Cincinnati Bell Doubles Down On The Bull Case

Summary

• Cincinnati Bell's acquisitions of Hawaiian Telcom and OnX came out of the blue - and on their face seem a bit odd.
• But the acquisitions do align with CBB's existing business and amount to a leveraged bet on the long-term bull case here.
• The market didn't like the deal, and it does amplify risk.
• But it also amplifies reward, making CBB a more leveraged play on the long-term value of fiber and the company's ability to create a legitimate consulting/reselling business.

I don't recall being more stunned by a major move of a company I owned than I was by Cincinnati Bell's (NYSE:CBB) announcement Monday morning that it was acquiring two companies for a total of about $850 million. The bull case for CBB was predicated mostly on a deleveraging/cash-flow-compounding scenario, particularly with capex spend on the company's fiber-optic network in the Cincinnati area expected to taper off towards the end of the decade.

Cincinnati Bell had hinted at some M&A interest and made a small acquisition in February. But that interest seemed limited to growing the company's CBTS IT solutions business - and CBB management spent just as much time highlighting improvements in the company's leverage ratio and discussing the possibility of share repurchases (see, for instance, the Q1 conference call). Add to that the fact that CEO Leigh Fox had taken the top spot only on May 31 (though he was COO prior to being promoted), and such a major move was a significant surprise.

The market didn't appear to like the deal much, sending CBB shares down 7%. And, I'll admit my initial reaction wasn't particularly positive, either. The combination of Cincinnati Bell and Hawaiian Telcom (HCOM) seems an incongruous fit. Existing shareholders are being diluted by roughly 30% at a price of $18.86, a price I (obviously) thought left CBB undervalued to begin with. And, a $200 million acquisition of OnX is a notable expansion of the IT services business - a tough business with smaller margins and one that dilutes the core fiber-based story here.

But looking at the deal more closely, CBB's play makes more sense. In fact, it's essentially a leveraged bet on the existing bull thesis for the stock. And, I think that bull thesis is strong enough to justify that bet - even if it likely adds a bit more risk long-term, and potentially more volatility in the near term.

Two Big Deals

Cincinnati Bell's larger deal is an agreement to buy out HCOM for a total of about $650 million, including debt. HCOM shareholders will receive $30.75 per share - a 23.7% premium to the 20-day weighted average price - with a 60/40 cash/stock split.

The combination of ILECs in Ohio and Hawaii seems an odd one. But Fox argued on the post-acquisition conference call that "it's just uncanny how similar our two companies are". Both companies have focused on building out fiber-optic networks, with Cincinnati Bell's penetration at 67-68% and Hawaiian Telcom's around 65%. Both compete solely against Charter Communications' (CHTR) Spectrum brand. Even the relative investment theses were pretty similar, with HT's capex expected to decline in 2017 (per its 10-K) and CBB's likely to do the same come 2019 or 2020, as the respective fiber build-outs came closer to their conclusions.

The tie-up of the two networks makes sense too in that it is a bet on fiber's place in telecommunications going forward. CBB's argument long has been that fiber will be a necessary complement to 5G wireless, rather than be cannibalized by it. From that standpoint, HT's fiber in Hawaii, plus cable capacity linked Asia to the U.S., is an attractive asset at a reasonable valuation.

And, at the end of the day, HT basically is an asset purchase. CBB estimated about $10 million in synergies realizable after two years, from systems consolidations, public company costs, and corporate savings. Against TTM Adjusted EBITDA for Hawaiian Telcom of ~$115 million, those synergies clearly aren't the main rationale for the tie-up. Rather, Cincinnati Bell thinks that it is well-positioned, and that it owns valuable fiber assets. And, clearly, Fox and the CBB board believe that buying a similar company at under 6x EBITDA (and almost 5x post-synergy) is a smart move.

As for OnX, it's perhaps an even more aggressive play. Cincinnati Bell made no secret of its desire to expand its CBTS IT solutions business beyond the Midwest - and OnX does precisely that. It adds offices in Toronto, New York, and beyond:

Source: CBB merger presentation

The two businesses (plus HT's own solutions business) also have some complementary skill sets. CBTS unsurprisingly has focused more on voice and data solutions, including UCaaS. OnX's strengths, per Fox on the post-merger call, lie more in storage and data center. OnX revenue has been growing, though Fox didn't break out past results. And, it's larger than CBTS, at least on the top line. CBB's merger announcement cited $614 million in sales and $29 million in Adjusted EBITDA for FY17 (ending April 30). For the 12 months ended March 31, CBB's IT Services & Hardware segment generated $414 million in sales and $36 million in EBITDA.

Those numbers show some of the risk involved here. CBB is nearly doubling its sales - but also moving its revenue split from ~64/36 network/services to ~50/50. That services business has a much lower margin: CBTS had TTM margins of under 9%, while OnX's are under 5%. That compares to 29.5% for HT (including corporate expense) and 37% (excluding corporate) for what Cincinnati Bell calls its Entertainment & Communications business.

The IT solutions business simply seems much tougher. CBTS had a noticeably poor Q1, with EBITDA dropping 40% year-over-year on a 16% decline in sales. Cincinnati Bell has argued that the transition to cloud has created near-term disruption in that business - which may be true. But, even if that's the case, it's a tough business regardless, with single-digit margins. And competition is increasing with many larger VARs like Insight Enterprises (NSIT) trying to move into services/solutions from even lower-margin product sales. (Insight acquired Datalink for that very purpose, citing data center and cloud offerings as a key rationale.)

All told, I don't like the OnX deal quite as much as HT. The EBITDA multiple looks reasonable at 6.9x, and there are more synergies here. An estimated $10 million gets the post-synergy multiple to a seemingly attractive 5.2x. (Datalink was taken out at 5.0x.) But if OnX/CBTS get squeezed, or the shift to cloud winds up limiting the overall market (a possibility raised by one analyst on the post-earnings call), this could be a deal that Cincinnati Bell regrets. And, while the EBITDA split (still 80%+ from network) means CBB still is a play on fiber, the OnX acquisition does dilute that case somewhat.

Looking Forward

I'm generally a skeptic of M&A as a value driver, and most studies show that the average acquisition destroys value. But there are a couple of points in CBB's favor here when taking a broad view of the transactions.

First, the rationales here aren't based on overly rosy revenue assumptions. There's some broad discussion about HT and CBB sharing "best practices," and the quick expansion of CBTS's footprint is obviously a strategic driver of the OnX purchase. CBB may invest more capital into Hawaiian Telcom's fiber expansion, and Fox argued that past ownership by The Carlyle Group (CG), which took HT into bankruptcy in 2008, had left HT somewhat under-invested.

But it's not as if CBB is projecting some huge acceleration in revenue simply based on the tie-ups here, or a massive trajectory change under new management. Cost synergies of $21 million combined are helpful but seem achievable and themselves aren't required to make the deals accretive, particularly if the longer-term strategic argument holds true.

Second, there's an overarching logic to CBB's substantial expansion. (And, it is substantial: CBB is adding roughly $1 billion in revenue against its previous 2017 guidance of $1.2 billion.) The thesis is rather simple: data needs are going to increase both in number and in complexity. So, the fiber networks of both Cincinnati Bell and Hawaiian Telcom will see accelerating demand (these aren't DSL networks; both CBB and HT offer faster speeds than cable). Meanwhile, 5G and IoT (Internet of Things) needs will increase complexity for businesses, which will spike demand for the IT solutions businesses.

That logic might not be correct. Verizon (VZ), for instance, seems to be focusing on running 5G near homes - but not all the way to the home, instead creating wireless solutions for the 'last mile'. And, there's a possibility that the CBTS/OnX tie-up leaves the combined business somewhat stuck in the middle: a bit too large to be local (beyond the Cincinnati metro), and not quite large enough to compete with established resellers and solutions providers.

But the logic behind the deals is essentially the same logic that drove the bull case for CBB before Monday's announcements, with perhaps a bit more emphasis on the IT solutions side. And, it means that the deals have a better rationale than the initial reaction to buying a Hawaiian ILEC and a Canadian solutions provider (which in my case was mostly unprintable).

And, third, Cincinnati Bell didn't blow up its balance sheet in the process. The pro forma leverage ratio appears to be about 3.7x - a tick above the 3.6x coming out of Q1 pro forma for the final sales of CyrusOne (CONE) equity sold by CBB in the beginning of Q2. Truthfully, I'd rather that figure be a bit higher, which would have required less dilution at a price below $19. And, it does seem from the post-earnings call that the lower capex/deleveraging aspect of the bull case might be pushed out a bit, if CBB management decides to ramp up HT's fiber investment. But the combined debt of the new entity still should be manageable.

Again, if an investor believed in the CBB bull case before the two acquisitions, he or she should continue to do so at the moment. Risk and reward probably are amplified by the new debt, and the IT business in particular needs to be watched closely. But CBB also looks cheaper in the wake of the deal - and not just because of the 7% drop - and it still offers a solid bull case. And if all works out here, the potential upside in CBB is much higher than it appeared on Friday.

Valuation

Part of why I thought CBB was attractive earlier this year was the fact that flat EBITDA essentially was good enough to drive upside. That seemed a reasonable scenario as legacy wireline revenues became a smaller part of the business, and as the Fioptics business in Cincinnati took market share (which grows with each succeeding year a location has been hooked up to the network). Progressively lower growth capex would allow for further deleveraging and shareholder returns, creating a classic cash flow compounder available at ~6x EBITDA and single-digit multiples to achievable out-year cash flow targets.

That story remains intact - and in fact strengthened. 2016 pro forma Adjusted EBITDA was $471 million. With CBB's prior guidance implying a $10 million decline year over year, and a modest Q1 drop from HT, 2017 pro forma figures probably are closer to $455 million (depending on OnX performance).

That's still about a 5.6x EV/EBITDA multiple - actually below that offered heading into the acquisition. (Even assuming CBB shares didn't drop on Monday, the multiple still would have come down 30 bps or so.) And as capex comes down for both companies, cash flow should grow sharply. Hawaiian Telecom both expected lower capex and cash payments from leasing of its trans-Pacific fiber. As a standalone, CBB was on track to hit $100 million-plus in free cash flow; adding $166 million in EBITDA, $42 million in interest expense (assuming borrowing at 7%), and under $90 million in declining capex (per HT's Q1 conference call) should get that target closer to $150 million, if not past. And, the deal adds more NOLs, with the balance near $300 million, enough to shield cash taxes for many years to come.

That's probably a better bull case than CBB offered on its own. The out-year FCF multiple - with a pro forma market cap around $1 billion - is closer to 6-7x. And, again, that multiple doesn't require some sort of accelerated growth - flat EBITDA and planned capex declines likely do the trick. CBB management guided for 3%+ revenue growth and 4%+ EBITDA growth going forward - which, like most post-acquisition announcements, are worth taking with a grain of salt (if not a shaker). But CBB easily can get to $20+ near-term and $25+ mid-term even falling short of those targets. The leverage ratio is roughly similar, the EBITDA multiple has come down (and is below peers, as the merger presentation pointed out), and cash taxes have been pushed out even further.

To be fair, risks have been amplified here as well. The most obvious near-term risk is that the merger creates a combination of businesses that haven't performed all that well of late. CBB's Q1 was disappointing. HCOM missed the sole analyst estimate badly in its first quarter and has had a pretty ugly run relative to estimates of late. CBB projected lower EBITDA and margin pressure on a consolidated basis in 2017; HT's profits fell in Q1. And, OnX's agreement to sell at under 7x EBITDA implies that its growth might be positive, but it's hardly torrid.

This remains a bit of an out-year story, particularly if CBB chooses to re-accelerate capex in Hawaii. And, a higher debt load, weakness in the space (see the stock plunges at Windstream Holdings (WIN) and Frontier Communications (FTR)), and declining revenue and/or profits could lead CBB to re-test the lows this year. And, the debate over fiber's role in the future of telecommunications can have some sway on the stock as well.

But - again - that's not really a shift in the bull/bear case here, which has been amplified, but not changed. I still think current fair value is over $20, and there's still plenty of cushion relative to Cincinnati Bell's expectations to support steady upside over the next few years. The risk and reward are both increased by Monday's acquisitions. But the potential rewards are still more than worth those risks.

Analyst’s Disclosure: I am/we are long CBB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This week, I may add to my position in CBB and/or buy shares of HCOM as a backdoor entry.

Comments

[walk57]

Thanks for the article. I have been observing this rapidly consolidating wireline space for a couple years now. Seems to me the larger dividend payers that have been doing the majority of the "consolidating" (and raising their leverage in most instances) have vastly under-performed the smaller wireline telcos who don't pay a dividend and have been concentrating on improving their balance sheets.

Here is the approximate stock price performance in the last 52 weeks of the two groups starting with the larger players:

FTR: -83%
WIN: -60%
CNSL: -33%
CBB: -32%

And now some select non-dividend smaller players that have been deleveraging:

LICT: +102%
OTEL: +73%
ALSK: +24%

Of these, I hold only OTEL. Despite announcing its intention to explore "strategic alternatives" late last year, and a sizeable increase in stock price since then, it is still by far the cheapest of the above mentioned securities ...trading at just 3.9x trailing twelve month EBITDA. Recent deals in this space, CBB/HCOM, CNSL/FRP, etc have been in the range of 6x. If Otelco hypothetically went for a bargain basement 4.5x its stock would be worth over $12/share versus its current $7.50/share price. Further, its credit line was nearing expiration early last year when the high yield market was essentially frozen because of the oil price decline. They were forced to agree to horrible terms, especially considering their leverage is superior to many wirelines. The high yield market has since seen rapidly declining rates so a re-fi is an option if they don't sell.

Good luck with CBB.

[Vince Martin]

I'm not sure how much if the split has been balance sheet or business focus - but it's an interesting point.

I'm only vaguely aware of OTEL, to be honest - I'm intrigued by your case though. Micro-cap play, sounds interesting.

[Ivan K. Wu]

I've followed the CBB story since 2016 (no position) and it's clear that your original thesis is broken:

1. Both HT and OnX are subpar assets. I'm from Toronto and worked in IT, so I happen to know this about OnX for a fact. Worse than IBM.
2. The deal reduces regional economies of scale and SG&A efficiencies, making CBB a less attractive acquisition target (all else being equal)
3. Management has a track record of throwing money away in pursuit of imaginary "synergies." The only reason the deleveraging opportunity existed was because of a prior disastrous merger with ICX. Old habits die hard it seems.

The argument that this "amplifies" the bull case is not convincing. The original value driver of the improving regional play is gone. Now you're just hoping the company gets bailed out of its bad decisions because it bet on the right technology. Not saying it can't happen (see STRP), but we're in speculative territory now.

Just an opinion from someone with no dog in this fight, but perhaps it's time to move on.

[Vince Martin]

Great comment, thank you. Obviously a number of investors feel the same way. And let me point out that I argued that it "amplifies" the bull case AND the bear case - there's more risk in the stock today than there was on Friday.

#1 - won't argue with you, and obv OnX is my least favorite part of this deal. When tech companies sell themselves for sub-7x EBITDA multiples, I wonder what they know that I don't.
#2 - fair take. I don't know that I saw CBB as a takeout play in the mid-term, and one analyst asked if CBB instead is going to try and be a roll-up itself.
#3 - ICX was a dot-com bubble purchase 17 years ago. And again this isn't a synergy-driven play. They're saying there are some synergies, but they're modest, and CBB itself isn't arguing that synergies are the driver here. They're acquiring ~$140M+ in EBITDA and projecting $21M in synergies. Maybe they hit that number, maybe they don't, but the $21M isn't the attraction here.

To me, it's simple. If fiber is a winner, the deal is a winner (at least the HT part). If not, CBB is a quicker, bigger loser. As always we shall see, and thanks sincerely for the comment.

[Charlie's Munger]

Doing business in Hawaii? No thanks...

[Vince Martin]

Why? Bc you think mgmt made the deal just to go to Hawaii, or bc you think it's a crappy market?