In the wake of Carl Icahn’s bid for the tiny piece of XO Holdings (news, filings) that he doesn’t already own there has been a flurry of activity in the media and blogosphere. Much of it centers around the amount offered versus what XO ought to be worth, and much makes no sense at all. So I thought I’d save the rhetoric about whether Icahn’s offer is good or evil or what he might do next for another post and talk about the valuation of XO itself a bit more dispassionately.
First let’s dismiss the EV/Revenue crap some are using to decide what XO is worth. In his excellent series on valuation, Dan Caruso over on Bear on Business explained why we use EBITDA when figuring out what fiber based telecoms are worth. Revenues aren’t useful because they ignore margins, and margins are critical to valuation in this sector. Cash flow doesn’t work because the business is so capital intensive, and highly successful companies in the sector re-invest their cash to grow while those under stress must conserve it – skewing the numbers. Rather, we need an estimate of the propensity to generate cash, if a company chose to do so. EBITDA is the best we have there, and that is why the ratio of EV/EBITDA dominates.
As of the end of last quarter, XO had $391.3M in cash, $1054.1M in preferred stock, and there were 182,075,035 shares outstanding. At the close on Thursday, common shares traded at $0.28, that put XO’s EV at $714M. The company hasn’t given us guidance for EBITDA in 2009, but lets give them the benefit of the doubt and use $150M which would be up 36% sequentially despite the economy and implies improvement from the first quarter’s $28.1M. That suggests that before Icahn made his bid, XO was trading at an EV/EBITDA multiple of perhaps 4.75. That compares unfavorably with TW Telecom (NASDAQ:TWTC, news, filings) at about 5.5 and somewhat more favorably with glbc at about 4.6. Icahn’s offer of $0.55/share corresponds to an EV/EBITDA ration of 5.08 given these assumptions. Note that I am estimating 2009 EBITDA for each rather than using 2008 numbers, so the ratios are a bit lower and fuzzier but hopefully reflect the present more than the past.
When put in that context, Icahn’s offer of $0.55 certainly isn’t a big premium but neither is it way out of line, so why all the hubbub? It’s the leverage. All those preferred shares are fixed in value (as long as we are below the conversion price) and therefore a small change in EV/EBITDA ratio corresponds to a large change in the price of common shares. A ratio of 6 would value common shares at $1.30, or more than 350% above thursday’s close. A ratio of 8 would imply a stratospheric price of $3 per share. But a ratio of just 4.4 would imply common shares are worth nothing at all!
In other words, the ‘fair’ price for common shares of XO based on standard metrics, current multiples, and a takeover premium could be anywhere between $0 and $3, the exact price is extremely sensitive to what multiple you choose. The question of whether Icahn’s price is fair or unfair comes down to what multiple is fair, and given the sensitivity that is an impossible judgment call – no one will ever agree because just a tiny difference gives them so much more money. On the two opposing ends are arguments like these:
- XO has fantastic assets, including 18 fibers on the original Level 3 longhaul build and 9000 metro miles connecting over 3000 on-net buildings nationwide – that’s infrastructure you just can’t build anymore. While margins are still low, the period of legacy churn is ending and the company is poised to grow its high margin revenues rapidly leading to margin expansion. They are poised for something big and don’t need to sell, and therefore should get a premium to the rest of the industry to sell out! FTGX got 7! Nothing below 7! The price of $0.28 was totally wrong, held down by Icahn himself, we deserve 10 times that!
- XO has by far the lowest EBITDA margins in the sector, and has for a long time. Their revenue is largely off-net and of low quality, and they do little more than churn revenue each quarter. There is no trend anywhere in the numbers that implies that is going to change anytime soon, and no buyer is going to pay for yet more unfulfilled promises. A ratio of a little over 5 is completely fair! All the value in this company is in the preferred shares, common shareholders are lucky they get anything at all! $0.55 is a gift!
Because of the leverage, it is possible to spin the numbers either way and both sides have points. Those who think the offer is unfair are largely pointing toward things the market does not currently value. In other words, they simply don’t want to be forced to sell in a bad market unless they get a good market price.
In the end though, the concept of ‘fair’ is and always has been a load of fresh buffalo chips. Icahn didn’t choose $0.55 because it was fair, he chose it because it is the lowest number he feels he can get away with and still get 51%. That’s just the kind of guy he is and we all know it. The market price is his justification, the stock hasn’t traded above his offer price since Sept 19, 2008 so the market obviously doesn’t believe the company is on the brink of anything great. In the background we still have his ownership of the class A preferred which comes due next spring, with which he can increase the pressure. Common shareholders will have to rely on the media and the perception of injustice to generate a ‘no’ vote and force a higher bid. That could work if they can get enough attention, if only because Icahn’s public image may be worth as much to him as XO is. Or not, it depends on his current mood.
Who wins this contest of wills? Can Icahn get 51% of outstanding common to take his offer? If you’ve read this far, you must have an opinion. What do you think?
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i totally agree with you, but if you use a 2009 ebitdas estimate of $115MM, which is +9.3% year-over-year (9.3% year-over-year ebitas growth is inline with the most optimistic forecasts for twtc and lvlt) you get to a take out ev/2009e ebitdas multiple of 6.7x. this is well in excess of all of xoho’s peers save lvlt.
Yes, a lower 2009 ebitda would make it higher. I used a higher one for now because the first quarter has seasonally high costs and is usually XO’s worst, yet they managed over $28M.
The biggest question here that we can’t answer, but which Icahn can because of his position, is what XO’s financials really look like for 2009. And because of that, any estimate of what the common should trade at that is based on valuation will have HUGE error bars on it.
“First let’s dismiss the EV/Revenue crap”
I definitively wouldn’t.
Corporate valuation is all about pronostication of future cash flows. EBITDA is a good proxy of future cash flows but by no means a remotely precise one. The reason why companies with negative EBITDA are not completely worthless.
Gross revenues also tell you a lot about potential to generate cash flows. A lot can be said about “quality” of revenues but in general, and in the long term, firms are expected to match the average profitability in their industry (or alternatively, competitors with the capacity to obtain superior margins will acquire the revenue to unlock the cash flows). In so many words, Gross Revenues can in fact be used to predict future cash flows. Highly imperfect but another proxy for future cash flows.
For what is worth, Broadwing had an EBITDA of 3 million dollars for the nine months before LVLT acquired them. LVLT paid 1.4 billion dollars ofr them. They might have overpaid.. but I suspect the 900+ million dollars in revenues might have something to do with it.
I agree that EBITDA is not the sole factor in company’s merging or being acquired and should not solely be used to determine a fiber-based clec. These networks cannot be duplicated and carry significant value to any acquirer. One can site another example of TWTC’s purchase of Xspedius for a multiple of ~14x EBITDA. It was not so much the revenue/cash flow they were after, it was the legacy e.spire metro fiber with an original cost basis of more than $1B.
I think we can safely say that what LVLT paid for BWNG was more than they have gotten out of it.
So then are you prepared to say that GLBC is worth 2x revenue, i.e. $5B? Is CBEY worth $800M? Both have tons of revenue.
I’m not saying we can totally ignore revenue. Rather I’m saying that there is absolutely no cross-industry standard valuation metric we can apply to XO. If you cherry pick your examples, you can come up with any valuation you want.
I don’t think you can ignore revenue.
If Icahn pulls this off at $.55 he will be rewarded for his own mismanagement.
It is appalling that XO’s margins are so far below the those of its peers. Even an embarrasingly low 15% margin on $1.4BN in revenue gets the company well above $200MM in EBITDA and thus at least $1BN in enterprise value–and a stock price of around $2.
Any prospective buyer would seek ways to improve margins. Strategic buyers would probably get $50 to $100MM from simple headcount reductions even before eliminating overlapping network costs and then starting to attack what has to be layers of unnecessary expense on things like real estate, redundant equipment, etc.
It’s not fair for Icahn to run this company into the ground, produce (by far) the lowest EBITDA margins in the business, and then justify a buy-out based on EBITDA alone.
At the very least he should put the company up for sale and see what interest is generated–and be willing to do an all-stock deal so the stockholders have a chance of making back some of their losses by riding a more competent horse.
Would it be an outrage that Icahn got XO for 0.55 now after the way he has managed it? I would say yes also. But that doesn’t change the fact that the company is what it is today, we can’t value it based on what it could have been. ‘Fair’ is something XO common holders are not too familiar with.
I can see the concern for the stockholders but I feel more for the people who are about to lose their jobs over this possible sale or merger. Yes I know we are all in it to make a buck but this economy is difficult to find a new job in. Hope all goes well for both sides.
My feeling is that XO would fetch around 800M-1B on the market at the moment subject to there being a willing buyer. Also sense that a key motivation for Icahn wanting to take it private is to give him complete freedom to negotiate the terms of sale especially in terms of a part cash/stock acquisition.
Yes 55 cents is far too cheap – including for the fact that this represents my cost base in this stock and i want a premium for all the pain 🙂 – and on reflection I think he will need to make a better offer. 1.50 – 2.00 would be “fair” but I reckon it he lifts it to around the dollar mark he will get there. The $64 question of course is who is holding all these outstanding shares and what they think they can extract from this.
One more thing… I really think discussing the enterprise valuation of XO in this transaction really is a moot point. Icahn is not buying XO, he is buying out the minority shareholders and with it total control of the company. Even if common shareholders were completely out of the money, buying them out for control would have significant value.
The way I see it Icahn has announced he wants those shares and his opening offer is 55 cents. If the minority shareholders fail to organize he will buy them for that. If they do get organized with 50%+ one share, they can bargain with Icahn. Minority shareholders are quite concentrated around R2 and a handful of other hedge funds. My best guess is that they will organize, bargain, and sell to Icahn. The final price will mainly depend on how badly Icahn wants total control of this company. The final price is likely to be quite different than 55 cents.
Actually, I would agree with you. The relationship between Icahn and minority shareholders is all about power. Valuation only comes in as a justification after the fact.
One thing you should keep in mind is how Icahn might respond to such organized opposition.
Rob,
The stock price is definitely related to a company’s revenue that is increasing steadily with positive EBITDA in every sector for many quarters.
XO’s ridiculously low price is largely caused by Icahn’s manipulation and few people want to get involved with him. Did you consider that?
tech101, of course I considered it, and it has always been a factor. But given that hasn’t changed, it is beside the point. The market isn’t a justice dispensing mechanism.
The stock is stuck with one large holder – so there really isn’t a market for the minority holders.
XO is loaded with metro assets — hard assets — seems to me that’s where the money and margin growth is coming from.
I give XO a 10x-12x EV/EBITDA value at a minimum if I were pricing out the minority share owners.
Recent analysts have been showing exit EV/EBITDA in this range for margin growth companies. Never get sucked in by a revenue line — margin and margin growth keeps one in business regardless of economic conditions.
Lots of high flying top line companies crashed during the telecoms downturn 2001-2003 because they didn’t have sustainable margin growth to served their debt loads. Those without hard asset margin growth this time around have slowed to a snails pace – refinancing and hoping.