By Jared Sleeper
Our most recent pick is Axia NetMedia (OTC:AXANF). Axia is a Canadian developer of next-generation broadband networks, meaning it builds and manages state of the art fiber optic lines that bring high speed connectivity to businesses, schools, and homes without delivering the content itself. Instead, Axia makes its fiber lines available to content providers (ISPs, phone companies, etc.) for a usage fee, generating massive competition and lower prices for consumers. The monopoly model of data provision, where service providers own the towers or lines (used by legacy companies such as Verizon (NYSE:VZ), AT&T (NYSE:T), Time Warner (TWC) and Comcast (NASDAQ:CMCSA) is eliminated in the areas Axia serves.
This business plan is based on government support, with Axia's networks serving as a type of ultra-modern highway governments can use to both expand access and lower costs for their citizens. The company's first project, the Alberta Supernet (Canada), consists of over 13,000km of fiber optics connecting thousands of users, including many power users such as business and schools with direct fiber links, with more than 87 service providers competing for customers on the network.
Financially, the project produces a stable stream of free cash flow for the Axia, totaling $23 million dollars for the FY2011. The company has used these historical cash flows to invest heavily in four other areas: France, Catalonia (Spain), Singapore, and Massachusetts, with the first three of those all on line in 2012. This is a pivotal period for the company, which we believe represents a compelling valuation at current levels.
At first glance, Axia seems reasonably valued, with EPS for the TTM of $.09/share, and a $1.60 share price, good for a P/E ratio near 18, well above the market average. The first clue that the company may be undervalued is its price/book ratio, hovering right around 1 as Axia has $103 million of net assets backing up its $102.8 million market cap. With only $8 million of intangibles and no inventories that could be subject to write-downs, we believe Axia has substantial downside protection. The company did trade significantly lower (below $1.00/share) recently, but the share buyback instituted by management appears to have corrected some of the inefficiency, though certainly not all. Axia is undervalued, in our opinion, because the market does not fully understand the way that the company's business model has been affecting its recent earnings results.
The first stage of constructing a next-generation network like Axia's involves creating a large "backbone" of fiber linking cities and towns. Generally, Axia does this with government support, with an arrangement that government run institutions (schools and universities, for example) will purchase services to help recoup the company's investment.
This backbone represents an enormous up front cost, and maintaining it is costly. After it is built, however, Axia is free to steadily grow its revenues through arrangements with nearby companies, data centers and other power users, or even communities with the desire to provide access to all of their homes, to branch fiber optic links off of their main network, giving the users access to the incomparable data speeds and reliability that come with a dedicated fiber connection. These arrangements usually lag construction of the backbone, and fiber-usage continues growing rapidly for years after one is built as the network proliferates around the established backbone. However, as soon as a network is activated, Axia begins depreciating the backbone, and also registering the cost of maintaining it as a COGS. As the network adds customers and it expands outwards through various small link-ups to companies, office parks, data centers, these costs remain constant and margins increase dramatically.
With two major networks at this phase of expansion (Singapore and France), Axia's earnings have suffered significantly in the past few years, dragging stock lower and keeping it more than 75% below its pre-crisis high of roughly $7/share, even as the company's Alberta operations remained steady and its total revenue grew. Combined net losses for the two segments(France and Singapore) for FY2011 were roughly $5 million dollars on their combined $28 million in revenue, but their strong top-line growth (834% and 35% for Singapore and France, respectively, YoY) and relatively stable cost base should rapidly turn those assets into accretive ones for the company as a whole, with France already EBITDA positive and Singapore on track to become so this year. In the long run, this trend will both stop masking the value of the company's stable to slightly growing Alberta asset and, we believe, generate substantial profits for the company.
Putting an exact price tag on these assets is very difficult since they are growing rapidly, but we'll begin with the company's established and relatively stable Alberta Network, which is on track to earn $12 million this year with EBITDA (and, approximately, free cash flows) of roughly $21 million. This means that, assuming the company divested all of its other assets for nothing, it would be trading at a P/E of 8.5 and an EV/EBITDA of roughly 5 (the company's cash is roughly equal to its long term debt, making Axia's EV very similar to it market cap), very reasonable valuations if not on the cheap side. However, this ignores 43% of the company's revenues, and by the end of 2012 likely less than 50% as the company Singapore and France based networks continue their strong growth!
Of course, the company won't divest these assets and should not: they will be very profitable in the long term; but it underscores our investment thesis, which is that the underlying company is worth far more than its current financial results indicate. Applying a profit margin similar to that enjoyed by the company's Alberta operation to its entire current revenue based is unfair because they are growing substantially and reliant on that growth for margin increases, but useful nonetheless: it would yield $22 million of net income and $33.54 million of EBITDA, or a company trading a P/E of 5 and an EV/EBITDA of roughly 3, levels we consider to be grossly undervalued. Of course, the company needs to execute to see this through, with increased revenues crucial to achieve Alberta like margins, but all indications are that it will be able to do so.
Before we conclude, we'll address a few of the largest risks we see to Axia's current business. Firstly, the company's interest on its networks is often temporary, under government contracts. The company's initial contract to manage the Alberta Supernet was for 10 years and will expire in 2015, however the company has indicated that it is likely to be resigned for the contract, though this is certainly a risk to watch. Other risks involving its interactions with various governments are always present as well, though the global economic recovery certainly works in their favor should it be sustained, as does Axia's newfound geographical diversity.
In addition, the recent election of a leftist President of France is a positive for the company, as his pledges to invest in infrastructure bode well for the company's operations there. Overall, we feel the company's strong market position (it has few competitors and is in high demand for partnerships) and government relationships should mitigate these government risks and prevent them from adversely impacting the company.
Systemically, replacements for fiber optic provided broadband are limited. Satellites appear incapable of providing the necessary bandwidth, and given current experiences with cellular networks and the limited amount of available spectrum in many parts of the world the risk to fiber in the near to medium term from wireless provision is extremely small, though in the long term the potential for disruptive technology cannot be discounted.
In sum, we recommend buying Axia's shares at current levels as a long term buy, and our fund has done so. As the company's networks in development move from their current stage to operational in the coming few years, we believe Axia's results will improve markedly and that the share price should begin to more closely reflect its true value, which as we have demonstrated is almost surely higher than its current level.
Our target price for reevaluation of this position is $2.65, about 65% above current levels, which is a 14 x multiple to the current earnings of the company's Alberta operations alone and still attractive relative to our bull case valuation. As always, we welcome comments from both bulls or bears, and will do our best to provide updates should we change our position on Axia. For more information, we strongly recommend Axia's well put together corporate website and quarterly letters to shareholders.
Special thanks to Andrew Walsh for the initial tip on Axia.
Disclosure: Both the article's author and the Harvard Financial Analysts club are long Axia at the time of this article's publication.