Mergers and acquisitions in the US cable market
17 February 2012 |
Last year wasn’t exactly a career high point for dealmakers in the metro markets. But despite several high profile failures, all the signs point to a new wave of consolidation that will redefine the fibre infrastructure sector forever. Richard Irving reports on some unlikely contenders.
A single question dominates the outlook for mergers and acquisitions (M&A) in the metro markets this year: if fibre networks are indeed as hot as some investment bankers would have us all believe, why is it that not one, not two, but three of the top six US fibre infrastructure players could not attract buyers when they were put on the auction block last year?
Sources with detailed knowledge of the sales processes confirm that AboveNet, the largest metro provider in terms of revenue; Sidera Networks, the private equity-backed operator spun out of RCN; and Fiberlight, one of the fastest growing infrastructure providers, were all in late-stage negotiations with buyers last year. But a plethora of messy complications and Europe’s slide into near-bankruptcy conspired to frustrate the dealmakers at every turn (see box on page 28). To complicate matters further, rumours continue to swirl around the remaining three major players in the sector – Zayo Group, Fibertech Networks and Lightower Fiber Networks – prompting speculation that consolidation in the metro sector is fast reaching the end-game.
To some extent, the dynamics of the metro fibre market are set up for a frenzied denouement. Of the big six network providers, just one – AboveNet – is owned by public shareholders. The rest are backed by private equity firms, which need to start cashing-in profits over the next three years in order to pass on returns to their own investors. But far from dampening expectations of imminent consolidation, this overhang of fibre assets is fuelling hopes that a transformational deal could surface, possibly within the next quarter, but more likely by the end of the year.
"Some look back at 2011 and see a glut of sellers coming to the market. I see only a queue of buyers," explains Dan Caruso, president and chief executive of Zayo Group and one of the key drivers of consolidation in the metro arena in recent years. For every infrastructure company that hoisted the for-sale sign, there was a steady stream of interested bidders looking to elbow their way into the auction process, he says. "What is more, if you talk to people who were at the negotiating table, the gap between what the sellers were looking to raise and what buyers would pay was relatively modest. Does that point to a situation where valuations are topping out? Certainly not. Do I expect to see more deals this year? Absolutely."
Caruso is not alone: even for a sector used to a steady flow of mergers and acquisitions, the metro market is alight with fevered expectation.
"Further consolidation among the larger fibre network providers is an absolute inevitability," says Mike Sicoli, chief executive of Sidera.
"There’s going to be unprecedented interest in the next round of bidding because it’s going to be the last opportunity of its kind to pick up premium fibre assets," echoes Rob Shanahan, chief executive of Lightower.
Even Bill LaPerch, one of the most conservative of all metro chiefs and the scourge of fee-hungry investment bankers on both sides of the Atlantic, is considering stepping out along the acquisitions trail. Uniquely among his peers, LaPerch has not bought a rival metro player since he restructured AboveNet in the wake of the dotcom crash. "If Bill is dusting off his cheque book, we really are approaching the end-game for consolidation," says a rival fibre chief.
This year might finally be when a cable company breaks cover and snaps up a metro network. Historically, cable companies have avoided buying metro networks for fear of contravening an unwritten gentleman’s agreement precluding them from competing head-to-head in each other’s core geographical markets.
As one senior stock market analyst who declined to be named explains, Sidera is a case in point: "Sidera would make an absolutely fantastic acquisition for Comcast in just about every region except New York. In New York, it would mean that Comcast would have to go head to head with Cablevison and Time Warner Cable to the death every single day. And that’s just not how Comcast views the world." At least, not until now.
Cable companies are increasingly willing to compete with one another amid a pressing need to acquire more fibre, partly to help drive expansion into the high-end business market and partly to help cope with the demand for bandwidth prompted by the explosion in video traffic.
The more that cable companies prioritise their Ethernet offering to enterprise, the more fibre network they will need to driver their capability and the quicker they will want it.
"For more aggressive companies like Comcast and Cox, the pressure to grow their fibre footprint will become urgent in the coming months," explains Mike Miller, chief executive of Fiberlight.
Circling the metro market
Several highly placed sources have confirmed to Capacity that Comcast, Cablevision and Time Warner Cable have all lodged very strong interest in different metro companies in recent months. One Wall Street source with detailed knowledge of negotiations goes further: "Cable companies are starting to drive the agenda in the metro market. With each transaction, they become more acquisitive and more aggressive – far more so than private equity."
Gillis Cashman, a partner at M/C Partners agrees: "I am not sure whether we’ll see it in the first half of the year, but 2012 could well be the year when we see a cable bidder step up to the plate."
Over the last two years, network providers in the metro arena have done a very good job of driving consolidation among themselves to create a handful of premium platform assets that are profitable and growing.
"We are really only talking about six core network operators here," explains Cashman. "When one of them goes, it will most likely spark a flurry of activity around the others."
Price, of course, is everything. Sources confirm that AboveNet, Sidera and Fiberlight all targeted valuations in the 10-12 times EBITDA range, putting them on a par with Fibertech, which sold for 10.3 times EBITDA to a private equity backer in late 2010.
But putting a Fibertech-style valuation on the top of a sales memorandum is one thing; finding someone to pay it is quite another. Sellers are benchmarking themselves to the Fibertech deal, while buyers are looking to AboveNet for valuation comparisons. And herein lies the problem. AboveNet, the only metro with a stock market listing, trades on a multiple of just seven times forward earnings. So the gap between what a metro company generating $80 million of EBITDA a year might want using Fibertech’s valuation, and the price that a buyer might offer using AboveNet as a guide, would be equivalent to $240 million.
To be fair, AboveNet has always suffered on the public markets, not least because institutional shareholders who were bruised and battered by the telecoms crash struggle to view bandwidth infrastructure in a good light. More recently, some industry watchers are beginning to wonder whether AboveNet’s valuation is suffering precisely because it appears reluctant to pull its own game-changing acquisition out of the hat.
Either way, its public valuation is a matter of consternation to some would-be sellers. "We saw the same issue in the collocation and hosting sectors," explains Cashman. "My belief is that valuations will really take off when a trade buyer such as a cable company makes a big strategic move on one of these companies.
Another Wall Street insider agrees: "A big deal with a big multiple – that’s what the metro sector really needs now."
Crucially, trade buyers have consistently struggled to muster the cash to make a knock-out bid, leaving the field pretty much open to private equity firms.
Several sources have confirmed to Capacity that a slew of around half a dozen private equity firms, who have yet to make their mark in the metro market, are circling around many of the larger network providers.
The list is understood to include Madison Dearborn, Carlyle Group and Providence Equity.
They are joined by a second clutch of private equity firms who already invest in the fibre network market but want a seat at the table when a final round of consolidation between the key players triggers. These include ABRY Partners, which owns Sidera; Court Square Capital Partners, which owns Fibertech; and M/C Partners, which has a big stake in Lightower and Zayo. They arguably represent the most powerful voices in the metro arena today.
The power of private equity
Clearly sellers at the right price, this band of investors nevertheless sees further opportunities for consolidation.
As one metro chief points out, a lot of the hard work has already been done: "I don’t see private equity readily passing up the opportunity to combine two or more of these assets into a stronger platform and I think they will probably be prepared to pay up for the privilege. These guys know what they’re doing in this market."
Indeed, private equity has become extremely powerful in the metro arena precisely because it can muster considerably more financial firepower when a metro network comes onto the market than rival trade buyers.
While trade buyers would struggle to borrow much more than around three times EBITDA in the bank markets to finance a bid, for example, financial bidders can tap the debts markets for anything up to five times EBITDA.
Moreover, private equity firms with existing metro assets will also be able to exploit potential synergies in any future consolidation, which could narrow the valuation gap between opportunistic sellers and bargain-hunting buyers. Essentially, a buyer with a dense metro fibre network might be able to table an offer in the 10 times EBITDA range, knowing that by the time he strips out cost savings, he can sell the deal to his own board on a multiple of around 8.5 times.
For these reasons, among others, says John Siegel, a partner at the private equity firm Columbia Capital, a final round of consolidation must soon begin. Fibre infrastructure is core to the evolution of computing and the development of the cloud, guaranteeing that demand for metro networks will continue to outstrip supply. "I get the sense that a lot of people are doing a lot of analytical work on metro providers," he says.
And after this round of consolidation plays out – what will happen next in the metro market? A rival private equity player sums it up thus:"Clearly, we are close to the point where all the growth-by-acquisition opportunities are fast disappearing. When that eventually happens, the focus will have to shift back to bread-and-butter long-term organic growth because that will ultimately drive valuations."
Devil in the detail – what went wrong when private equity turned seller
If 2011 was something of a "dry run" for the time when private equity firms must eventually cash-in their profits in the metro market, then it won’t have left many backers feeling all that confident. But take heart, analysts say; practice makes perfect. Below, we analyse what went wrong and the lessons to be learned for the future.
The sales pitch: The biggest pure metro player in terms of revenue, AboveNet’s stock market worth has surged tenfold since 2008 to $1.6 billion. Its fibre footprint serves 20 metros in the US and a further four in western Europe and spans more than 2.3 million fibre miles. Chief executive Bill LaPerch has gone from strength to strength since restructuring the company in 2003, creating an exceptionally strong business with just $50 million in debt. But the company has failed to make a single acquisition, leading to criticisms from some shareholders that it is lacking strategic vision. The company is currently valued at a 30% discount to privately-owned rivals.
The potential buyers: The sales process is understood to have been very heavily targeted at two private equity buyers, both of whom are already key players in fibre infrastructure. However, news of the tender process apparently emerged in an email to clients sent out by an investment bank working on the process. Sources suggest that one of the contenders got to within "less than $5 a share" of the asking price and a heads of agreement deal was close.
The deal breaker: Sources suggest that there was some concern as to the nature of some of the flexible terms associated with a slice of the uncommitted financing in the debt package. Wider liquidity problems surrounding the US’s credit rating downgrade and the ramifications of that in the high yield bond also turned sentiment negative.
The sales pitch: The company was formed in September 2010 after ABRY Partners took RCN private in a $1.2 billion deal and spun out the metro assets in a separate company. Under the hugely talented chief executive, Mike Sicoli, Sidera has created one of the densest networks in New York and is a leading provider of ultra-low level latency connectivity to the financial services sector, including two of the world’s largest stock and derivatives exchanges. The company’s network extends to more than 450,000 fibre miles and around 2,900 on-net locations. Sales grew by 40% last year and are projected to grow by 20% this year, leading analysts to pencil in forecasts of double-digit revenue growth by the end of this financial year. Sidera’s chief is seen as one of the sharpest minds in fibre infrastructure.
The potential buyers: Sidera’s owner, ABRY Partners, is understood to be reluctant to pursue an IPO as an exit strategy, leaving a sale in the next round of consolidation as the most likely option. The company went to the market with an $800 million price tag and is understood to have received an offer in the mid-$700 million range from a strategic buyer. Sources have suggested that Sidera was confident that a deal would be closed by the end of 2011, despite market reservations that ABRY had moved too quickly to hoist the for-sale sign. It is understood that there was little interest from private equity buyers.
The deal breaker: There has been speculation that RCN retains control of some key fibre assets in the Sidera portfolio although Capacity understands that those concerns were largely unfounded and relate to a small portion of the network in revenue terms. Worries were also thought to be expressed as to how the two companies might subsequently operate as competing entities, especially in the enterprise market. Sidera had a large disconnect from a customer during the tender process and this cast significant short-term doubts over the company’s growth trajectory.
The sales pitch: While some metro providers might be accused of focussing on their core competencies, Fiberlight is in the throes of a massive expansion programme that will see chief executive Mike Miller double the company’s footprint to more than 7,000 route miles over the course of the next 18 months. Fiberlight was bought in 2003 by Thermo Group, a Denver-based private equity firm specialising in wholesale telecoms investments. Thermo could be nearing the end of its investment cycle and thus keen to seek an exit, leading some sources to suggest that while there does not appear to be an ongoing process under way, Fiberlight is still effectively for sale.
The potential buyers: It is understood that both private equity and trade buyers expressed a strong interest in the business, with some analysts suggesting that a trade buyer with private equity backing might have been able to tease out enough synergies to get close to the $500 million asking price.
The deal breaker: Sources claim that a price was agreed but that the buyer was unable to secure funding in the debt markets, requiring it to pledge more equity than it was able to muster.