In the wake of Carl Icahn's bid for the tiny piece of XO Holdings (news, filings) that he doesn't already own there has been a flurry of activity in the media and blogosphere. Much of it centers around the amount offered versus what XO ought to be worth, and much makes no sense at all. So I thought I'd save the rhetoric about whether Icahn's offer is good or evil or what he might do next for another post and talk about the valuation of XO itself a bit more dispassionately.
First let's dismiss the EV/Revenue crap some are using to decide what XO is worth. In his excellent series on valuation, Dan Caruso over on Bear on Business explained why we use EBITDA when figuring out what fiber based telecoms are worth. Revenues aren't useful because they ignore margins, and margins are critical to valuation in this sector. Cash flow doesn't work because the business is so capital intensive, and highly successful companies in the sector re-invest their cash to grow while those under stress must conserve it - skewing the numbers. Rather, we need an estimate of the propensity to generate cash, if a company chose to do so. EBITDA is the best we have there, and that is why the ratio of EV/EBITDA dominates.
As of the end of last quarter, XO had $391.3M in cash, $1054.1M in preferred stock, and there were 182,075,035 shares outstanding. At the close on Thursday, common shares traded at $0.28, that put XO's EV at $714M. The company hasn't given us guidance for EBITDA in 2009, but lets give them the benefit of the doubt and use $150M which would be up 36% sequentially despite the economy and implies improvement from the first quarter's $28.1M. That suggests that before Icahn made his bid, XO was trading at an EV/EBITDA multiple of perhaps 4.75. That compares unfavorably with TW Telecom (NASDAQ:TWTC, news, filings) at about 5.5 and somewhat more favorably with glbc at about 4.6. Icahn's offer of $0.55/share corresponds to an EV/EBITDA ration of 5.08 given these assumptions. Note that I am estimating 2009 EBITDA for each rather than using 2008 numbers, so the ratios are a bit lower and fuzzier but hopefully reflect the present more than the past.
When put in that context, Icahn's offer of $0.55 certainly isn't a big premium but neither is it way out of line, so why all the hubbub? It's the leverage. All those preferred shares are fixed in value (as long as we are below the conversion price) and therefore a small change in EV/EBITDA ratio corresponds to a large change in the price of common shares. A ratio of 6 would value common shares at $1.30, or more than 350% above thursday's close. A ratio of 8 would imply a stratospheric price of $3 per share. But a ratio of just 4.4 would imply common shares are worth nothing at all!
In other words, the 'fair' price for common shares of XO based on standard metrics, current multiples, and a takeover premium could be anywhere between $0 and $3, the exact price is extremely sensitive to what multiple you choose. The question of whether Icahn's price is fair or unfair comes down to what multiple is fair, and given the sensitivity that is an impossible judgment call - no one will ever agree because just a tiny difference gives them so much more money. On the two opposing ends are arguments like these:
- XO has fantastic assets, including 18 fibers on the original Level 3 longhaul build and 9000 metro miles connecting over 3000 on-net buildings nationwide - that's infrastructure you just can't build anymore. While margins are still low, the period of legacy churn is ending and the company is poised to grow its high margin revenues rapidly leading to margin expansion. They are poised for something big and don't need to sell, and therefore should get a premium to the rest of the industry to sell out! FTGX got 7! Nothing below 7! The price of $0.28 was totally wrong, held down by Icahn himself, we deserve 10 times that!
- XO has by far the lowest EBITDA margins in the sector, and has for a long time. Their revenue is largely off-net and of low quality, and they do little more than churn revenue each quarter. There is no trend anywhere in the numbers that implies that is going to change anytime soon, and no buyer is going to pay for yet more unfulfilled promises. A ratio of a little over 5 is completely fair! All the value in this company is in the preferred shares, common shareholders are lucky they get anything at all! $0.55 is a gift!
Because of the leverage, it is possible to spin the numbers either way and both sides have points. Those who think the offer is unfair are largely pointing toward things the market does not currently value. In other words, they simply don't want to be forced to sell in a bad market unless they get a good market price.
In the end though, the concept of 'fair' is and always has been a load of fresh buffalo chips. Icahn didn't choose $0.55 because it was fair, he chose it because it is the lowest number he feels he can get away with and still get 51%. That's just the kind of guy he is and we all know it. The market price is his justification, the stock hasn't traded above his offer price since Sept 19, 2008 so the market obviously doesn't believe the company is on the brink of anything great. In the background we still have his ownership of the class A preferred which comes due next spring, with which he can increase the pressure. Common shareholders will have to rely on the media and the perception of injustice to generate a 'no' vote and force a higher bid. That could work if they can get enough attention, if only because Icahn's public image may be worth as much to him as XO is. Or not, it depends on his current mood.
Who wins this contest of wills? Can Icahn get 51% of outstanding common to take his offer? If you've read this far, you must have an opinion. What do you think?
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