GTT Communications: Interoute Acquisition Biggest In History
Summary
- GTT Communications has returned more than 1,700% since 2013, obliterating any benchmark.
- The company hits a lot of checkmarks for investors in today's market: a successful roll-up, low capital needs, heavy free cash flow generation, great end market.
- The Interoute deal is massive and nearly doubles the size of the company. The move into Europe will provide excellent cross-sell opportunities.
- Today, the company looks fairly valued to asset-light comps. Strong deal execution leaves room for more upside for bulls.
Successful roll-ups are not common, but GTT Communications (GTT) is one of them. As of this writing, shares are up 1,718% since the beginning of 2013. The company has nearly everything investors are looking for in common equity nowadays. Cloud-based technology? Check. Recurring revenue? Check. Asset-light business model? Check. Excellent revenue growth? Check.
Valuation multiples at GTT Technologies have gotten pretty stretched compared to peers, but that hasn’t kept shares down. Management has built a reputation as a leading consolidator in the space and recently announced a game-changing acquisition: the $2,300mm buy-out of European-based Interoute. It’s by far the largest acquisition in company history, but investors have already written this off as another feather in the cap of a compelling management team. Does the valuation on the deal make sense, and perhaps more importantly, has management bitten off more than they can chew this time around?
Business Overview
GTT Communications owns and operates cloud infrastructure and fiber connectivity lines. The company’s IP backbone, built off of more than five hundred points-of-presence ("PoPs) facilitates the flow of information across different local area networks (“LANs”) or subnetworks and is one of the largest in the world. While the jargon can be confusing, simplistically GTT Communications helps customers both connect to the internet and send and receive data cross it.
As no internet service provider (“ISP”) has complete network coverage globally, it also sells access to its assets to other network providers as everyone tries to connect in the most efficient manner. In the same vein, it has relationships with thousands of regional suppliers so that it can re-sell space on assets it leases from these companies to provide the best user experience (low latency, minimal downtime, large data limits) to its customer base.
Contrary to what one might expect for those familiar with the telecommunications space, the GTT Communications business is light on capital expenditures. This is no AT&T (T) or Verizon (VZ); most assets are made up of the routing and switching infrastructure, with last mile access leased from local carriers.
Put another way, GTT Communications focuses on the inter-state highways (such as its trans-Atlantic subsea cables) while it lets local carriers deal with the relatively more expensive neighborhood roads. The last mile has always been the notoriously more expensive part of the story, and GTT Communications (in part due to its prior size, also due to its business model) has avoided throwing money down the last mile moneypit.
Cloud networking is a great buzz word in investing today, and it is for good reason. Markets are forward-looking, and the high growth points to how the business landscape is set to change. IP-based and cloud traffic has been growing at a rapid pace: Cisco (CSCO) pegs cloud growth at 30% between 2015 and 2020.
With the consumption of data on the rise, it shouldn't be a surprise to see stronger demand from large multinational companies looking for scalable and dependable networking. These customers do not want to focus their information technology (“IT”) infrastructure on in-house network development; it makes sense to outsource so that costly IT staff can focus on application development and other more pressing initiatives.
Most revenue comes from high capacity internet (25%), broadband internet (15%), and ethernet (21%) solutions, built off of the back of a series of tuck-in acquisitions (UNSi, MegaPath, One Source, Hibernia, Global Capacity). Most of these have been relatively small, but GTT Communications has tied together the assets well. EBITDA has grown from $36mm in 2014 to $222mm in 2017, with EBITDA margin expanding as the company gained size and scale.
Organic constant currency revenue growth came in at 5% in Q4 2017; adjusted EBITDA was up 11%. That is solid growth, but I think the story on margins is what continues to dominate investor sentiment. More strength for legacy operations is likely next year, as management states that there is about $30-35mm in EBITDA expansion yet to be realized from recent acquisitions just from cost savings. Even with that still on their plate for next year, it was not a surprise when the company announced yet another transaction, but this one was its largest yet: the purchase of Interoute for $2,300mm in cash.
Interoute Acquisition
This is a massive (and arguably aggressive) deal that is set to increase the enterprise value of GTT Communications by 75%. It will be no small undertaking, and management has not had to deal with anything of this size yet in its time at the helm. The price represents a multiple of 11x trailing EBITDA (perhaps giving pause to the current valuation of 14x for GTT Communications), but management believes it can squeeze out $100mm in run-rate cost synergies to push that multiple down to 7.5x in a few years’ time.
At first glance, that’s a big burden, as such savings would effectively improve underlying EBITDA margin by 60% at Interoute. Despite the risks, current major shareholders are betting big on a clean execution. Management secured $250mm in committed equity financing from The Spruce House Partnership – an existing shareholder – and Acacia Partners to help close the Interoute purchase. The rest will be funded with new debt; terms are not yet known.
While management has not spoken to the duration or whether they are going the secured or unsecured, investors should expect interest expense to run about $130mm annually in my view, which assumes pricing at around 6.5% coupon. The company’s current bonds, such as the 7.875% Senior Notes due 2024 (CUSIP U3829QAA0) currently trade well above par despite higher leverage being on the horizon.
Deal rationale is simple: more breadth, depth, and scale. Interoute is European-based and has 72,000 miles of fiber spanning most of the European Union and two dozen major metro markets. It has an established presence in both physical and digital data center locations and owns the route for intercontinental cables running from East Africa, Israel, Malta, and Tunisia into Europe. Prior to the acquisition, most sales (three quarters) were to American customers. This opens up the company to a whole new set of European-based clientele and gives better options to its American multinational companies with an Old World presence.
Leverage is expected to be 5.25x at close; a figure that includes pro forma EBITDA and the realization of all synergies. In response, Moody’s and S&P have put the company on watch for a downgrade. While ratings agencies acknowledge scale and market position of the combined firm means better leverage tolerance, analysts seem skeptical of GTT Technologies’ ability to digest this deal. The company has built itself into what it is today off of a multitude of small, quickly accretive deals where leverage was easily controlled given the high cash flow nature of the business.
Takeaway
$280mm in EBITDA looked likely before this deal; $460mm with Interoute before synergies. Capex will likely come in at $130mm (guided at 7% of sales), interest expense at $210mm. That leaves $120mm in free cash flow, or 5.2% free cash flow yield. I think that’s spot on for a high growth, capital-light business, and if you're a believer in the story, it leaves room for upside if the company executes on its synergy guidance. GTT Communications comps well to other asset-light businesses, but direct comps of a similar size in this business are rare.
GTT Communications is now a rather unique case when it comes to size and scale. Given the past execution here, no one is eager to bet against the firm. Just 214,000 shares were short as of last reporting. This is out of a float of nearly 44mm: precisely 0% if you round to the hundredths. However, longs do need to approach this deal very critically. There is a world of difference between paying $529mm for Hibernia Networks (its prior largest deal) and integrating it versus Interoute.
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This article was written by
Michael Boyd is an energy specialist with a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, he is a full-time investor and "independent analyst for hire.”
Michael leads the Investing Group Energy Investing Authority. The service focuses on finding total return opportunities within the energy sector, ranging from upstream producers to pipelines to refineries. Features include: model portfolios, real time trade alerts, high quality research, and an active and vibrant chatroom of professional investors. Learn More.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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