Windstream misses the message

Contact: Ben Kolada

As the telecom industry continues its buying spree, some firms are missing the bigger picture – hosting and datacenter services are the new growth channels for telcos. While CenturyLink and Verizon have each announced acquisitions in the growing datacenter services industry, Windstream Communications appears to be satisfied with consolidating telecom assets. The telco’s purchase of complementary competitive carrier PAETEC is its seventh telco rollup since its formation in 2006. And while PAETEC does provide a wealth of network assets, it contributes little in the way of revenue growth. For the price it’s paying for PAETEC, Windstream could have gobbled up a number of hosting properties at a fraction of the cost.

To be fair, Windstream’s PAETEC pickup does provide more than 50,000 high-revenue enterprise accounts and an expanded fiber footprint. But the target’s organic revenue has been flat in recent years, and growth this year is likely to come primarily as a result of the Cavalier Telephone buy it completed in late 2010. (We would also note that Cavalier’s revenue was in precipitous decline, due primarily to churn in its consumer division. Cavalier’s revenue dropped from $421m for full-year 2009 to an estimated $390m in trailing revenue at the time of its sale.)

Beyond fiber and enterprise accounts, Windstream is also interested in PAETEC’s datacenter services assets. And rightfully so, considering Windstream’s hosting assets could certainly use a boost. The company’s last pure M&A foray into the hosting sector was in November 2010, when it shelled out $310m for Hosted Solutions. That target only generated $51m in trailing sales, or about 1% of Windstream’s total revenue. But for the $2.2bn the telco is paying for PAETEC (including the assumption of debt), it could have easily expanded its hosting footprint in the US and abroad by acquiring both InterNap Network Services and Interxion. Applying a flat 20% equity premium to the pair would put their combined deal value at about $1.6bn on an enterprise value basis, or about three-quarters of PAETEC’s price.

Is Earthlink looking to link up to a hosting company?

Contact: Ben Kolada

Earthlink on Monday said that it is acquiring regional competitive local exchange carrier (CLEC) One Communications for $85m in cash or stock, plus the assumption of $285m in debt. The deal is Earthlink’s second telecom play of the year, and from our view, it looks like the beginning of a strategy that’s already playing out at Windstream Communications.

The One Communications announcement came just three weeks after Earthlink closed the purchase of southeastern US CLEC ITC Deltacom. Both One Communications and ITC Deltacom are fairly large, as regional CLECs go. ITC Deltacom generated $451m in revenue in the four quarters before its sale, and we understand that One Communications came in at $575m in trailing sales. However, both companies’ sales were declining, and we suspect that the deals were primarily done to build out Earthlink’s facilities-based presence and lay the ground for an eventual hosting play.

If that’s correct, then the ISP will be setting itself on a similar track to the one laid by Windstream Communications. The Little Rock, Arkansas-based company picked up six telecom service providers before announcing last month that it was buying hosting provider Hosted Solutions. At least three other telcos have scooped up hosting companies just in the past two months. The reason for the shopping spree is pretty simple if we consider the relative growth rates of the two sectors: While the core telecom market continues to decline, hosters are putting up fairly solid growth – and that should continue. In their 2010 ‘Multi-Tenant Datacenter North American Market Overview’, our colleagues at Tier1 Research project that the sector’s total North American revenue will hit $11.1bn in 2013, up from an estimated $6.8bn this year.

Select recent telecom-hosting transactions

Date announced Acquirer Target Deal value
December 15, 2010 Telephone and Data Systems TEAM Technologies $47m
November 22, 2010 Sidera Networks Cross Connect Solutions Not disclosed
November 4, 2010 Windstream Communications Hosted Solutions [ABRY Partners] $310m
November 3, 2010 Cbeyond MaximumASP (assets) $31m
May 12, 2010 Cincinnati Bell CyrusOne [ABRY Partners] $525m
March 22, 2010 TDS Telecommunications VISI $18m
January 25, 2010 Cavalier Telephone NET Telcos (assets) Not disclosed

Source: The 451 M&A KnowledgeBase

For CLECs, valuations flatline

Contact: Ben Kolada

As the retail wireline communications industry loses steam, valuations for competitive local exchange carriers (CLECs) have flatlined. Regardless of whether or not the firms were growing their bottom line, CLECs are being sold at just north of one times trailing revenue. We don’t see much that would change this metric.

EarthLink’s recent purchase of ITC DeltaCom is the third instance in the past year in which a regional CLEC was acquired by a larger provider. The deal was announced shortly after PAETEC picked up Cavalier Telephone and just under a year after Windstream Communications bought NuVox Communications. Of these three providers, we believe only NuVox was growing its revenue, while Cavalier was experiencing losses and ITC DeltaCom was lying stagnant.

Yet all three firms were valued nearly the same. EarthLink’s offer for ITC DeltaCom values the Huntsville, Alabama-based company at just 1.1x trailing sales, including debt, while both Cavalier and NuVox went for 1.2x. (As a side note, we would add that both Cavalier and NuVox were owned by M/C Venture Partners.)

We wouldn’t be surprised to see other similarly sized CLECs – such as Cbeyond, TelePacific Communications or Integra Telecom – fetch roughly the same valuation in any sale. For example, take Cbeyond, which is similar in size to ITC DeltaCom. The firm is currently priced at 0.9x trailing sales, nearly mirroring the 0.8x valuation ITC DeltaCom had in the day before EarthLink announced that it was buying the company.

Recent CLEC valuations

Date announced Acquirer Target Enterprise value EV-TTM sales multiple
October 1, 2010 EarthLink ITC DeltaCom $516m 1.1
September 13, 2010 PAETEC Cavalier Telephone $460m 1.2*
November 3, 2009 Windstream Communications NuVox Communications $664m 1.2

Source: The 451 M&A KnowledgeBase *451 Group estimate

PAETEC’s risky business

Contact: Ben Kolada

As the communications industry continues to consolidate and the pool of desirable targets dries up, the remaining buyers appear to be stretching a bit in their M&A moves. But even within that, PAETEC’s recent pickup of Cavalier Telephone looks to us like the riskiest telecom acquisition we’ve seen in the past year. The reason? Roughly three-quarters of Cavalier’s business is outside PAETEC’s focus.

To be fair, other telcos have also made challenging moves. Windstream Communications took big bites in the past 12 months, acquiring four companies that set the telecom provider back $2.7bn. (That figure includes the debt at the acquired companies that Windstream will be taking on.) The vendor’s spree boosts its top line by about 50%, a substantial increase that brings a not-insignificant amount of risk. Even Cablevision Systems, which is typically a stay-at-home company, inked a deal, reaching across the country to pick up Bresnan Communications for about $1.4bn.

However, the deals by Windstream and Cablevision made sense, if just because they expanded on each company’s existing strategy. Not so with PAETEC’s purchase of Cavalier. When we look at the transaction, we suspect that PAETEC was really only interested in Cavalier’s fiber assets. Understandably, the Richmond, Virginia-based competitive local exchange carrier wouldn’t have considered selling its fastest-growing division. Since it was unable to just get the part of Cavalier’s business that it probably wanted, PAETEC was forced to shell out $460m (including assumption of debt) for the whole company.

Cavalier had $390m in sales in the year leading up to the acquisition. However, the company’s fiber division itself generated only about $98m, or 25%, of total revenue. That means that a vast majority (75%) of Cavalier’s business appears to us to be an ungainly match to the business its buyer is in. PAETEC serves enterprises, which generate an average of $2,300 in monthly revenue. On the other hand, the majority of Cavalier’s revenue comes from consumer accounts and small businesses with monthly recurring revenue of only about $500.

Rather than spend to get this odd pairing, we think PAETEC would have been better off buying one of the number of fiber operators looking for a sale. A juicy target would have been Zayo Group. The company is on a $240m run rate for 2010. Based on recent valuations for Zayo’s competitors, we believe it could be had for roughly $500m – only slightly higher than Cavalier’s price tag, but without the unwanted baggage.