Description

(Note: All $ in CAD)

Axia is a chronically mispriced equity with near term catalysts to collapse the discount between trading price and fair value. We believe Axia has 30-40% near-term upside should the activist that has recently filed on the company prove successful in forcing the company into a sale, or over 100% upside over the next 12-24 months if the company remains public and trades to fair value.  Additionally, the French government is likely coming to a conclusion in the next three months on the future of rural fiber that could result in Axia trading at multiples of the current share price in the near to intermediate term given the potentially dramatic positive impact on penetration rates. This massive optionality is not priced into the share price at present. Clarity on any ruling from the government is likely to come in advance of a take private announcement.

Axia is an operator of rural fiber networks in North America and France.  The French asset, Covage, is a unique growth asset which we believe will grow EBITDA at ~25% CAGR from 2014-2016 and is significantly undervalued given the complex corporate structure at the parent Axia.  Axia trades at 7.5x ’15 EBITDA and 6.2x ’16 EBITDA (proportionate for its 50% stake in Covage), versus public fiber comps and recent transactions in the space in the low to mid double digits.   Our valuation work indicates Axia’s 50% stake in Covage is worth over $3 / share, implying that you are getting the North American business for free today.  We believe a management led buyout, which is being lobbied for by the activist, could result in a deal price of ~$4.50 / share (11x France ‘15 EBITDA, 8x North America ’15 EBITDA, $0.25 DCF value for recently announced FTTH contract), a ~35% premium to yesterday’s close.  Our 12 month price target for Axia is over $6 (~80% upside), based on forward EBITDA multiples and a DCF analysis. 

While we believe the stock is intrinsically worth over $6 / share, the complex corporate structure, international asset base, limited trading liquidity, and lack of sell side following are likely to contribute to some level of discount to fair value.  We believe management is likely to consider a take-private in the near term, which could crystalize value and close some of the discount for current shareholders, and provide an attractive IRR from the current share price. The CEO is no stranger to take private transactions having taken his previous company (Husky Oil) private in the 1990’s.

Lpartners previously wrote up Axia in October 2013, however given the recent developments and potential near term catalysts, we believe an update to the thesis is warranted.  

Company overview

Axia designs, builds, and operates rural open-access fiber networks delivering high-bandwidth broadband transport between remote communities and global internet network connections.  Axia currently operates fiber networks in Alberta, France, and Massachusetts. 

Across all regions where Axia operates, it enjoys a model with recurring revenue, minimal churn, operating leverage, and limited competition.  Revenue is non-cyclical and given its rural footprint and unique government relationships, Axia faces limited competition.    

Alberta

Axia operates 13,000km of fiber in Alberta, connecting 429 rural communities with lit fiber services.  Axia delivers its services on both a wholesale and direct model in Alberta, with ~80% of its revenue in 2014 generated from government entities and the bulk of the remaining 20% from enterprise customers.  

Contracts for government entities are negotiated at the local level (not a blanket deal with the Government of Alberta) with the highest concentration in schools and hospitals, and are typically 1-3 years in length. 

Bell Canada owns the underlying fiber of the Alberta “SuperNet” which serves 429 communities, however the Government of Alberta (“GOA”), through IRU’s that run through 2045, has the rights to operate the infrastructure and also has the ability to assume ownership of the assets from Bell in 2035.  Axia operates the network for the government on a contract initially signed for 10 years through 2015, which was recently extended to 2018.  We expect that this contract will be renewed with the GOA well in advance of 2018.  Axia is in the process of investing $20m into a “community interconnect grid,” connecting the 27 largest communities in rural Alberta, with infrastructure that will be fully owned by the company.

France (Covage)

Covage currently operates 8,530km of fiber across 19 municipalities (DSP’s) in rural France, offering both lit and dark fiber services primarily to enterprise customers.  In January, Covage also announced it had won a contract to roll out fiber-to-the-home to 319k homes in one of the DSP’s it already operates in.  Covage is a wholesale provider of network services, with over 150 reseller/service provider relationships.  The local DSP’s own the fiber and sign Covage to terms averaging 20 years to construct and operate the network.     

Axia owns 50% of Covage with the other 50% owned by Cube Infrastructure, a private equity firm based in Luxembourg.  Cube purchased its 50% stake in 2011 for ~$90m from Vinci Networks.  

Massachusetts

Axia’s Massachusetts network is still under construction and the first portion was lit in the first half of 2014.  Axia will operate 2,150km of fiber in rural MA under a renewable ten year license (first term ends in 2023).  On both a wholesale and direct basis, Axia plans to serve government entities and enterprises. 

The Covage opportunity

Covage’s network today serves primarily enterprises in rural France.  Covage has limited competition and a significant network quality advantage where it does compete, as there is only a small cable footprint overlap and France Telecom (Orange) has under-invested in its legacy copper network assets in these regions.  Moreover, during the last few quarters, SFR (the primary cable MSO, recently purchased by Numericable) and France Telecom have put in place agreements to resell Covage’s network to their customers. 

The company currently has ~12% penetration of the 46,000+ enterprise doors it passes with its network, and it has guided to achieving 20% penetration in the next 2-4 years.  As the company expects ARPU to remain relatively stable, this would imply that revenue should nearly double over the next 2-4 years, and do so at over 60% incremental EBITDA margins given the operating leverage of the business model.  We estimate that Covage’s enterprise business will generate ~$30m of EBITDA in 2015 and ~$38m in 2016, growing from ~$23m in 2014.  

Covage will spend ~$18m in capex during 2014, however the bulk of that is growth related customer premise and last mile capex (on which the company has indicated there is a 9 month payback), with less than $2m of ongoing maintenance capital requirements.  The company expects to spend ~$20m capex annually to get to its target 20% penetration in the next few years.  Telecom networks are primarily fixed cost business models, and as such, along with low maintenance costs from the all-IP newly constructed network, the business model scales quickly and is highly free cash flow generative. 

Covage Upside Optionality

Based on recent developments at ARCEP (French equivalent of the FCC), there is also a potentially game-changing call option embedded in the Covage business.  Both France Telecom’s and Covage’s networks were constructed with significant grant money from the French government, much like public utilities.  The view of the government is that taxpayers should not have paid for two networks to compete against each other and that they should be provided the highest quality of service.  Based on our conversations with management and releases from the French government, ARCEP will likely make a decision as soon as during 1H 2015 on shutting down the legacy copper networks and routing all rural traffic over Covage’s network in the regions where it operates.  The process would likely entail a gradual shutdown of the legacy copper network (e.g. over 5 years) and a dramatic expansion of the wholesale relationship between France Telecom and Covage.  Incumbents have penetration rates of over 80% of doors passed in some rural areas, indicating massive upside to the Covage model if its fiber replaces the incumbent copper.  In order to quantify this opportunity, we ran our model assuming 80% penetration for Covage in its core markets in 2019, resulting in nearly $260m of annual EBITDA, which at a 10x multiple implies over $20 per share for Axia’s 50% stake in Covage. 

Management

Based on our interaction with them over the past few months, we believe that the members of the senior management team, particularly Chairman and CEO Art Price, are prudent allocators of capital with a long-term view to grow the business.  Art, who has been with the company since 1995, was formerly the CEO of Husky Oil, where he led a take-private.  Art has consistently indicated that if the company remains under-valued in the public markets, he would consider pursuing private market alternatives.  We believe Art would like for Axia to own 100% of Covage and have the flexibility to invest for growth there and in North America, particularly in FTTH.  If he can find a capital partner with a similar vision for Axia, we believe a deal is highly likely to occur in 2015, particularly in light of the recent shareholder pressure. 

Financial projections

Covage

As discussed above, the model in France is driven by increasing penetration of enterprise doors passed.  We estimate the Company crosses 20% penetration in 2018.   Axia’s US fiber counterparts are growing penetration well north of 20%, and the company has indicated that it expects growth to continue after it reaches the 20% threshold.  We also believe our model is conservative on ARPU, which we hold stable during the projection period despite strong volume growth by end users.    

Covage also recently announced a 25 year FTTH contract win in the Seine-et-Marne region outside Paris.  The contract covers 319k homes and the French government through grants will cover nearly half of the capex required for the network build.  The company believes this contract could produce over €20m in run rate EBITDA at maturity, and that the project will be FCF breakeven after 5 years of operation, with peak EBITDA drag of €3m.  Axia projects that the maximum level of cash that it may have to inject into the FTTH build is €17m during the first 5 years, but that a significant portion of this could be debt-financed.  Assuming no debt financing and assigning no terminal value to the contract beyond the initial 25 year term, Axia estimates it will achieve a mid-teens IRR on this project. 

North America

Despite a lower revenue growth trajectory than France, Axia should report consistent EBITDA and FCF growth in the near and medium term in North America as it exits a significant investment period.  In 2H’15, Axia exits a restrictive revenue sharing agreement with Bell which also coincides with the lighting up of its community interconnect grid.  These two events open up the $400m Alberta enterprise market to Axia, of which management has guided (very conservatively in our view) to capturing $10m annually in the first 3-5 years of operations.  

80% of North America service revenue (~$40m in 2014) is from government entities in Alberta.  This portion of revenue should grow low single digits throughout the projection period. 

The company has a material growth opportunity for the 20% of the North American remaining business, which includes Alberta enterprise revenues, Alberta FTTH, and the Massachusetts network.  The step up in capex in 2014-2015 is related to the aforementioned interconnect grid ($20m) and FTTH trials ($10m), both in Alberta.  The company has guided that after it has completed the interconnect grid, it can double non-government revenue in Alberta within 5 years.  

Capex should step down materially in 2H’15 and 2016, after the completion of the interconnect grid.  Similar to France, maintenance capex runs below $2m annually in North America.  We believe our North American assumptions are conservative, as they do not include revenue from the potential FTTH opportunity, and very limited EBITDA contribution from the Massachusetts network.             

Corporate

Full year 2014 corporate expenses at Axia should be in the $3.5m range, which we view as a reasonable run-rate for the business.  The company expects to return to a ~25% EBITDA margin on a reporting basis (North America segment + corporate). 

 Valuation

We believe a deal, if reached, could conservatively be in the low to mid-$4 / share range, based on recent deals in the fiber space.  Our 12 month valuation, which blends a DCF and multiples, is over $6 per share.  Given the low-churn, recurring revenue model, this is definitely a leveragable model, and an LBO analysis shows that a $4.50/share purchase price with only 3.5x leverage still yields IRR’s over 20%, making Axia an extremely attractive candidate for private equity. 

Axia trades at a material discount to public fiber peers despite a much more attractive organic growth profile.  On a proportionate basis for Axia’s 50% stake in Covage (including 50% of Covage’s net debt), Axia trades at 7.5x our 2015 EBITDA estimate, well below the ~12x median of other pure-play fiber companies.  We believe the accounting treatment of Covage (equity method) further exacerbates the discount at which Axia trades today as the growth of the French business does not appear when screening the company.    

A summary of the valuation methodologies we considered is below.  Please note that each value per share includes $0.25 for the recently announced FTTH contract (based on a DCF of the cash flows over the 25 year term of the contract); management estimates this contract adds $0.50 / share based on their internal modeling so our estimates may prove conservative.   

M&A in the fiber space has been very active over the last few years, with Zayo in particular and Level3 both paying well above 10x forward EBITDA for fiber infrastructure assets.  Our conversations with investment bankers covering the telco/fiber space indicate that the primary area of investment over the next few years will be Western Europe, as evidenced by Zayo’s recent deal announcements there.  If put into play, we believe there would be strategic interest in Covage, which could push deal value into the high end up the multiple range illustrated below given its EBITDA growth trajectory.  Please note that no value is attributed for the FTTH business in the analysis below.

Axia trades at a significant discount to intrinsic value and has potential near and medium catalysts which could close the gap between the current share price and fair value.  We believe there is limited downside today given the current discount and the non-cyclical, recurring revenue business model.  Either through a near term sale / take-private of the company or via continued execution under an improved corporate structure being pushed for by the activist, investors are likely to generate alpha in Axia over the near to medium term regardless of broader market conditions.    

Risks

·         Revenue concentration of government entities in Alberta

·         End of GOA network contract in 2018

·         FTTH dilutive to Covage EBITDA and FCF in near term

·         Trading / liquidity

·         Currency

Catalyst

·         4Q’14 earnings – expected to show continued EBITDA margin expansion and customer connection growth at Covage

·         Sale of company / announcement of strategic review

·         Announcement of incremental contract wins for FTTH deployments in France

·         Potential announcement regarding shutdown of legacy copper network in rural France

·         End of Bell revenue share contract in 2H’15