Cbeyond (CBEY) is undervalued, generates high free cash flow and its focus on the cloud will drive higher revenue and margins as well as provide stickier customer relationships.
CBEY provides bundled cloud and communications services to 58,000 small and medium sized business customers (~third are referrals) using secure all-IP network in 14 markets in the United States. The all-IP network requires significantly lower capex and operating expenses compared to traditional networks using legacy technologies and provides improved reliability and quality of service.
Source: Company presentation
CBEY is currently valued as just another IT company providing a commodity service rather than a high growth cloud company providing specialized and valued-added services. The investment opportunity only exists due to the fact that management only recently started to transition customers to the cloud. Short-term oriented investors and competitors have ignored the substantial market opportunity due to frustration over the longer sales and installation process. However, current educational efforts should develop long-term strategic customer relationships and provide a higher margin, more stable revenue stream.
If investors wait until a majority of revenue is generated from 2.0 customers (see below), CBEY could have appreciated significantly. The greatest profits and lowest risks are at the beginning of the trend (in this case to the cloud) rather than the middle or the end.
Valuation is based on past business model - not present
CBEY is undervalued on an absolute basis...
...and relative basis
...and based on a recent industry M&A multiple.
CBEY trades at a P/S of 0.48x while cloud company SoftLayer Technologies was acquired by IBM for ~$2 billion, or 5x revenue.
The transition to the cloud will benefit CBEY and its customers
Source: Company presentation
CBEY made a strategic shift in early 2012 (new dedicated 2.0 direct sales group, reduced 1.0 sales force, consolidated offices) to focus on customers with complex IT needs. The acquisition of Aretta Communications and MaximumASP in late 2010 expanded its cloud product portfolio and geographic footprint. CBEY is now focused on driving revenue growth rather than unit growth.
The 2.0 platform is fully available in all 14 markets and is the only integrated offering (combining network, cloud and security) available to small and medium sized businesses. The low amount of competition is due to a general lack of customer education about the benefits of moving to the cloud (higher ROI, improved business continuity and security, greater resource flexibility). The TotalAssist service helps customers seamlessly transition to the cloud and represents a significant competitive advantage.
There is a significant opportunity to convert existing lower paying, 1.0 customers who purchase a few products to higher paying, 2.0 customers who purchase a bundle of products. Management said on the 1Q13 conference call that two-thirds of its 2.0 customers were existing customers that upgraded.
Signs of progress include:
- 2.0 customers provide over 70% higher ARPU than 1.0 customers. This figure is expected to grow.
- In 1Q13 CBEY added more than 600 2.0 customers
- Revenue from 2.0 customers rose 99.8% from a year ago and accounted for 11.4% of total revenue in 1Q13 vs. 9.5% in 4Q12.
- 2.0 revenue is expected to account for 20% of total revenue by the end of the year
- CBEY completed a metro ethernet conversion in 2011 and built out its optical fiber network last year. This will result in increased bandwidth capacity, ability to offer additional product offerings and reduce traffic transport costs (compared to leased T1 technology).
Bottom line: The cloud will drive higher ARPU, margins and stickier customer relationships
- Total revenue increased 0.9% to $120 million and ARPU increased 2.8% to $656 from 4Q12
- Adjusted EBITDA of $20.8 million, an increase of ~$2 million and adjusted EBITDA margin of 17.4% vs. 15.8% from 4Q12
- Free cash flow of $8.4 million from $4.3 million in 4Q12
- Gross margin increased 70 basis points to 67.7% from 4Q12
- Monthly customer churn of 1.6% was unchanged despite price increase. Management said on the 1Q13 conference call that a majority of the churning customers over the past few quarters are lower ARPU customers (lower-margin, declining-revenue) and not the ideal candidates for up-sell to 2.0 services. Management expects 2.0 customer churn to be lower than traditional customer churn going forward.
Rising revenue, EBITDA and free cash flow
Strong balance sheet
CBEY has a $75 million unused line of credit, $10 million senior secured delayed draw term loan (only $2 million outstanding) and $23.8 million in cash/equivalents.
History of significant stock buybacks
CBEY completed its $15 million buyback plan last year.
Competition. CBEY competes against local telephone and cable companies, competitive local exchange carriers, mobile service providers and larger cloud service providers.
Shareholder unfriendly provisions. CBEY has a staggered board, prevents stockholders from calling special meetings of stockholders or removing board members without cause, does not allow written consent and the board is permitted to issue preferred stock which may discourage a takeover. In general, this would discourage investors however there are two mitigating factors. First the low valuation provides a "floor" for the stock to some extent. Second the stock buyback plan mentioned above shows that the board does care about shareholder value. While the possibility of a takeover is remote, the potential for upside appreciation is substantial.
Rapid technology changes. The communications industry is constantly changing and requires significant capex in order to remain competitive. However the shift to the cloud, new optical fiber network and expanded product offerings mitigate this risk significantly.
Small and medium sized businesses are most dependent on domestic economic growth. However this risk is mitigated by the following:
- The essential nature of products offered reduces the risk of customers canceling service (e.g. businesses always need phone and internet service in all economic conditions)
- Product bundling provides customer and revenue "stickiness". Companies are less likely to cancel service if they use multiple products/services.
- There are significant cost and time savings to outsourcing IT needs vs. providing them "in-house" (especially for small and medium sized businesses). The shift to the cloud will reduce these costs even further.
- Small and medium sized businesses can generally only access higher capability products/services through outsourcing due to significant resource requirements.
A conservative price target of $10.30 is based on a 4x EV/EBITDA multiple using 2013 EBITDA of $75 million (low end of management guidance of $75-82 million).
A tight stop should be placed below the recent low of ~$7.40. The time frame is one year.