One of my New Year's Resolution was to post more "work in progress" articles: articles on companies where I think there could be something interesting happening but I've still got a lot of open questions. Often, I'll have smaller positions in these stocks because, while I have open questions, my preliminary work is telling me the situation has an interesting risk / reward. My goal in posting these articles is to (hopefully) elicit some discussion / feedback from people who are more knowledgeable on the company / industry / situation than me.
Anyway, today is the first of those posts. Zayo (ZAYO; disclosure: long) is a bandwidth infrastructure provider. They provide a range of bandwidth infrastructure, but the majority of their value comes from their fiber network. Fiber is the basic backbone to the internet (basically, all data transmission is done by beaming light down a fiber-optic cable that runs from city to city / data center to data center, etc.), so Zayo's dense fiber network forms part of the backbone of the internet.
Zayo's interesting because the stock plunged in early November when the company announced earnings well below expectations plus a plan to split into two public companies. On the heels of that announcement, Bloomberg reported a group of private equity funds (lead by Blackstone) were interested in taking Zayo private. All was quiet until last week, when CTFN reported Zayo had received an offer at >$30/share and dealReporter followed that up with a report the private equity group was talking to banks about financing w/ an eye towards closing a deal over the next few weeks.
My thesis here is simple: I think there's a decent chance a sale happens, and if it does, I think it'll be in the low to mid-$30s, presenting the opportunity for a pretty solid return from today's price of ~$27. Why low to mid $30s? At that price, I think the PE buyers could realize a strong return (both from buying Zayo at a slight discount from its intrinsic value and especially from using Zayo as a platform for future synergistic acquisitions) and the management team could claim victory for their shareholders on a lot of different fronts. If a sale doesn't happen, I'm sure the stock would suffer in the near term, but I think Zayo is ultimately undervalued at today's levels and there would be a lot of different routes for value creation over the medium term (on top of improved financial performance, following through on the REIT split, an activist investor, or continued share buybacks are all within play).
Let's start with the basics: what's Zayo worth? That's a somewhat difficult question to answer, as Zayo reports six different segments that all have vastly different economics (growth rates, margins, capex requirements, etc.) and thus deserve vastly different multiples (the table below, from their Q1'19 earnings slides, highlights this).
Fortunately for us, Zayo has provided us with suggested comps in the recent past. In March 2017, the company published an investor deck that walked through each segment and whole they thought the best comps would be. So we can simply take the LTM EBITDA for each segment, assign a multiple to it, and then figure out ZAYO's sum of the parts (SOTP) that way.
Before we do that, a quick note. Zayo's EBITDA numbers probably deserve an asterisk or three as their adjusted EBITDA definition includes "amortization of deferred revenue". Amortization of revenue comes when a customer gives Zayo cash upfront; because Zayo can't immediately book that revenue, they set up a "deferred revenue" liability against that cash on their balance sheet and then slowly bleed that deferred revenue liability down as they recognize the revenue from the customer. Adding this amortization back inflates Zayo's EBITDA: Zayo took in the cash from this add-back months / years ago, so by adding that amortization back Zayo's adjusted EBITDA is higher than their "cash EBITDA." This add-back doesn't make a huge difference as long as Zayo is growing / adding to their deferred revenue account (so cash build from new deferred revenue offsets that add-back), but when valuing Zayo on a steady state basis it means the adjusted EBITDA number they present is probably too high.
Because "amortization of deferred revenue" is about as empty of an earnings add back as there can be, I've removed the number from Zayo's Adjusted EBITDA calculation for valuation purposes. On an LTM basis, Zayo has done ~$1.3B in adjusted EBITDA and ~$140m in deferred revenue amortization, so LTM "cash EBITDA" is ~$1.15B . The table below shows the adjusted EBITDA on a segment by segment basis, along with a potential multiple for each segment, in order to come up with a first crack at a SOTP for ZAYO.
Don't focus too much on the specifics of that chart for now (though, FWIW, that valuation results in a wholeco value of 10.5x EBITDA; there are no perfect comps for Zayo but Level 3 was probably a good one; CTL bought Level 3 for ~12.5x EBITDA and their proxy listed Zayo, CCOI (trades for ~13.5x EBITDA), and Lumos (taken out at just shy of 10x EBITDA) as their best peers. In addition, p. 44 of Zayo's proxy suggests they value the company at 10x EBITDA though I think that's just a low ball estimate to enrich management for growing the company). I think the multiples are directionally correct but you could flex any of them up or down a turn or three and I wouldn't have huge arguments, and you could rightly protest the ~$100m in annual stock comp Zayo gives out is a very real expense that isn't picked up by the adjusted EBITDA number. Countering this, I've probably been too conservative assigning all deferred revenue amortization to the Fiber segment (their most valuable segment), but I haven't found any clear breakouts in Zayo's financials so far so figured I'd just lump it in there since it accounts for the majority anyway. So don't focus too much on the specifics of the SOTP; I just wanted to put that SOTP together to highlight one thing: the majority of Zayo's earnings and the vast majority of Zayo's value comes from their Fiber segment (that's what happens when one segment account for ~half your earnings and deserves a multiple double the rest of your businesses!), so we should probably spend the bulk of our time thinking about that segment.
What is the Fiber business and why do I think it's worth such a high (mid-teens) multiple? I think the quote below (from Zayo's March 2017 investor deck) helps frame it
The big question is if that valuation makes sense, and I think it does. I tracked down 10 different "fiber" deals (Wow / Verizon, CCI / Lightower, CCI / Wilcon, Uniti / Southern Light, CCI / FiberNet, CCI / Sunesys, GTT / Interoute, Uniti / BlueBird, Zayo / Optic Zoo, Zayo / Neutral Path, and Zayo / Spread Networks); I'm sure there are plenty more fiber transactions and would be open to suggestions if you know of any. Below I've pasted the basic deal stats for those ten fiber deals (note that for some of these the numbers were not laid out perfectly, so I may have made some assumptions based on what was given in the PR but these should all be directionally correct).
Are any of these perfect comps for Zayo's Fiber business? No. These are generally bolt on acquisitions, the price of fiber is very dependent on its quality (how dense it is, how attractive the region it's in is, etc.), and some of the deals have very specific quirks (Uniti / Bluebird, for example, has a headline price of ~10x EBTIDA but included the seller prepaying >5 years worth of rent, so the effective price is probably much higher, and the GTT / Interoute deal was a European deal (Europe makes up a small portion of Zayo's value)). So the table certainly has some serious limitations, but it does serve as a nice starting point for thinking about value. On average, the pre-synergy multiple paid for Fiber is ~15.6x (16.7x if we takeout out Uniti and GTT, which are the least comparable), and the average price per route mile is approaching $150k. The SOTP I used above valued fiber at 15x LTM EBITDA and ~$63k/route mile, so I don't think it's a crazy valuation by any stretch.
Again, I'm not saying these are perfect comps (and I doubt Fiber is going for the $150k/route mile average value mentioned above!), but I am just using this as a sanity check. I would not be shocked to see Zayo's Fiber trade for a premium multiple to where those comps were traded for two reasons. First, it's tough to know the value of fiber without looking under the hood (i.e. seeing exactly where all the fiber is, how dense it is, and the customer demand in those locations), but Zayo consistently suggests that their fiber is among the deepest / densest / most unique in the industry (here's one more quote for good measure). I always take a company's view of their own asset value with a grain of salt or three, but my understanding based on reading up on the industry / listening to competitors seems to suggest that Zayo's base is of at least above average quality. Second, those acquisitions were generally of "bolt on" size. Zayo is much bigger than those deal comps, so a buyer could look at Zayo as a "platform" that they could use to roll up a still very fragmented industry. That makes a difference for, say, a private equity / infrastructure fund looking to get into the space and deploy capital at an attractive ROI. Say fair value for fiber assets is 15x: if you're a private equity company, you need to pay less than fair value so you can get a juicy IRR for your fund.... but you could convince yourself to pay 15x (i.e. full and fair value) for the "platform" and then pay 12x for a bunch of bolt-ons that, after synergies, you'll effectively have bought for 8x. Double a company's size through those bolt ons and you'll have achieved a very nice IRR on a very large pot of money (important for giant funds looking to deploy all their dry powder! Also apparently the strategy EQT is pursuing at the company formerly known as Lumos.).
Speaking of bolt on acquisitions, one of the really interesting things about Zayo (and any fiber asset in general) is the ability to leverage an initial fiber investment by adding new customers to an already built fiber line (note that this is not unique to Zayo; for example, AT&T talked about how they are using AI to improve their fiber build out ROI). That dynamic presents pretty interesting growth dynamics for Zayo; in general, when they lay a new fiber route, they have an anchor investor committed to the route that will allow them to already achieve an attractive ROI. If they can then sign up more customers to that route, the incremental cost is minimal and the ROI is huge. Below are two screenshots: the first is a quote from Zayo talking about how they think they can do 20% equity IRRs given this dynamic. The second is a screenshot from a UNIT investor presentation that I think does a really nice job of illustrating exactly how a fiber build out works and how strong the IRR can be. It's also interesting to think about that "anchor fiber buildout" dynamic in light of coming 5G investments (5G will require lots of new small cell, and the ability to quickly and easily hook up a small cell to an existing fiber branch should present huge incremental growth opportunities for fiber providers).
I'm saying Fiber is worth at least a mid-double digit EBITDA multiple, so these profitable growth opportunities are largely captured by the high valuation I've given Fiber (profitable reinvestment opportunties are generally baked into above average EBITDA multiples). Still, I highlight that anchor fiber buildout opportunity for two reasons. First, a lot of people will read "Fiber valued at 15x EBITDA" and get a bit of a nosebleed from the multiple, so I wanted to highlight (one reason) why the business deserves a high multiple. Second, it seems like Zayo is in talks to get bought by infrastructure private equity funds, and these type of high IRR reinvestment opportunities are catnip to infrastructure private equity funds (it lets them put more money to work, and given they'll use an aggressive debt structure they can do so at very high IRRs).
Anyway, my bottom line is that Zayo's fiber segment is very valuable. My earlier SOTP used 15x LTM EBITDA but that's likely too conservative. Comps have generally traded for at least that level, and it appears Zayo's assets are both better on a standalone basis than those comps and offer more growth / platform potential than comps. If Fiber was worth 17x instead of 15x and all other segments were worth what I estimated them at earlier, Zayo would be worth ~$31/share.
There's a lot of assumptions in that SOTP, chief among them that Fiber is worth a small premium to recent transactions and that all of the other segments are worth the multiples I've given them. I'm comfortable with both those assumptions: I walked through why I think Zayo's Fiber is worth a premium above, and you can compare the multiples I'm giving Zayo's other segments to the comps from Zayo's March 2017 investor deck and see that my multiples are likely pretty conservative (though some conservatism is warranted; for example, in that 2017 presentation Zayo wants their Colo segment valued like CyrusOne (CONE) but Cyrus is growing at mid-double digits while zColo is shrinking). Ultimately, it doesn't make a huge different to the Zayo case: flexing the non-Fiber multiples up or down a bit doesn't move the needle close to as much as small changes in the Fiber multiple, so I'd rather be conservative on the former and focus on the later.
Another reason to believe that ZAYO's SOTP is significantly higher than today's share price? Management's capital allocation. Over the past two years, management has been a voracious buyer of shares when they trade into the mid-to-low $30s. In FY18, the company bought back ~$94m of shares @ $34.02 (~1% of shares out; see p. f-40), and then in October / November of 2018 the company bought back $400m of shares (~5% of shares outstanding; see p. 33). Over time, I've increasingly come to discount share repurchases as a "value signal" (I've seen too many companies buy back a huge chunk of shares before reporting a complete disaster of a quarter and ending up over-leveraged with a way lower share price (very similar to Zayo buying back 5% of the company at >$30 before barfing a quarter and seeing their shares trade to the low $20s!)) unless I really respect the management team's capital allocation chops, but I do think there is some signal to Zayo's share repurchases. As mentioned in the Fiber section, a big piece of Fiber's value is a bit of a black box. How well situated is the Fiber? If they've got tons of untapped fiber in rapidly growing metro areas, that's obviously way more valuable then if most of their fiber is currently being used and generally sits in shrinking rural areas. The only people who can really know where Zayo's fiber sits on that spectrum is the management team, and for them to be buying shares up pretty aggressively in the low $30s suggests that the Fiber is very solidly positioned / that they see a SOTP for Zayo at the high end of what I'm projecting.
I'm going to largely wrap this article up here. Again, this is a more speculative position. Would I feel more comfortable buying this at $22 than $27? Duh. But my gut is telling me that Zayo's intrinsic value is higher than today's share price, and I think there's a very decent chance that private equity takes Zayo out in the near future. If Zayo isn't taken out, shares will probably be volatile in the short term but given the increasing strategic value of fiber and Zayo's positioning, I think in the long run shares would do well from here.
Other odds and ends