The Basic Model:
The VALUE of the common equity of a firm is the value of the residual claim on the assets. For most ongoing concerns this is equal to the present value of future cash flows minus net liabilities. Thus, we need to look at three variables:
- Net Liabilities (i.e. all claims on the firm minus cash).
- Estimated future cash flows (typically some sort of EBITDA measure)
- Discount rate for future cash flows. This is another way of saying “multiple”. It is depended on interest rates, overall market conditions, and firm specific uncertainty of cash flows.
Furthermore, empirical research has demonstrated that financial structure also matters (this is not an obvious one, under perfect markets assumptions financial structure should not matter... turns out markets are not perfect). Thus we have a fourth variable that affects the value of the common stock:
- Financial structure of the firm (i.e. leverage and liquidity considerations). This assumes market frictions that prevent costless adjustments of the balance sheet. By the way... leverage is not always a bad thing.
Finally, in conditions of distress, one must also consider the optionality value of equity. This is because even when the value of the residual claim of assets is zero (because the net liabilities are greater than the present value of expected future cash flows) the common stock will still have some value because there is a probability that the residual claim might turn positive in the future. The further out of the money the equity is or the shorter the time left for this residual claim to become positive, the lower the optionality value of the stock (Black Scholes). In “normal” companies (i.e. firms where this option is well in the money) the optionality value of equity is negligible.
Now, the PRICE of the common stock is equal to the VALUE of the common stock plus an error term.. This error term - or noise- is related to the market liquidity of the common stock security. The standard deviation of the distribution of the error is positively correlated to lack of liquidity. Thus, a large buyer or seller of an illiquid stock can temporarily move the price quite a bit. This noise should, however, eventually go away.
The problem with this model is that Net Liabilities is the only known variable (and sometimes not even that - as bankruptcy courts have taught us, claims on assets can easily multiply). So everything is estimated. And different variables cannot always be separated in a very clean manner. But the model does give us is an indication of how changes in each of the independent variables affect the dependent variable (i.e. stock price).
Looking at XO one variable at a time:
- Net liabilities - The number seems to be 660 million. And growing every quarter. But not by much.
- Estimated future cash flows - This is where industry experts come in. Looks like 125 million EBITDA for 09 is quite reasonable (if not conservative). Many think starting in 2010 EBITDA might really take off. My own estimates are 125-140 (2009), 135-160 (2010).
- Multiple - Industry multiple seems to be close to 6 (using TWTC of CCOI as references… these are relatively deleveraged players… reasonable visibility into future cash flows). The "Icahn" factor also comes in here. Definitively a discount but probably not as much as many think. Ultimately XO is an acquisition candidate and the value to others is ex-Icahn. The discount factor for Abovenet for example (which for years was unable to provide any financials at all) was never that high.
- In my opinion not real liquidity issues - Next year’s preferreds should be easily taken care of via a senior secured deal. Fairly cheaply too (even in these credit markets).
Does the optionality value of equity come into play here? Definitively. A quick calculation tells us the equity is not that much in the money (125 million times a multiple of 5.5). How much is this optionality value? Another quick calculation tells us this value should be significant. An at-the-money three year option on 660 million using an implied volatility of 10% -which is incredibly conservative-is worth 110 million. The current market cap of the common is around 30 million. The numbers are quite sensitive to assumptions but it is safe to say the optionality value of the common should be significant. LVLT’s current valuation-which is a multiple of close to 7-, for example, reflects the fact that a good chunk of the value of its common stock lies its optionality (i.e. the stock is probably out of the money when looking at 2009 EBITDA vs net liabilities, but a multi- year option on the upside potential of LVLT’s assets and business is in fact worth a lot of money). The longer they push out maturities the higher the option value.
So if optionality value of the stock is supposed to be high how come XO trades for less than 20 cents? My best argument is for the error term in the model. I am convinced the lack of institutional investors, combined with a pre-crisis dominance of hedge fund investors caused the demise of the stock. The dumping into an illiquid market has annihilated the stock price (and still is). Should eventually correct itself (the distribution of the error should have a mean of zero).
For those that made it through the end … feel free to ask any questions.