By Andrew Chung The Standing Stone
- Cincinnati Bell is valued as it were three years ago yet there has been a number of transformative events that have occurred between this time including: (i) the divesture of its wireless segment, (ii) its sale of CyrusOne, (iii) the completion of a 1-to-5 reverse split, (iv) its growth in fiber internet subscribers to 67% of total subscribers (up from 42% at the end of 2014), and (v) a recent purchase of SunTel Services to pragmatically expand into Michigan
- A transformative fiber optics network is in progress. Contribution of Fioptics sales has more than doubled over the last few years. We estimate Fioptics will be greater than 50% of total revenue in 3-5 years. The costs of deploying fiber to the home has reduced by more than a half over the past decade and this trend will continue.
- We think Cincinnati Bell is positioned favorably in a horizontal market. For a firm operating in a horizontal maturing market with low growth like wireline, we would like to see non-core assets diversified, and an opportunity to be easily acquired. If not acquired, we want to see the firm positioned to compete well against peers because it holds regional scale advantages. We want the firm to have relatively newer fiber technologies, while also having nimbleness in relative size. These two factors will allow for better navigation in a dynamic landscape that calls for SD-WAN, IP Elastic cores, OTT offerings, and more.
- We are currently in the midst of an infrastructure upgrade cycle which is creating uncertainty, yet also an investment opportunity. What we do know so far, is that Cincinnati Bell is able to grow its Fioptics subscribers at over 25% annually versus national averages of around 15%. We believe its success is due to its concentrated geographical footprint, regional economies of scale, and SG&A efficiencies allowing it to compete against larger cable peers.
- We think Cincinnati Bell conservatively should be valued above $22 today. Cincinnati Bell reported ~$660mm in Strategic sales in the last 12 months. We recategorized what we think is “Strategic” and adjust this number down from $660mm to $350mm, with the remaining deemed “Legacy”. We looked at peer multiples from various types of wireline providers and believe a 12x and 4x EBITDA multiple is conservative for Strategic and Legacy assets respectively. A look at its discounted (unlevered) cash flow supports our target. We followed this up by modeling out how Cincinnati Bell should look like three years from now. We think this three-year target has a high probability to be beat. More importantly, three years from now its fiber-to-legacy asset mix will make it very difficult to be ignored.
- We believe an inflection point exist in the coming years where its growth in fiber outweighs its declining copper assets. There is mounting evidence that the demand for fiber will dramatically outweigh supply over the long term. However, there will be a number of catalysts in the near 3-year term. This includes the development of a 5G cellular network, in addition to the next wave of video technology will rely on high throughput in addition to low latency.
Cincinnati Bell (CBB) offers wireline services in Ohio, Indiana, and Kentucky. It has a long history dating back to 1873 when it was the incumbent local exchange carrier (ILEC) in Ohio and neighboring states. This means it use to be the monopoly prior to telecom being liberalized for competition. The opportunity today exists because of a disastrous merger with ICX in 2000. Cincinnati Bell had to borrow $2.1bn to fund the merger in addition to eliminating its dividend. Since then, they have been repairing themselves with a number of meaningful divestures in the recent years.
Today, they are focused on providing high-speed broadband internet access throughout the Midwest. They have accelerated their fiber investments over the past few years which has proven to be successful. Amongst its telco peers, Cincinnati Bell is the only one consistently adding internet subscribers, albeit slowly. In the past few years, we’ve only seen the beginning of their next-generation “Fioptics” network. Two characteristics are worth mentioning. First, we have seen its success with capturing share versus its peers. Second, we have seen improving cost economics in deploying fiber to the home. It is likely these trends not just continue, but accelerate into the near-future.
Cincinnati Bell’s balance sheet has meaningfully transformed over the past few years. This has been accomplished through the sale of non-core assets, specifically their wireless segment and stake in CyrusOne. We think this billion and a half reduction in net debt is meaningful for a firm currently under $1.8bn in enterprise value. Gradually, their Net Debt / EBITDA has come down from 5.2x in 2012 to 4.2x in 2016. This has also positioned Cincinnati Bell to have a more natural equity investor base. They have meaningfully delevered, successfully completed a 1-to-5 reverse split, diversified non-core assets, and will be in a position to institute a dividend in the coming years.
The company is currently suffering through a competitive infrastructure upgrade cycle. Their legacy copper network is under pressure from its cable peers, but this will subside. We believe an inflection point exist in the coming few years where their copper DSL network stabilizes while their fiber network accelerates upwards. We believe a number of catalyst will occur in the near-term to accelerate the demand for a fiber network that presently doesn’t exist. This acceleration should occur before the launch of the 5G cellular network, and driven by the next wave of video technology and applications which rely not just on high throughput but low latency.
Despite the uncertainty around competitive environment in wireline, what we do know from the past few years is that Cincinnati Bell can grow fiber internet subscribers 25%+ year-over-year versus the national fiber average of around 15% year-over-year. We will investigate what is driving its success and where we expect Cincinnati Bell to be 3-5 years out.
Who Is Cincinnati Bell
For those looking for a more complete analysis, we have included Appendix A: Overview of Wireline Industry. Here we introduce the competing technologies, the number of subscribers per technology, and its relative market share.
In Appendix B: Industry Map, we take a high-level view of the industry and look at how the various parties exchange product/services with one another. It is not meant to be exhaustive, but rather to set to stage in [i] explaining why competitive advantage exist and, [ii] to propose what we think is a pragmatic growth strategy.
We follow the industry map with a look at the sources of competitive advantage that exist in the wireline industry (Appendix C). Despite the escalated competitive environment, it is worth noting these key sources that drive steady profitability remains intact.
The above table shows various wireline providers in the United States. It is in no way a rigorous list but provides a quick sense of various players, their relative sizes, sales and margins. The first observation worth noting is Cincinnati Bell’s relative size. Although it appears relatively small and may lack scale advantages, this is not the case. In actuality, its concentrated presence in Ohio, Indiana and Kentucky gives it more scale economics than larger peers in the context of its own states. This can be seen from its more efficient operating expenses.
The second observation is the relative multiples appropriately reflect maturity and growth potential of the technologies. Telcos predominately own copper DSL technology and are attempting to grow their fiber network. Cablecos predominately own coaxial cable technology with a hybrid fiber/coax network. IP Transit providers are predominately fiber. One part of any telco wireline thesis relates to the probability they can transition from their legacy copper network to a fiber network. Moving on, we will very briefly glance over some multiples of Telus, a Canadian telco/wireless carrier.
Although this is not an apples-to-apples comparison, it offers what we feel is a good relative sense of the industry. You will want to model out a dozen wireline peers yourself, but the general characteristics of this industry can be seen using Telus as an example. Note, you would have to adjusted accordingly given Telus’ dominant wireless assets. Having built a base-line sense of the industry, we will shift focus back to Cincinnati Bell and look at how it’s different from its peers. We will start by looking at Cincinnati Bell’s recovery efforts over the past 5-years.
Over the past few years Cincinnati Bell has been patiently deleveraging its balance sheet from 5.2x Net Debt / EBITDA in 2012 down to 4.2x in 2016. One key event was the sale of its wireless segment to Verizon in 2014, which was bleeding cash. More notably was its gradual sale of CyrusOne which completed in the first quarter of 2017. To provide some context, this data center business grew revenue from $74mm in 2009 to $529mm by the end of 2016.
We think the recent changes have positioned it to have a more natural equity investor base. Specifically, its debt pay down, 1-to-5 reverse split in 3Q 2016, diversification of non-core assets for easier understanding of business segments, and option to institute a dividend. Additionally, its balance sheet has gradually improved. Expenses have been eliminated around its wireless segment, pension obligations, and maintenance from legacy copper operations.
We think Cincinnati Bell is positioned favorably in a horizontal market. Counter to AT&T’s strategy to vertically integrate, we believe the industry is and should be moving horizontally. The industry is in a multi-decade cycle to break apart vertically with niche verticals such as: data centers, IP transits, content delivery networks, tower operators, communication platform providers, security platforms, and various OTT offerings. For a firm operating in a dynamic vertically integrated market like Salesforce.com, top line growth is important. The firm with more resources will more likely create that fully-integrated solution. We want our CRM to be fully integrated to connect our sales department to support department. We want all data centralized and marketing and analytics already tied into the same system. The opposite is true for a firm operating in a horizontal maturing market with low growth like wireline. In a horizontal maturing market, we would like to see non-core assets diversified, and an opportunity to be easily acquired. If not acquired, we want to see the firm positioned to compete well against peers because it holds regional scale advantages. We want the firm to have relatively newer fiber technologies, while also having nimbleness in relative size. These two factors will help it navigate the future of SD-WAN, IP Elastic cores, OTT, and more.
For those looking for a deeper dive into the industry structure, we have a section titled Revisiting the Computer Industry included in Appendix E. Here we look at how the telecom industry has matured and why it is flattening in a horizontal structure. We discuss what the requirements are in order to succeed in such a structure, and Cincinnati Bell’s alignment to this. We end off by proposing how we think the near-future will look and why we think Cincinnati Bell will be acquired.
Cincinnati Bell's Business Segments
Cincinnati Bell categorizes its business segments as follows:
- Entertainment and Communications (E&C) – primarily internet and TV services
- IT Services and Hardware – IT services such as cloud hosting, VoIP phones, network security, etc.
Within Entertainment and Communication (E&C), it is further segmented into:
- Consumer – bundled internet and TV packages offered to consumers
- Enterprise – internet services to businesses
- Carrier – leasing of internet pipes to wireless carriers
Simplistically, one can think of the Entertainment & Communication segment as TV and internet, and the IT Services are the additional services such as VoIP phones (that run on that internet circuit). In considering asset value, it is more informative segmenting Cincinnati Bell in terms of its technologies (DSL vs. Fiber), as oppose to their consumer or enterprise segments.
In Appendix G, we include an Introduction to Digital Subscriber Line Landscape for those want some background. We think the current wave of subscribers switching from DSL to cable is both very real and will likely accelerate in the near-term. However, this switch in technology will take longer than expected and DSL assets will continue to have value over the next 5-10years. When the value in Cincinnati Bell’s DSL assets start to stabilize, the focus shifts to its fiber assets.
We offer a brief Introduction into the Fiber Landscape in Appendix H. We take a deeper dive into this by looking at Cogent, a pure play fiber provider in Appendix I. Over the past decade, the cost of bandwidth has been coming down at staggering rates. This called into question the sustainability of firms like Cogent. Thus far, many have been surprised of the robustness of demand. We think this trend will continue to prove the skeptics wrong.
In Appendix J: Fiber Supply vs. Demand, we take a longer-term view and propose where we think supply and demand will be a decade from now. Here we conclude that wireless is not a substitute technology to fiber, but rather connected technologies. A decade from now we expect technology could have as much as a 10x multiplying effect on the supply. However, demand will vastly outpace the supply, driven by content richness and the number of devices. This idea is core to our thesis.
Cincinnati Bell's Fiber Build Out
A transformative fiber optic networks is in progress. Over the past few years, Cincinnati Bell has spent around half a billion dollars in building out its “Fioptics” fiber network. This Fioptics investment represents a significant amount relative to their size. As a percent of their Property Plant & Equipment, it is approximately 50%. This contrasts with CenturyLink which is less than 20%, assuming a similar weighting of fiber to maintenance capital expenditures.
Fioptics sales have been growing at a nice 30%+ annually and its contribution to total sales have more than doubled. This sales figure however is misleading. It is a poor representation of the longevity of its future cash flows. The earning potential of the fiber assets should increase for the next decade but will remain useful even further. Currently, cable has taken the majority share of residential internet due to its technical superiority. Fiber is and will continue to offer a path back into the residential market.
“The business case for FTTP has improved dramatically over the past few years, with costs falling significantly. Ten years ago, Verizon’s cost to deploy FTTP was roughly $1,500 per home passed, plus another $1,500 per home to connect. Cincinnati Bell and CenturyLink have recently estimated the cost per home passed at $500–700, almost one-third of what it used to be.” (Ovum)
A better metric for Cincinnati Bell’s Fioptics success is their subscriber count. Over the past few years CBB has been able to grow subscribers at around 25%+ y/y versus the national fiber average about 15% y/y (4% broadband subscriber growth y/y). Looking into the near-future, the cost of deploying fiber will continue to come down, while the addressable market will continue to expand.
In Ohio, Indiana, and Kentucky, fiber penetration rates are low relative to the national average. This offers favorable opportunities for organic growth.
“Passing” measures how many potential customers the fiber network exposes CBB to. For example, if you owned the fiber assets along a street with 20 homes, your “passing” would be 20. CBB’s passing has expanded from 276 thousand homes at the end of 2013 to 533 thousand homes at the end of 2016. Additionally, the number of Fioptic internet subscribers relative to the Total Passing has been improving every quarter. What is important to note here is absent an investment in new construction, growth can come from increasing penetration.
In thinking about the long-term margins of fiber, we can use Cable as a lower bound benchmark. Most cable providers are around the forty percent EBITDA margin at maturity. This margin assumption is also consistent with the valuation built into pure fiber providers like Cogent. However, it would be wise to exercise some caution on margin potential looking into the future. Specifically, as the industry evolves into a more horizontal structure, competition should drive margins down. This is further discussed in the section on Industry Structure. Additionally, CBB’s primary competitor in the cable space is Time Warner Cable (now owned by Charter Communications), and run by a true visionary that needs no introduction.
Finally, it is worth considering how fiber deployment has played out historically. How did fiber compete vs. cable in 2007? Looking at Net Subscriber Adds between 2007 and 2012, it is clear cable ‘net subscriber adds’ beats out DSL’s ‘net subscriber adds’ during the same quarter. However, when Telcos added video (bundled in a Fiber offering), it consistently beats out cable. We are seeing this pattern reoccur now and probable to assume it will continue into the near-future. To further emphasize, this does not even consider the benefits of latency that fiber offers because the use cases have not yet emerged.
Source: Bek R., Rizzi, T., Grewal, K., “Canadian Cable/Telecom – Outlook For 2013”, (2012)
Growth Strategy Looking Forward
We should begin by segmenting the opportunities for growth. A logical way is simply following how Cincinnati Bell segments its business: Consumer and Enterprise. Additionally, we should simplify by only focusing on growth from its core business of providing internet services.
- Should Cincinnati Bell grow its consumer internet organically or through acquisitions?
- Should Cincinnati Bell grow its enterprise internet organically or through acquisitions?
- Of these four opportunities, which is of priority? Which would be most pragmatic?
Currently, cablecos hold the majority of share in the consumer segment. Telcos on the other hand have good reach to enterprises because they run off the historic telephone copper network. Like cable in its early days, fiber optics is now being pushed to the consumer segment and gaining share. This should happen quite organically due to the superiority in technology. The enterprise segment should at the same time become more competitive.
We think it would be pragmatic to organically grow the consumer segment. There isn’t a need to aggressively grow this through acquisitions, which could further disturb the competitive environment. On the other hand, it is worthwhile for Cincinnati Bell to invest and more aggressively defend its enterprise segment. Breaking down the enterprise segment, there is two sub-components: internet and IT Services (eg. VoIP, network security, hosting). Let’s review our industry map.
The Enterprise Customer is looking for an internet connection, Unified Communication, network security, and hosting. It engages a Service Provider for this packaged solution. The Service Provider acts as an integrator, leasing the internet circuit from the local carrier (in some cases, its competitor). There are two paths in investing to boost the enterprise business,
- Directly – through focusing efforts on the Service Provider (IT Services)
- Indirectly – through investing in the wireline infrastructure (which local Service Providers will in turn purchase for Enterprise Customers)
We think it would be most pragmatic to focus efforts firstly on the Service Provider who services the Enterprises. In the case of Cincinnati Bell, this would mean focusing on building that enterprise relationship first, even if they do not own any wireline infrastructure in service area. This could mean having to lease the underlying wireline infrastructure from a competitor to service the end-customer. This offers a key ancillary benefit. Over time, the fiber wireline infrastructure can be built to the end-customer, knowing they already have the relationship in place. When the fiber arrives, the existing cable circuit can be cancelled. This is the approach Cincinnati Bell is taking to expand its footprint into Michigan.
The wireline competitive landscape has weighed heavily on DSL carriers over the past year and we believe this will continue for the next few years. As DSL continues to lose share, there is a compounding effect because the costs of supporting the infrastructure do not symmetrically move downwards. Measures such as augmenting the DSL network with fiber (Fiber-to-the-Node) will help, yet these improvements still struggle to compete with cable speeds. In our next section on Valuation, we redefine what we believe to be true Legacy assets. We think it will take about three years until CBB’s Fioptics business surpasses ‘legacy’ as a percentage of total sales. As such, a reasonable argument is to wait. This disproportion negative emphasis on DSL legacy assets could continue. The rebuttal is that with high probability the competitive landscape will subside. At that time, the less noticeable fiber assets will be proportionally valued.
The risk in turn shifts to the robustness of fiber growth. Categorically, the concerns are either [i] a disagreement on a macro supply-demand for fiber assets in the future, or [ii] Cincinnati Bell’s ability to build out their fiber network. The first concern we discuss in Appendix J: Fiber Supply vs. Demand. The second concern we briefly discuss in the following section on Valuation. This concern relates to whether CBB will have sufficient cash to continue its fiber build out. Not currently issuing a dividend to its common shareholders puts them in a good position. This contrasts with names like Frontier who has had to cut their dividend. The immense importance of maintaining this dividend policy is difficult to describe. For those interested, we recommend reading in on Telus quarterly conference calls. As Entwistle describes, everything that relates to financial engineering is in servitude to their dividend growth model – their top priority. Regardless, it is highly recommended to follow Telus’ quarterly commentary as Entwistle is likely the most articulate and formidable competitor in the telecom space.
In Cincinnati Bell’s case, we would closely monitor its cash availability to pay down debt, in addition to investing in its fiber network. Any sudden movement in its leverage ratio would justify a reassessment of our short-term thesis. This quandary has been weighing on firms like CenturyLink as they are also trying to build out their fiber network. Over the past few quarters, their capital has been able to fulfil their dividend quite effortlessly. However, looking holistically, it has fallen short in improving its capital structure.
Our three-year timeframe is in line with the 2020 target for 5G technology. Over the past few years there has been skepticism around high frequency mmWave spectrum and its application in 5G technology. The latest bidding war for Straightpath hopefully settles this debate. In the world of 5G, the demand for new fiber is a prerequisite for the technology to come to fruition.
The fiber thesis and catalyst follows the same logic of mmWave spectrum. That is, the catalyst are typically events that validate the demand for the spectrum or fiber asset. How will fiber/spectrum technology play a role (if any) in the future? Some of these catalyst in spectrum included,
- The Federal Communications Commission (FCC) publishing a Notice of Inquiry (NOI) in October 2014, in which they sought comments on several bands as potential for 5G
- The FCC confirming StraightPath’s high frequency bands are of value by fining them for hording it
- Verizon acquisition of XO Communication’s spectrum
- AT&T intention to buy FiberTower’s spectrum and cell backhaul network
- Technical reports from Samsung, Qualcomm and other vendors validating their adoption of the technology utilizing the high frequency bands.
In the present environment, wireline remains highly competitive with carriers offering significant improvements in speed at little to no cost. One could make the argument that an optimal entry point is during these competitive environments when uncertainty is most prevalent. Unfortunately, determining this slowdown in competition likely unknowable. What we do know is that historically the industry has been known for its tacit coordination and lack of direct price competition. The likelihood that the price wars will persist for more than three years seems unlikely. As the competitive landscape decelerates and CBB’s fiber reach scale, they have the option of instituting a dividend.
In 1Q17 Lumos Networks was acquired by EQT Infrastructure. Lumos had three business segments: Data, R&SB, and RLEC Access. Roughly, their Data is “strategic” assets, while R&SB is closer to “legacy” DSL technology including PRI, long distance and analog lines. RLEC is something in between, some valuable, some not so much. One approximate way to categorize and normalize its assets mix is as such:
Above, Lumos’ Data segment is renamed Strategic, R&SB renamed Legacy, and RLEC split between the two. The blue values are inputs while the black font are calculations. We start by using the acquisition price of approx. $900mm and assume an EV/EBITDA multiple of 4x on Legacy assets. The goal is to calculate the implied EBITDA and Sales multiples of Lumos’ Strategic and Legacy assets. By assuming a 4x EBITDA multiple on Legacy, it implies a 12x EBITDA multiple on Strategic assets. Lowering the 4x EV/EBITDA multiple on Legacy would increase the multiple on Strategic, and vice versa. Next, we will look at additional wireline peer multiples to validate our Lumos analysis, in addition to getting a better sense of the rest of the wireline carriers.
Before thinking about the current multiples, we will categorize the types of wireline carriers as seen above. For example, it is worthwhile separating wireline carriers with a cable assets versus copper assets. The EV/EBITDA of 4x for Lumos’ Legacy is lower than the average as we believe copper DSL will continue to come under heavy pressure in the next few years. Directionally, it should come down and not up, however, feel free to adjust as you see fit. We used peer multiples and chose a ‘base multiple’ representing what we feel would be conservative. For example, Frontier trades around 5x EBITDA but we feel 4x is more reasonable. These base multiples will then be applied to Cincinnati Bell as comparison. As a sanity check, we looked at recent wireline acquisitions such as CenturyLink’s acquisition of Level 3 (13x+ EBITDA), Windstream’s acquisition of Earthlink (~5x EBITDA), and Consolidated Communication’s acquisition of Fairpoint (~6x EBITDA).
For Cincinnati Bell, we applied our base multiples of 12x EV/EBITDA on Strategic and 4x EV/EBITDA on Legacy. The results imply a price per share of $22.38. However, there are a few other observations,
- Both Strategic and Legacy use a multiple we think are conservative.
- EV/Sales of Legacy imply DSL sales may cut in half. We don’t think it will be that extreme but we will use this in a separate valuation model below.
- 3.6x EV/Sales of Strategic assets is lower than our conservative ‘base multiple’ of 4x.
Additionally, we should discuss how we are approximating Strategic and Legacy sales for Cincinnati Bell.
- CBB currently reports approx. $660mm of “strategic” revenue in the last 12 months
- What is defined “strategic” by wireline carriers is based on speed capabilities. This definition unfortunately changes. The trend is faster speeds which is why the definition changes. Given that a number of wireline firms re-categorize “strategic”, we don’t think it’s fair to trust this definition.
- We will instead define CBB’s strategic assets as only: Fioptics, Unified Communication, and a small portion (5%) of their DSL network. These totals $360mm which is almost half of the reported $660mm. $240mm to Fioptics (excluding Voice), $80mm to Unified Communication, and $40mm to DSL.
Finally, the EBITDA Margin can be approximated in a few ways. We consider CBB’s current margins, peer margins, its relative strength versus technologies like cable long-term, etc. The below table shows historical margins. What isn’t shown below is the implied EBITDA margin in the terminal years based on current valuations. This terminal average margin for cable and fiber carriers is around 40%.
This analysis point to nice downside protection from the current price. Next, we will look at a 10yr unlevered free cash flow.
Assumptions in the above model include,
- Discount rate of 6%
- 0-1% top line growth until maturity
- -1% maturity growth rate at year 10 and on
- Minimal gross margin improvement. This is conservative considering the cost structure of a fiber network is lower than a DSL network and meaningfully lower than managing a DSL and fiber network.
- Terminal EBITDA margin of 30% which we think represents a meaningful amount of conservativism relative to cable peers.
As a quick sanity check of the Discounted Cash Flow,
This valuation also arrives at the same conclusion that there is upside at the current price while applied to what we think are conservative assumptions. We however feel this traditional method of valuation is not appropriate given the industry is in a consolidation phase. As discussed in [p6] ‘Revisiting the Computer Industry’, we suspect a continued pattern of natural consolidation and inorganic growth. This makes modeling based on historic growth quite unrealistic. We believe CBB will either grow through acquisitions or be acquired in the long-run. It therefore makes more sense to only model for the next few years.
Over the next few years, we believe fiber demand will remain strong and likely accelerate. However, it is Cincinnati Bell’s cash availability that will limit their fiber investment. We estimate Cash Flow from Operations to remain around $150-200mm over the next few years. This assumes around $20-25mm annual restructuring and $40mm working capital. At this level of cash generation, we anticipate new fiber buildout will slow relative to the past few years. Legacy DSL will continue accelerate downwards while Unified Communication and IT Services will grow. Three year from now, the thesis is essentially an asset-mix swap from legacy to fiber. The below model follows our above ‘legacy’ definition and margin assumptions. We think there is safety even using conservative assumptions such as,
- Fioptics EBITDA multiple and margins remain at current levels although it continues to grow
- Unified Communication EBITDA multiple and margin comes down as growth slows
- Legacy EBITDA multiple and margin continues to come down