On the Viability of Rolling Up Metro Fiber

July 7th, 2010 by · 30 Comments

Two items in the past several days have come up questioning the viability of Zayo's acquisition strategy.  Following the agreement to purchase AFS on the heels of the AGL deal, they certainly must be considered as a very aggressive purchaser of such assets right now.  After some 15 acquisitions over the past three years, though, we already knew that much eh?  Over at On Rad's Radar, Peter Radizeski asks:

"Zayo as a group does about $59M in revenue per quarter which is about $240M per year from $400M in invested capital. At 10% growth, how do you even pay back the note?"

And in an anonymous comment on this site yesterday:

"there seems to be very fair question here as to whether zayo is simply raising 15-20% (or whatever) capital to buy 10% returns."

In other words, is Zayo paying too much for metro fiber?

I think it all depends on how one sees the economics of this business developing over the next decade.  Dan Caruso and Zayo and their backers believe that such assets are fundamentally undervalued right now.  How can this be at 9-10xEBITDA?  EBITDA helps measure the current state of the business, but it doesn't tell us the future.  Simply put, they think that they can grow EBITDA and cash flow at a faster rate than others think is likely, whether because the whole sector accelerates or because they start taking a bigger share of the pie, or more likely both.

Can they do it?  Hey, they are taking the chances and will bear the risks and reap the rewards.  What I will say is that for all the 'obviousness' I tend to ascribe to the value of metro fiber on this blog, there are actually only a handful of executives in this business who have demonstrated that they know how to really operate such assets profitably, plus another handful who think they have it and are actively trying to prove it.  Even amongst that select group, there are substantial differences about how the economics work a few years out on things like wireless backhaul.  It's not for the faint of heart.

Private equity groups sense something is there, and there are a bunch that want a piece of the action.  But this isn't the datacenter business, which is a business model that is fairly easy for outsiders to understand at a basic level - you buy land, build a big facility with familiar internal structure, then sell the space by the rack and cage, rinse & repeat.  In the metro fiber business, the geographical variations both between and within markets, the much wider range of customers and customer behavior, and the rapidly changing mix of traffic being carried are all things that don't lend themselves nearly as well to financial analysis.  I think much of that private equity money has thus far been unsure what to pay.

So is Zayo a roll-up that will inevitably implode due to paying too much for assets that will never develop the way they think they will?  Or are they a visionary company that sees the future of a valuable asset more clearly than the spreadsheet jockeys?  Bluntly, Zayo will have to prove it on the ground over time and actually do more with those assets than their previous owners would have.  They do seem to understand that quite well, and amongst other things they are making pretty big bets on the wireless backhaul space and are taking greater advantage of stimulus money than most.  The designation 'just a roll-up' is one that gets applied to a company that fails to differentiate its own performance from the assets' previous owners, and I'd rather give these guys some time to prove otherwise before I make a judgment.  It's much, much too early yet.

I do think that others will be winning auctions for metro fiber assets this year, and will be paying similar multiples to what Zayo is paying.  There is a groundswell of new private equity money looking for a home that will find a way in eventually.  Zayo isn't the only one that sees what they see, they are just more confident about it right now.

What do you think?  Are metro fiber valuations at a local maximum or are we just getting started?

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Categories: Mergers and Acquisitions · Metro fiber

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30 Comments So Far


  • Anonymous says:

    With each acquisition, Zayo is narrowing the competition, which could bode well for pricing down the road (which also helps the sector). Also, remember what the cost is to replicate what Zayo has purchased, which brings up the whole barrier to entry point as well.

  • anon says:

    Thanks Rob. I think a couple of questions remain: If one loves metro fiber, why not build it? Like any other tangible asset, it ultimately runs into the constraint of replacement cost (if a mall owner raises prices too much, a developer builds one across the street). This is literally how AGL got into the business — they built to Hi Cap demand that the LEC’s were over charging.

    As for the removing competitors comment, this may or may not be real. It would present fair competition issues, but not at the rounding error percentage of market share vs established players. Also, 4G, metro ethernet, ethernet exchanges, etc., are radically reducing local transport pricing so this is a moving target in any event.

    As for buying in place cash flows, these aren’t there forever… the wholesale space has longer agreements and IRU’s, but many of these deals are 3 – 5 years. So at a 10x multiple, you have paid 2-3x for these cashflows and growth is Required to make this work, not just optimal.

    The most strategic reason to own metro fiber is to connect it to national and international networks (see, e.g., L3, ATT-TCG, VZB-MFS, etc). As such, one would think that the TW, L3, XO, GX, AN, etc crowd could pay up for these assets. But they have studiously avoided same… Why?

    As an investment thesis, “This time is different” is often used, but rarely validated….

  • Anonymous says:

    Dont rely on the EBITDA “X” multiple metrics. It is a fact these assets are fundamentally undervalued, not based on a multiple chosen to set value, but the fact that these assets are underperforming. We all value the “business not the assets” to value an acquisition because these deals are self-liquidating. That is smoke and mirrors when you consider the networks Zayo has acquired dont register double-digits in market share capture. They are rich on passings, but weak on market share.

    Every business passing is a potential customer. Look closely at their business units; It is clear they are positioning themselves to capture small enterprise customers in their footprint.

    A strong footprint with a large number of cell tower, enterprise, hi-cap passings, a self-liquidating acquisition basis and tons of extra capacity; the only limiting factor is available capital to build to new customers.

    Footprint is critical. When you can add a $1,500 of durable MRR for about $20-25k in a 1 mile construction, you are creating considerable enterprise value. $1500 * 12 * 35-40% EBITDA margins = $7200 * 8x = $57,600 in value or 288% return. (Wondering how many new businesses did they pass with the additional ~1 mile of construction?)

    While an efficiently run company today might be running at 35-40% EBITDA, as we see a deeper adoption of all-on-net customers, margins naturally increase by shedding off-net expenses.

  • Anonymous says:

    You better be in rural america or some other good ROW for $20-25k per mile construction costs. Point is the same though if it proves out for the first client.

  • Dan Caruso says:

    This is an enjoyable string to read. I wish I could participate in the dialog, but with public debt I cannot. For those who really want to opine on the merits of what we are doing, focus on our next earnings release–specifically the supplement. In the supplement, we will provide vast analytical insight into how we are doing–and you can judge for yourselves (with the benefit of financial facts) on our performance.

    I will focus you on one key metric. Invested Capital divided by Annualized EBITDA. That is, how much money have we put to work (Debt + Equity) compared to the amount of EBITDA we are generating. Moreover, how is this changing quarter over quarter.

  • CarlK says:

    Considering the train wreck you were partly responsible for during your tenure at (3) surrounding this metric, it will be interesting to see what you have learned.

    Hopefully, you’ll keep Dave Rusin around so that he can implement the Jenny Craig program he has opined about here, however. He likes to whip boys like you, I understand.

    Rob, you forgot to put an option for Rusin as (3)’s CEO in your earlier query. Caruso’s last mentor, continues to be MIA for creating shareholder “VALUE” as opposed to the “DESTRUCTION” remaining no stranger to his equity “bag holders.”

  • Anonymous says:

    I liked the comment “it’s different this time hasn’t been validated.” While this is true, I believe it also true nobody has tried a large scale rollup of under-utilized metro assets of any real scale and failed.

    You simply cannot size up a metro fiber business with traditional telecom metrics. True a business is worth what someone is willing to pay for it but unfortunately we still use antiquated telecom metrics for evaluating very different business models.

    First problem; Most competitive telecom models are based on leveraging artificial market advantages originally designed (in my opinion) as a short term advantage hoping to prime the pump for competition. Without ownership of the network you are vulnerable in product distinction/evolution and not sustainable. I dont care what magic box you put in your colo today, if you lease from the incumbant it is a matter of time before someone eats your lunch.

    Secondly, the typical private equity investment time horizon is only 5 years. It took the incumbents better part of 100 years to build the network most use today. When you can simply lease copper UNE’s, preserve capital and still acheive high x-multiples, many investors have followed the same short sighted formula. Some built intercity routes, many built metro rings for interoffice transport, but it was laughable to suggest buildout of end user connections at any major scale.

    The result is most telecoms still sell in increments of 1.5Mbs in a world where customers are increasingly demanding services in Hundred Meg or Gigabit incremenets at no additional cost. Telecoms not focused on building network will eventually become irrelevent& die or perhaps end up buying their loops from companies that do. Either way, their largest expense will continue be the payments they make to their competitors. I just hope it’s not the incumbants who get the last laugh.

  • anon says:

    First of all, many many thanks and kudo’s to Dan and Zayo for seeing and engaging this dialogue. That in itself suggests that Zayo has an engaged and pro management team.

    Macro issues, though, continue to concern me. As is see things, most LEC’s remain regulated and have return-on-capital hurdle that they are allowed to charge. assuming that it is ~20%, for a metro fiber provider to beat the ILEC and its brethren (VZB, ATT & Q are not particularly interested in competing with each other out of their respective home regions), the metro player has to price lower than the incumbent. [price is key because it is unlikely that they will gain advantage via “capacity utilization” because like them or not, each ILEC still has the substantial majority of customers, revenues, miles, buildings, etc.]

    So, how do you use 20+% private equity to buy 9% assets? only to use the assets to compete with a regulated ILEC with a statutory right of return on capital. And/or to compete with folks that bought networks below cost in telecom bust.

    Dan’s comment re returns is a fair one — it could be labeled the “scoreboard” argument — in that invested capital / ebitda “is what it is.” But this is too general — this thread was not discussing whether overall Zayo’s returns are acceptable. The question is “at the margin” are these roll up acquisitions adding or destrying value to owners.

    This exact (if unit level) calculation: “invested capital/ebitda” analysis is how we got here: It is the equation of the cap rate of a given metro fiber acquisition. if one pays 9x ebitda, the math shows an 11.11% unlevered cash on cash return on that capital. If it costs someone 15% (or whatever the actual WACC is) to capitalize the biz, then this is simply a destruction in value. Pure and simple. Doing lots of deals (volume) won’t help — just becomes a serial destruction of value. If the larger balance sheet still foots, one can assume that buyer is using positive return businesses to subsidize lower return businesses (see, e.g., google ads vs youtube).

    Adding “high return” laterals to the acquired network may help but still has little to do with the core acquisition economics. The reason is that they could have signed an IRU for 2-6 strands on these networks and gained the same “add on” economics. The question is economics of the buy, nothing else.

    Again, all of the above are questions and opinions. I assume that Dan is correct and they like their numbers. Whether the broader market agrees is up to the broader market.

  • Dan Caruso says:

    Okay, let me try this again. As Rad points out, Zayo put ~$400M of capital to work (as disclosed in last quarter’s earning release supplement)…Net Debt of $150M + Equity of $250M (also as disclosed in the earnings release supplement).

    If the company is worth less than $400M, our investors are underwater. If more than $400M, they are in the money.

    Our annualized EBITDA was $85M. $400M / $85M = 4.6.

    So if the value of Zayo Group is 4.6M, they are in the money.

    What EBITDA multiple do you think is appropriate on a fiber-based property like Zayo Group? 3? 6? 9? 12? At each of these multiples, what gain multiple would the equity holders realize?

  • CarlK says:

    Four decimal point six years is about the most “TIME” reasonable investors should expect to receive their first in SHEKELS back tied to such risky, capital intense investments. Your investors should stay at par until you graduate to a more “success based” path, i.e., less than 3 years.

    You must be high on Colorado Mountain air to suggest that 12 years before first dollar payback is a reasonable return for a “private company,” excluding the fact that dumb money is “typically” forced by Wall Street to pay such multiples in the public venue. That’s not nearly the case today, mind you, as the BEAR MARKET CLAW continues to take its toll on valuations.

    You need to “shoot” wrestling style for your mentor’s much faster cash pay backs at 1.5 years for “SUCCESS based capital,” as he describes it.

    Of course, in his case, all that success is buried in the rubbish called “churn” because of fierce competition. Another reason for investors to exercise prudence on EBITDA multiples in your private space.

    Buffett likes to pay FOURS for private businesses on the earnings front, and convert them to public multiples-sucker money-via his holding company which whether bull or bear market resides, is significantly higher than FOUR!

  • Anon says:

    The questions raised were not whether overall Zayo features a good investment/return. To do so, one would need to start with Dan’s analysis and add in duration/years/IRR, add backs, depress/abort etc. I have not looked at the question & express no opinion on this.

    The question raised Was on the viability of rolling up metro fiber — at the prices Zayo pays. Using AGL as a case study, several questions were raised:

    1. How do you use ~ 15% capital to buy 9% assets ?

    2. Are these “cash flow” streams locked in for a sufficient duration to drive a return on the deployed capital? Example – large multiples are routinely paid for Class A office buildings due to long-term, credit leases in place.

    3. Are the M&A winning bids higher than Replacement ?

    The point is that Cost of Capital matters and that all of the “upside” is not owed to the buy because a lease (IRU) provides same position to access upside.

  • CarlK says:

    I recall you complaining that you didn’t get enough when you sold ICG at a SIXTEEN multiple of FCF based upon the more conservative numbers that were being utilized by Sunit in 06. You’re a greedy man, it seems.

    Of course, (3) was using overpriced “collateral” at the time(approx. $5 pps), when Jim Crowe kept asking the James Cramers’ of the world, ” Err, where’s my stock price?” I’m sure your team quickly exited stage left and SOLD those shares as soon as you could while not anticipating (3)’s collective businesses to perform as (3) expected in order to make the stock more valuable in time.

    Look at their stock price today!

    Your ICG is baked and buried in the cake at this time, without ones ability to determine what the hell really happened to that hot potato you passed along!

    In the mean time, what CAPITAL DESTRUCTION ensued for (3) share owners while you talked about being happy working with their management team tied to this deal.

    (3) was describing and is talking free cash flow metrics, as you should be tied to such a capital intense business. For a public company, TEN multiple on FCF is sufficient freight inclusive of tech companies in bear markets. Telecom is TECH today!

    Back then, however, it appears that Jim Crowe knew as you didn’t based upon your greedy comments, that his stock price was significantly overvalued making the sixteen on the surface BS or fake inflation which INURED to your investors as soon as they sold overpriced stock to suckers being lured by CRAMER!

    “ICG standalone is expected to generate approximately $75 to $80 million of annualized revenue and approximately $10 to $15 million of annualized positive cash flow after approximately $10 million in capital expenditures,” said Sunit S. Patel, chief financial officer of Level 3 Communications. “We expect annualized cash flow to improve to approximately $30 to $40 million once we have completed integration, which is expected to begin later this year.”

    http://www.level3.com/index.cfm?pageID=491&PR=127

  • Dan Caruso says:

    If it came across as complaining, I apologize. My strong belief then and even more so now is that the property we sold to LVLT was a great deal for them. We were happy too, but it would have been worth a lot more if we kept it. I wish is was part of Zayo Group. Oh well.

    As for how the value of ICG interplays with Level 3’s stock price then or now, I would only point out that ICG is a drop in the bucket relative to the scope of LVLT’s overall business. Whether it was worth half or double what they paid wouldn’t move the needle on their overall performance.

  • Anonymous says:

    CarlK… its OK to critique, but your attacks are child-like. Dan, thanks for having class and partaking in this discussion even if the face of the the personal attacks.

    It amazes me how some arm-chair investors are quick to size someone up for something they have never done themselves (ie. run a business)… and for good reason.

    • Ben Hilborn says:

      This was an entertaining read and there was some knowledge to be gained by reading it. Speaking on behalf of a “utilized” metro fiber network in Tulsa, we certainly see a future value based soley on the increasing demand for the capability that exists with fiber vs. T1. How many times can you dice and slice a T1 and keep business customers? We have been experiencing very steady growth and the demand for bandwidth continues to increase. We certainly enjoy offering 100mb and Gig-E solutions to clients in Tulsa and the surrounding metro areas.

      • Frank A. Coluccio says:

        I agree wholeheartedly with you Ben. A torrent of nascent applications awaiting conversion to optical and hybrid optical-wireless solutions from their copper-based beginnings are only now beginning to surface. When the C-Suiters learn how to untagle the political knots in their pants and begin to realize that they all work for the same organization (hence, begin to seek real benefits when doing TCO vs. first-costs trade-off analyses), the dams will burst open. And the straw that breaks the proverbial camel’s back will be electric power consumption and related carbon objectives, where, IMHO, it will be demonstrated that fiber’s light shines the brightest.

  • carlk says:

    Anonymous, How is it that Dan Caruso needs you defending him? As far as I can tell, he is doing a fine job on his own while gaining some lost respect, at least from my personal perspective valuable or not!

    Speak what you know definitively about or STHU about things you can’t possibly know including my business skills as well as experience, Mr. ANONYMOUS.

    Long before becoming an “ARM CHAIR” investor and at a very young age, I ran a successful business.

    Although it wasn’t one that required a PHD in engineering inside of a rapidly changing technology model, something which telecom continues to morph into today, it was a wonderful residual business model supported by various authorities and ran with very “high margins” as a result of our operating prowess.

    Dave Rusin’s Jenny Craig plan, more than likely, would pale compared to ours!

    As far as this capital intense sector with a TECH FLARE continues panning out, one can see Buffett’s wisdom in force for a long time now-shun technology-even though the old maven once used his own name as a false flag for investing in what appears to be “HORSE DUNG,” or is it “PIG’s S**T!”

  • Dan Caruso says:

    Carl,

    What was the business that you ran? Did you have outside investors? How much money did they invest?

    Dan

  • carlk says:

    It was a fire prevention company which included intense “manual labor” cleaning inside of commercial restaurants and institutions-required by law-in addition to recharging portable fire extinguishers. We built the company from ground zero-pun intended-since its factual founder, my father, was and remains a retired N.Y.C. fire captain. No investors, and no debt including the commercial/residential building where we domiciled it. At the point of sale-exit strategy-“Safety Kleen” of Chicago attempted to become the “low multiple” buyer expecting me to stay aboard, which wasn’t going to happen. They couldn’t understand how we maintained such high margins and efficiencies surrounding “labor intense” services. We ran a tight ship-small, family run business-with absolute focus on customer satisfaction! Lack of “unions” much to the chagrin of certain influences around us at the time, remains part of our successful margin story. I can assure you that “unionizing” would have enabled us to grow much faster excluding the “tribute factors” which would have owned us in the end! With hindsight, our greatest error was not “FRANCHISING” our model in lieu of selling it! “Lawn Doctor,” for example, had no beef compared to the essential nature of our services comparatively speaking.

  • Dan Caruso says:

    Interesting. How long did you run this? Who did you end up selling it to?

  • carlk says:

    Twelve years, nine of which included my full time tenure. Ultimately, a “private buyer” introduced to us by a “business broker.” That buyer was an outstanding businessman that knew intimately the challenges of dealing with labor services that ran under the moonlight much of the time. His background included a produce biz that ran around the clock off of the Cross Bronx Expressway. Very tough neighborhood back two decades ago, as it still must be today from a control and security standpoint, I’m sure! He was wired perfectly to run with the foundation that we built. The original buyer, also “private” and a business friend of his, had to gain our approval to transfer their ownership stake-a note was still in force-early on, due to the two younger sons of that family having lost their passion out of the gate, mostly because of dealing with the labor challenges as I recall.

    http://www.chieffire.com/

  • this is better... says:

    This is better than TV during the summer… Except for Entourage on HBO.

  • Haha And just as much says:

    B******s nurse nurse carlk is out of bed again !

  • Dan Caruso says:

    How did the stakeholders of your business make out? By stakeholders, I mean the banks/debt holders as well as the equity owners. If you had debt, did everyone get paid back in full? How much did the equity owners make when they sold the business? How did it translate into an IRR?

  • carlk says:

    Refer to past comments about “no debt.” I would say that us equity owners were very happy as are the new owner(s) who had and continue to have unlimited UPSIDE in a high growth business.

    One caveat, however. At the point of sale, “tax rates” were at ordinary income rates, which if we were selling today, as
    opposed to the political machine coming straight for US business owners’ heads in real time again, would have been much more friendly to our net pocketbooks.

    On the other hand, with respect to what you must deal with, in addition to public companies having to kowtow to these Wall Street SCOUNDRELS oftentimes CRIMINALS, some whom traverse this board with smart ass comments and anonymous ID’s , along with the incessant pressure placed on management teams to please them on a quarterly basis; it’s UNNATURAL and quite UNFAIR most of the time!

    I’d probably resort to punching one of them out, if they weren’t such CHICKENS!

    Level 3 (LVLT) Given Sell-Rating By Oppenheimer Managing Director Due To Percieved Weak Balance Sheet And Poor Pricing Power
    July 13, 2010

  • Patient in bed next to carlk says:

    Nurse nurse please put carlk back into bed once and for all and tie him down this time, he will hurt himself and whilst you are at it take those drugs away from him 🙂

  • anon says:

    all very interesting. but, does buying metro fiber networks at 9x or even more make sense. What is replacement cost? to what extent do the returns on capital exceed the cost of capital? what does the purchase of the physical layer get you that an IRU, Conduit or strands would not get you ?

  • carlk says:

    YUM! In the mean time, one of their main brands, KFC, previously owned by Heublein industries during the seventies into the early eighties before Reynolds bought Heublein, was an anchor customer of CFP as respects all NYC corporate owned stores in addition to the entire Long Island franchise stores. In addition, Mickey D’s, corporate N.J. stores out of Bloomfield, was a second anchor customer.

    Today’s growth, however, at least for KFC, seems to be in far away lands!

    http://finance.yahoo.com/news/Yums-profit-slips-but-its-apf-1739555539.html?x=0&sec=topStories&pos=main&asset=&ccode=

  • carlk says:

    So, Dan the Man, we must progress with your original question to shed more light on telecom’s situation.

    Since DEBT, if not efficiently managed and especially during times of “deflation” where it acts as an albatross around the NECKS of those owing it becomes the subject of non payment because “REVENUES” refuse to rise, what MULTIPLE should an investor pay?

    Telecom, your business, seems to continue following deflationary trends. I have heard your mentor’s description of SILICON ECONOMICS supposedly being applied to this space for more than twelve years now; however, the fierce competition continues to wreak havoc so that even with the internet growing exponentially, various players across the sector seem hard pressed to GROW their TOP lines meaningfully!

    Couple that with CHURN from competing forces buying anchor customers away from one another, well, that makes the scenarios unfolding more troublesome.

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