The measure of M&A

01 February 2011 |

The frenetic pace of mergers and acquisitions (M&A) reached astonishing new highs last year, and this year the sector is alight to the buzz of rapid integration. Richard Irving reports.

Industry insiders expect the metro arena,already one of the fastest growing parts of the entire US economy, to continue to grow by more than 30% a year for the next five years. By 2014, the market is slated to be worth up to $40 billion. Fuelled by a plethora of new developments in cloud computing and data storage, as well as the roll-out of 4G, the US’s hunger for bandwidth capacity – and by necessity, the infrastructure to support it – appears insatiable.

Reason, perhaps, why cash-rich private equity funds just can’t get into the sector quickly enough. According to bankers, 20 metro players changed hands last year, 13 of which were acquired by private equity investors alone. But crucially, more is to come. The chief executives of two major metro players have separately told Capacity that as many as 12 private equity funds – as yet with no presence in the space – are desperately seeking an opportunity to establish a strategic foothold through a big-ticket acquisition.

A new wave?

As Blake Battaglia, a partner at ABRY Partners readily admits, the investment case is utterly compelling: “Do I think there will be a record number of deals this year? Probably not – many of the larger metro fibre businesses that were ripe for consolidation have been taken off the table. But do I think there will be another wave of consolidation? Absolutely.” For every buyer, of course, there is a seller. Last year’s flurry of deals was in part prompted by persistent speculation that the Obama administration was considering hiking capital gains tax on investment profits from 15% to as much as 25%. The proposals were eventually shelved, but not before some early stage investors beat a hasty path to the exit.

This year, a more rational exuberance pervades the air. Although the tax issue will almost certainly raise its head again in the presidential elections, many players are more concerned with bedding down their current investments than looking for new acquisitions. ABRY’s Battaglia sums it up thus: “I think for the most part, the private equity houses which invested in new businesses in 2010 will spend the next year or so focussing on organic cash flow growth and paying down debt – in other words, meeting those cash flow projections they drew up in last year’s auction processes.”

That said, analysts believe that of the 100 or so metro fibre networks still out there in play, as few as six network providers will eventually dominate the market.

Dominating forces

Those which have already reached a critical mass of scale – that is, with EBITDA of around $50 million or more – include AboveNet Communications, the sector’s only publicly-traded representative; Fibertech Networks, which was bought last year by Court Square Capital for $500 million; and Zayo Group, which has so far bought 15 metros in deals valued anywhere from $3 million to $100 million. FiberLight, Lightower Fiber Networks and Sidera Networks are also expected to emerge as playmakers (see box ‘A survivor’s guide to consolidation’).

“Looking out to the next one to three years there will likely be additional consolidation within this set,” says Dan Caruso, co-founder and chief executive of Zayo Group.

A common strand linking these potential survivors is their access, either though the financial markets or through existing credit lines with financial sponsors, to large pools of capital. The metro arena is one where only those with deep pockets stand a chance of survival. Most companies budget to spend in excess of 35% of their annual revenues on new network construction and the pressure to expand will only mount as customers demand more diverse networks.

But this drain on financial resources is as much a positive for the incumbent metros, as it is a negative: “If you wanted to go out and build a network as dense and as extensive as many of the current providers have, it would cost hundreds, if not billions, of dollars to replicate,” explains Colby Synesael, an analyst at Cowen & Co, the investment banking boutique. “That’s assuming you would ever want to take on the hugely risky business of building out a network without fully understanding who your customers might be.”

If the barriers to entry are high, they are as much physical as they are economic: city officials were certainly traumatised by the hollow promises made to them by infrastructure companies at the height of the dot-com boom and now place onerous requirements on network providers before they will ever allow diggers to roll down the street. As Gillis Cashman, a partner at M/C Venture Capital explains, there’s more to the metro markets than having deep pockets and a winning way with local government: “Even if you had the capital to do it, you couldn’t replicate some of these networks – for one thing there’s not enough room on some of the poles. It’s something that investors in the public markets are still slow to appreciate.”

Finite opportunities

Undoubtedly, the end game is fast approaching. Many remaining metro networks, including a sizeable number still in the hands of the US’s utility giants, will fall prey to the consolidators via a raft of so-called ‘tuck-in’ acquisitions. Some will be opportunistic, where the valuations might allow for bidders to look for attractive synergy savings from their targets and yet still bolster top-line growth; others will be strategic, such as bolting on a spur to a network where the buyer is already geographically strong. By gaining access to an existing customer in a new location close to where a network provider might already boast a core presence, it is possible to add an extra level of assurance to revenue projections and thus bolster the rate of return forecasts.

Here Zayo has proved itself to be particularly canny. The company, one of the most aggressive in the M&A arena, rigidly avoids companies with undesirable legacy assets that might dilute efforts to continue generating double-digit growth. All this, of course, relies on valuations in the sector holding up. And herein lies the problem. While pure play metro fibre providers in the private market are estimated to be changing hands at up to 13x EBITDA, AboveNet trades at a considerably more conservative 8x EBITDA (see box A survivor’s guide to consolidation). The huge gap makes it difficult for many strategic buyers to justify the prices they are being asked to pay for assets in the private market. Few observers doubt that the opportunities for the pure play metros are somewhat finite. It is inevitable, they say, that with the IPO route all but barred, those companies currently successfully stalking the hunting grounds will someday soon become hunted themselves.

“Later this year, and going into next, I think we’ll see the first of the bigger mergers involving the likely survivors,” says M/C Venture’s Cashman. Those most likely to lead the next wave of consolidation include Fibertech, Sidera and Zayo as their private equity owners begin to look for a profitable exit. “Logically, I think in five years from now you would expect a larger private equity specialist such as Blackstone or Kohlberg, Kravis & Roberts to try to draw the north eastern metros together in to one supermetro,” says one banker familiar with the sector.

A metro with greater scale might then become an attractive target for a regional ILEC or a large CLEC: “The CLECs are under extreme pressure trying to meet the demand for capacity right now, let alone five years from here. They face a huge investment in their networks and it seems to me that a large metro with a strong local presence and a loyal customer base might make for an extremely attractive proposition,” he adds.

More deals along the lines of Windstream’s $818 million acquisition of Kentucky Data Link and Norlight are widely anticipated. Cincinnati Bell, for example, has made little secret of its desire to compliment its $525 million acquisition of CyrusOne, the largest private data centre in Texas, with further deals in the collocation arena, and analysts believe a foray into the metro space could follow.

America’s cable companies might also prove a worthy suitor to some metros. Observers believe that several might consider adding metro networks to their portfolios in an effort to deliver more services to their end users and some companies are already making waves in the enterprise market. However, they are seen as very methodical and unlikely to be able to move at the same speed as rival metro providers, preferring instead to make sure that they have the technological specifications in hand to make an acquisition work.

But most eyes are on PAETEC’s next move. In January, the company promoted Clint Heiden, the former head of Intellifiber, to run a new national fibre division in a clear signal that it intends to use its $460 million acquisition of Cavalier (of which Intellifiber was itself a subsidiary) as a springboard for further expansion in the metro sector.

Concludes Cowen’s Synesael: “If RLECs and CLECs don’t have a wireless play and they are still relying heavily on voice orientated services, then they are going to be looking for an alternative growth strategy very soon and I think some of these bandwidth infrastructure companies could be potential targets.”

 Bridging the great valuations divide

  Love them or loathe them, the private equity contingent has played a pivotal role in a record-breaking year for mergers and acquisitions in the metro sector. To a few, they are the unacceptable face of the metro space, pricing genuine strategic buyers out of deals in frenzied bidding wars with scant regard for the asset bubble they might be creating; to many, they are the steady hand of reason, providing long-term funding when the door slams shut on the public markets. Whatever your view of private equity investors, the confounding difference in valuations between public metro providers, ie AboveNet, and their private counterparts, lies squarely at their feet.

How big is the gap?
AboveNet is something of a stock market darling among analysts – nine of the 10 stock pickers covering the business currently rate the company a ‘buy’ or a ‘strong buy’ at the current level – effectively a multiple of around 8x EBITDA. And yet it still trades at a significant discount to its peers in the private sector. Court Square Capital, for example, is thought to have paid around 10.3x EBITDA for Fibertech while Lightower is estimated to have paid a multiple of 12.2x EBITDA for Lexent.

Why the difference?
Firstly, there is a huge wall of private equity cash sitting unused in bank accounts and a finite period in which it must be put to work. Quite simply, financial buyers can price the likes of AboveNet and Lightower out of the market, even though trade buyers should be able to make deals stack up more easily through cost savings.

Secondly, private equity bidders can take on more debt than their publicly-listed counterparts. Typically, a public company will struggle to raise borrowings equivalent to more than 3x EBITDA while financial buyers can easily load up debt equivalent to 5x EBITDA on their balance sheets. The higher leverage allows them to accelerate growth by putting more money to work but also reduces their weighted cost of capital, allowing them to be more aggressive.

Finally, and perhaps most tellingly, there still remains today – more than 10 years after the dot-com crash – a stigma attached to fibre network operators. Public investors typically lump the metro players into the same category as long-haul fibre providers. They see the market as a commoditised business where competition is vast and margins are constantly under threat. Private equity investors, on the other hand, have a profound understanding of the metrics at play, they frequently have access to financial data that public investors could never hope to see and they have good relationships with management.

What happens next?
AboveNet trades on a multiple of just under half other bandwidth infrastructure plays, such as co-location providers and data centre specialists (currently both trading at around 14x EBITDA). Most observers believe AboveNet’s share price underplays the company’s potential and expect a substantial re-rating sometime in the next 12 months, bringing the company’s valuation into line with the private sector.