FOOL ON THE HILL: An Investment Opinion
Valuing telecommunications carriers is one of the more art-laden jobs an investor can have. In many occasions, because of the extreme price of replacement, companies will be priced in the market based as much as anything on acquisition value. Still, not all companies are built the same, and similar revenues and similar profit (or loss) characteristics do not mean similar valuations. Return on invested capital, net asset value, and revenue growth are part of the equation.
Briefly, the following are some of the measures I use. Depending on the business of the actual carrier (Is it a long distance carrier? Is it a reseller? Does it lay its own facilities and serve as a wholesaler?), I will weight some criteria more heavily than others. But that much is art, or more directly, my dodge.
Two weeks ago, Brian Graney and I did a five part series on converged network business models, with one of the parts focusing upon what we called the "Sunk Asset Model." At their base, carriers of all flavors fall within this description. Essentially sunk asset means that a company has deployed capital into building a network for providing service. The assets must be deployed (even if they are in the form of capital leases) before any such revenues can be derived. With carriers, this makes a great deal of sense: a carrier that lacks facilities (or service contracts) cannot very well provide service.
For those not so familiar with telecommunications carriers, there is a reason that I keep referring to capital leases and contracts. Some carriers build their own long haul, local, and switching facilities, be they over fiber, copper, satellite, or wireless mediums, while others extend their networks by purchasing or leasing capacity from these other carriers.
In the case of fiber and satellite, these capital leases are typically under indefeasible right of use (IRU) strictures, meaning that the channel is dedicated to the leasing carrier no matter the capacity restraints on other channels of the fiber. In this way, carriers can extend their networks without having to assume the up-front cost of construction. Some of the underlying cable builders include Global Crossing (Nasdaq: GBLX) and Flag Telecom (Nasdaq: FTHL). Satellite companies include Loral (NYSE: LOR) and Lockheed Martin (NYSE: LMT).
Telecom carriers are really priced on a combination of things: Return on invested capital, asset value, and revenue growth (both relative and absolute). As such, companies with similar make-ups, revenue bases, and growth rates can be valued dramatically differently. As an example, let's look at two high-growth telecom companies, Viatel (Nasdaq: VYTL), and Level 3 (Nasdaq: LVLT).
First, some vital statistics:
Level 3 Viatel
Annual Sales: $718 mil $586 mil
EBITDA -$654 mll -$47.5 mil
Book Value per share $14.51 $5.07
Return on Assets (ROA) -8.22% -15.73%
Revenue Growth (yoy) 98% 194%
Gross Margin: 51% 43%
To summarize, Level 3 has a much higher level of book value (shareholder equity) per share and return on assets (net income/total assets), while Viatel has significantly higher revenue growth. So one would think, that these companies, with roughly similar sales figures, would be close in market capitalization.
One would also be wrong. Viatel's total market value is $627 million, Level 3's is $21 billion, a magnitude of 32 times difference. Although I'm not one for believing in the infinite efficiency of the market, this difference has to be attributable to something invisible in the "snapshot" view.
The first valuation characteristic we look for is return on invested capital (ROIC), which takes into account something most carriers have in spades: debt. From its annual report, Viatel's shareholder equity of $537 million thus has $1.801 billion in long- and short-term debt, with a net income of -$144 million, Viatel's ROIC is -9.3%. For its part, Level 3 has a debt level of $3.995 billion and revenues of -$487 million, for a ROIC of -12.1%. So here again, the numbers between the two are not that different.
Both of these companies are losing incredible amounts of money, but as development-stage companies in capital-intensive businesses, they are really supposed to be losing money. We've also seen that Viatel's gross revenues are growing significantly faster than Level 3's. It should also be noted here that Viatel's days sales outstanding is also significantly higher, 168 days versus 103 for Level 3. Still, there's not anything here to suggest such a huge discrepancy in market value.
So where's the beef? One of the largest functions of valuation for carriers is asset base. Why? Simply stated, deployment of facilities is so capital intensive that in many situations carriers will look to acquire completely built-out networks rather than take the time-to-market risk of building their own. And with these two companies, the asset base is the beef. Viatel's asset base is marked at $2.7 billion, whereas Level 3's is marked at $9 billion.
Since companies in takeout scenarios also get to deal with the debt, Viatel's net asset base is $900 million, while Level 3's is just under $5 billion. The non-current asset portion of these carriers is also depreciated on schedules provided by FASB, as such the deployed value is higher than that carried on the books. This information is carried in the note to the financial statements in the annual and quarterly reports.
On a cursory glance, it would seem that Level 3's premium is based largely upon its significantly higher net asset value than Viatel's, and perhaps the "quality" of its earnings. Still, just looking on this level I have some question as to the gross difference between the two.
There again, trying to treat this topic in a short report is perhaps foolhardy. And readers should know that such treatment really underplays the complexity of these dispersed asset beasts. As such, the above should be treated by investors wishing to price out telecommunications companies only as a starting point. As in anything involving investing, these things can be infinitely complex.
Bill Mann, TMF Otter on the Fool Discussion Boards