.3x; median 6.65x)

  • Non-Zayo CLEC M&A, as outlined in the recent LVLT-TWTC proxy, ranged between 6.5x-11x (averaging 7.9x; median 7.3x)

  • Zayo’s 29 acquisitions (as outlined in their presentations), averaged 9.44x LQA EBITDA. Its largest, ABVT was purchased for 9.1x LQA EBITDA and 9.4x LTM EBITDA

  • Public Market Values (all EBITDA numbers do not add back SBC)

  • Prior to the June 2014 acquisition announcement from LVLT, TWTC was trading at high 11.7.x LTM EBITDA and 11.5x 2014 EBITDA and 10.21x 2015 EBITDA

  • LVLT, trades at 10.3x E. 2015 EBITDA and 9.2x 2016 EBITDA

  • CCOI trades at 15.2x 2014 EBITDA, 12.9x 2015 EBITDA and 11.0x 2016 EBITDA

  • Most other public Telco’s including CLEC’s trade 6.5x-7.5x E. 2014 EBITDA

  • In order to justify their multiples most “sell-side” analysts used Tower companies and DataCenters into their comps

  • ZAYO Valuation:

  • It is my opinion, that all of the mentioned comparable CLEC’s (LVLT & CCOI) are overvalued

  • Even so, it is hard to say that Zayo deserves a premium valuation, especially considering it isn’t growing on a secular basis faster than CCOI

  • M&A opportunities are dwindling, Zayo has even said that there shouldn’t be much expectation of M&A (at least here in the US)

  • Base case - Zayo trades at 11.0x E. 2016 EBITDA (I am using calendar year, which is an average of 2014 and 2017) comparable to CCOI (of course not adding back SBC), then it would trade at $21.25 or 20% lower than today. This would be an astounding 35.5x E. 2017 Free Cash Flow and 42.3x Earnings (this free cash flow does add back SBC)

  • Bear Case – Zayo trades at 9.2x 2016 EBITDA, comparable to LVLT, then it would trade at $15.85 or 40% lower than today. This would be an 26x E. 2017 Free Cash Flow and 31.5x Earnings

Why Does This Opportunity Exist?

• Frothy Valuations of CLEC’s, much of it created by Zayo’s own aggressive M&A

• Excitement around fiber and the growth of broadband. This is a real secular trend that will provide growth for years.

• Lack of focus on CAPEX, which is the major driver of secular growth and the lack cash flow generation. Like other CLEC's, Zayo claims that 85% of its capex is success based and that maintenance is a small sliver of total capex. Reality is that Capex expense is recurring. Anytime a CLEC has cut back on CAPEX spending they have seen a dropoff in revenues

• Strong “headline” Revenue & EBITDA Growth rates – Since 2008, Zayo has achieved an amazing 61% Revenue CAGR and 86% EBITDA CAGR

  • While these growth rates are impressive, it came from a very small base – Revenue grew from $64.6 million EBITDA grew from $15.6 million in 2008

  • Most of the growth has been driven by M&A, which the company admits will be much slower going forward

• Confusion in the market how to deal with Stock Based Comp

• Sell-side using Tower Companies & Datacenters as comps

  • While dark fiber leasing is very profitable, and under long term leases, it doesn’t deserve the valuation of Tower REITS that actually pay dividends and have the high multiples due to their dividend yields

  • Zayo’s trading multiple, is actually higher than many of the data centers / interconnection companies

Risks

• Continued M&A that is rewarded by the market

  • There are some large private fiber CLEC’s still around including Icahn’s XO Communications and Sidera Netwoks (old RCN)

  • Some phone companies have Metro Fiber divisions, including WIN, ELNK, LMOS and SHEN

• Company get purchased by a large well capitalized Telecom Company (ATT, WIN, CTL or Verizon)

• Investors ignore all that is mentioned here, the company continues to perform and trades to Sell-side targets of $30 (11.5% increase)

Catalysts

• Quarterly Earnings – The company now breaks out pro-forma prior quarters so we can see real growth rates

• Secondary – expected in 6 months from the IPO when the lockup expires

Catalyst

• Quarterly Earnings – The company now breaks out pro-forma prior quarters so we can see real growth rates

• Secondary – expected in 6 months from the IPO when the lockup expires