Description

Introduction: In response to a request from a member for an update to my May 4, 2017 posting on the company, I have prepared and updated my original report to include new information, including: the acquisition of Interoute (its largest to date), new financial growth targets, recent results, insider buying, my current estimates as well as a discussion of share price volatility, valuation and upside potential. I have incorporated in this update a similar discussion regarding background related factors (i.e. strategy, competitive differentiation/barriers, track record, etc.) to assist any members new to the story. In short, I continue to believe GTT is a high quality business run by a strong management team, trading at a valuation significantly less than its value in a private sale to intelligent buyers (the likely end game for the company) and the recent drop in the share price creates a great opportunity for investors today with significant share price appreciation potential.

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Investment Viewpoint:

GTT Communications, Inc. (GTT) is a rapid growth compounder with an asset-light, disruptive, high return, cash generative business model; a large TAM with strong and sustainable competitive barriers; run by an outstanding and well experienced management team that are prudent capital allocators with solid track record of execution over an extend time period and a significant ownership, including recent insider buying; valued significantly below intrinsic value. The current opportunity to invest in the shares at a very attractive price has been created by the ~55% drop in the share price since March of this year, due primarily to integration concerns tied to the acquisition of Interoute , its largest acquisition to date (and the general market selloff in high leverage companies), and has occurred despite management’s comments that the merger is proceeding on plan and its stellar history of successfully integrating about 10 acquisitions over about the last decade. The shares are currently valued at an EV/EBITDA multiple of 8.5x our FY19 estimate of $550 million for the merged company, which is significantly below the company’s historical 13x-14x multiple, as well as those accorded to other slower growing asset-owned comp’s. Additionally, GTT is a unique asset in an industry marked by significant M&A activity by the global telecom giants that could attract the interest of a diverse range of buyers in an auction at a meaningfully higher price. Noteworthy in this regard, GTT’s current valuation is well below the ~14x ttm multiple that Masergy, a smaller private competitor,  was acquired for in December 2016 and highlights that the company itself could be an attractive target for either a strategic acquisition or a PE firm and there are multiple ways for investors to win. Should the shares re-rate back to a 12x-14x EV/EBITDA multiple, our valuation matrix shows the shares would trade up to a range of $62-$82 per share, representing upside of ~125%-200%. Longer-term, should management achieve their FY21 target of $900 million in EBITDA, I believe the shares could rise to about $100-$130 per share, or roughly +4x the current share price. Thus, the shares have the potential to compound at a ~25% rate over the next 3-5 years. Adding to our enthusiasm for the shares is recent insider purchases by the company’s Chairman and largest shareholder.

Business Overview - A Disruptor in the Telco Industry:

GTT is a provider of internet connectivity services on a global basis. In essence, think about the internet as a global connected system of roads, where each packet of data needs to be transported. GTT helps their customers, primarily large multinational corporations, transfer data over this system of roads. For example, if Apple (AAPL) was a client of GTT and needed to transfer information from its Palo Alto office to Berlin, the data needs to first travel on the last mile providers network in Palo Alto, going to a network, most likely owned by AT&T (T) or Verizon (VZ), to transfer to New York. From there it would travel on GTT’s owned subsea cable to Dublin, get picked up by British Telecom, then Orange in France, then Deutsch Telecom (DB) in Germany, and then the last mile provider in Berlin to reach its office. Someone has to make sure the providers have pricing for Apple, and the client does not want to do this itself, and the large incumbents (AT&T, Verizon, BT, Orange, and Deutsche Telecom) tend to opt to not be involved in this lower margin business given they spend heavily on capital expenditures (cap-ex).

This is where GTT comes in. GTT will create a custom network path, contact each operator and get pricing for Apple.  They negotiate and manage each relationship, and make sure the data gets transferred with low latency (fast), redundancy (backup connections), and security. GTT has one of the largest global networks, making it a tier-1 provider. GTT has a different business model than its competitors. Other companies spend significantly more on capex and thus need to have the majority of their business on net (on the fiber they built), given the higher margin. If they are selling off net (not on their fiber), their margins are lower and can’t justify their capex, which is the advantage GTT has given its lower capex structure. GTT has been able to attack this off net market because most of the incumbents are not interested in going after this business, leaving a void for GTT to serve these customers and grow rapidly.

GTT signs long-term contracts with its customers with ~ 75% of incremental sales coming from upsell.  This, plus low customer churn translates into a predictable ~94% monthly recurring revenue business.

A key element of the company’s competitive differentiation is GTT’s status as a leading tier-1 internet service provider (ISP) and its asset-light, low cap-ex, business model (unique among the public competitors). This differentiation has enabled GTT to be a disruptive force in the telecom industry. Unlike the large asset-owned communications companies (i.e.  AT&T, Verizon, BT, Deutsche Telecom) that own their own a significant portion of their fiber networks, GTT purchases the majority of its transport from other networks and is among the largest customer of each of these incumbent telco providers. Given that GTT’s internet protocol (IP) backbone is consistently ranked a top five network in terms of internet routes, it is considered a tier-1 (ISP). This status gives GTT access to the entire global Internet routing table through their peering relationships. This positions GTT alongside the leading asset-owned global telecom service providers, providing scaled opportunities that differentiate it against a number of smaller competitors. For its niche, GTT specializes in more complex configurations with “off-net” and “last mile” solutions.

While GTT has lower EBITDA margins versus major public asset-owned providers (still at ~30%), it has the lowest cap-ex/revenue among its comp’s, translating into its unlevered cash flow (as defined by EBITDA – cap-ex) to revenue ratio among the leaders in the business. This highly generative FCF business model is a key element of the company’s growth strategy, giving GTT cash to make significant accretive acquisitions to grow the company at a very healthy pace.

Sustainable Competitive Barriers:

GTT’s business model gives the company strong and sustainable competitive advantages relative to both small and large competitors. GTT’s status as a tier-1 (ISP) and its peering privileges provide access to global networks that smaller competitors would find challenging and costly to replicate. Additionally, GTT’s large relative scale, with +600 points of presence on six continents, 140+ countries with client services, and an internet backbone top-ranked in the industry give it buying power, and provide additional advantages that smaller competitors cannot match. Finally, the breadth of GTT’s product portfolio and service offerings, garnered through various acquisitions over the last decade, provide further competitive advantages, allowing the company to garner a greater share of wallet and make the customer relationship more sticky.

Relative to larger ISP’s, GTT’s “off-net” focus, provides certain competitive advantages resulting in market share gains. “Off-net” tends to be a lower margin, more complex sale. As such, telecom providers with higher cap-ex cost structures tend to focus more on higher margin “on-net” sales opportunities. Consistent with their own business models, these companies are more incentivized to sell capacity on their networks (including to GTT, who is a major customer to most) to help offset the significant initial costs associated with laying fiber. As such, they are more reluctant to route traffic to competitive networks or spend time helping customers with their “off-net” communications. Conversely, GTT can provide a more customized solution by picking and choosing the best network routes using its proprietary software, can create agreements at competitive prices using its scale advantages, and provide last mile and additional services.

This puts GTT in a sweet spot versus both large and smaller competitors, which has allowed the company to grow at such a rapid pace for a long period of time. I think they are just getting started, and that the business could be 5-10x larger in 10 years.

Currently, organic growth is driven by favorable secular trends, mining the customer base, market share opportunities and investments in their sales force. GTT’s TAM is estimated at several hundred billion dollars with the large legacy ISP’s holding the largest market share. Cisco Systems forecasts that IP-based and cloud traffic will grow at a CAGR of 22% and 191% respectively in the 2015-2020 period. This growth is being fueled by favorable secular trends, including the insatiable appetite for bandwidth, movement of (SaaS) and apps to the cloud, and the growth of web services. After factoring in the declining per bit prices, management targets organic revenue growth in the mid-to-high single digits over the next few years.

With roughly 75% of incremental sales coming from existing customers and low customer churn, there is a significant opportunity to generate organic growth. GTT has been successful at increasing market share due to better service and the more flexible and customized solution it offers users. GTT’s customized approach saves customers time versus shopping/structuring individual agreements with various ISP, leverages GTT’s buying power and gives network IT managers the comfort of “one throat to choke” if problems arise.

GTT has a goal of double-digit growth from a combination of rep-driven sales and small acquisitions. The company has been making investments to increase its salesforce in the 2016/17 time period. The number of reps has about doubled during the last year to about 300 from the combination of new hires from the large legacy telco’s and via the company’s acquisitions. Given the approximate 12-18 months for new sales reps to begin contributing full-quota revenue, I believe this is beginning to have a positive impact on internal growth.

A Proven, Highly Accretive M&A Strategy To Grow And Transform The Company’s Business:

GTT has historically redeployed the cash flow from its business model to fund accretive acquisitions to grow scale, drive strong growth in profitability and increase intrinsic value. As illustrated below, over the last decade GTT has successfully completed/integrated ten major accretive acquisitions that have helped transform the company.

Source: GTT, Inc.

While organic growth is important, I think the real opportunity in GTT (and which has been the most important element to its historical growth) today is management’s plans to continue to grow through acquisitions. Management has been highly acquisitive over time, and is able to buy businesses at 5-6x EBITDA using either low cost of debt or issuing their own equity at higher multiples. This private/public multiple arbitrage is a business model I have seen be very successful across various industries. Management has stated at a number of investor events and on its recent Q3 investor call on November 8^th that the pipeline for both large and smaller bolt-on acquisitions is full of opportunity. Thus, I expect GTT to continue growing revenues at 20%+ per year due to their highly acquisitive nature. 

The focus of these deals has been to add new customers, expand the company’s product portfolio and scale. These acquisitions have completed its transformation to a global tier-1 (ISP) network; and added a portfolio of managed services, enterprise grade voice services, and a trans-Atlantic fiber network.

GTT has a very disciplined approach to M&A. The four cornerstones to its successful acquisition strategy are: 1) a product or technology that bolsters its core network, 2) adds to its client base, 3) can integrate within 6 months and 4) a purchase price which yields a highly accretive post synergies multiple (normally about 4-5x EBITDA). The company has historically financed these deals primarily with debt.

Recent M&A activity for GTT has increased from the perspective of the number of deals closed, as well as their size and diversity. Most notable were the acquisitions of Hibernia Networks, completed in January 2017, Global Capacity, completed in September 2017, and Interoute completed on May 31st of this year. The acquisition of Hibernia Networks somewhat differs from past deals in that the acquired company owns its own fiber network. 

In February 2018, the company announced its acquisition of Interoute, its largest merger to date and one that will double the size of the company. The attractiveness of Interoute is that there are a large amount of synergies between the businesses, the company operates one of the largest fiber networks in Europe, possesses a large base of enterprise customers, operates a number of data centers (which enhance GTT’s cloud connectivity platform), and has technology in the fast growing (SD-WAN) area. Interoute accelerates management’s prior FY21 financial growth targets forward by about 2 years.

Highly Experienced Management Team, With An Excellent Track Record Of Accomplishment With Significant Ownership & Recent Insider Purchases:

GTT has a knowledgeable management team with high ownership and an excellent track record of execution over the last 10 years in successfully deploying cash to acquire/integrate various acquisitions, achieving multiple financial targets and rapidly expanding profitability and intrinsic value. Noteworthy to the GTT team is the depth and knowledge of the telecom industry of senior management and the Board. The leadership of CEO, Rick Calder forms an important part of our GTT investment thesis. Since becoming CEO of GTT in May 2007, Calder helped engineer and execute a differentiated and disruptive asset-light business model in the enterprise communications market. Fueled by a number of accretive acquisitions, this strategy has led to a 12-year period of rapid growth in GTT’s profitability, cash flow, and shareholder returns. Over Calder’s tenure, GTT has grown from a minor industry player with annualized revenues of $55 million to a well-regarded industry player, with annualized revenues of ~$1.8 billion. The company’s business model has scaled well evidenced by EBITDA expanding at an impressive ~32% CAGR from ~$23 million to a current run-rate of almost $500 million. It is now highly cash generative helping to support its acquisition strategy. All these accomplishments under Calder’s tenure have translated into a period of prolonged share appreciation with the stock price up ~18x, compounding at a 30% IRR over the last 12 years.

Management and the board are well aligned with investors given their meaningful share ownership position and compensation structure. Chairman Brian Thompson maintains an ownership of about 12.5%, CEO Rick Calder owns 3.34% and the entire management team and the Board own about 19.4% of the company. Over his tenure at GTT, CEO Rick Calder has steadily increased his holdings. Adding to our enthusiasm for the shares is recent insider purchases by Chairman Brian Thompson and Spruce House Management. GTT’s Chairman added to his holdings with purchases totaling 21,200 shares in November, while Spruce house added 375,000 shares in November, about 1.1 million shares in January and about 3.7 million shares (or 21.9% ownership) since August. Total compensation is heavily weighted in favor of stock and this year management set targets receiving stock awards for its three most senior executives with achieving GTT’s stated FY21 financial objectives; further aligning management with shareholders.

Over the last decade, the company has hit all its major financial growth targets, demonstrated success in deploying cash in integrating a number of accretive acquisitions and has significantly increased intrinsic value. More recently, as illustrated below in the 5-year period beginning in FY14, revenues have grown at a 71% CAGR, while adjusted EBITDA has grown at an 86% CAGR.

Source: GTT, Inc.

Management has a history of setting aggressive long-term growth objectives and has a strong track record over the last 7 years of achieving them. With the announcement of Q3-FY18 results on November 8th, management established its next financial objectives of $3 billion in annualized revenue, $900 million in annualized adjusted EBITDA and a minimum of $5 per share of annualized adjusted free cash flow, to be achieved within the next three years (year end FY21).

Source: GTT financials & press releases

Interoute Integration & Synergies Will Significantly Increase Profitability:

I believe that when the ~$100 million of synergies associated with the integration of Interoute are realized EBITDA will increase significantly on a pro-forma basis from prior levels. As illustrated in the table below, EBITDA will increase from $221.3 million reported in FY17 to about a $550 million run rate in FY19. I do not believe investors are fully discounting this earnings potential in the shares.

Source: Authors estimates

Attractive Valuation On A Number Of Different Metrics:

I believe the shares of GTT are attractive on both an absolute basis and on a relative basis on a number of different metrics, including relative to: its prior trading multiples, the valuation accorded its closest comp’s and private market valuations. The shares are currently valued at an EV/EBITDA multiple of only 8.5x. I believe this multiple is attractive and unusual for a company expected to compound profitability at a 25%+ rate over the next 3-5 years should management achieve its growth targets. Additionally, GTT is trading at a ~10% unlevered free cash flow yield today, and a ~15% free cash flow yield in 3 years based on management’s projections.

As illustrated below, this valuation is significantly below the company’s historical multiple, which over the past 5 years has ranged from 10-26x (though there is some noise in these figures given their acquisitive nature, and has averaged ~16.5x.

Source: S&P Capital IQ

The shares of GTT are also attractive on a relative basis. Notably, the company’s closest comp, Cogent Communications (CCOI), is currently valued at a ttm EV/EBITDA multiple of 16.6x and 13.1x next year’s EBITDA.

The combination of GTT’s low relative valuation and strong growth prospects could make the company an attractive target for either a strategic acquisition or a PE firm (the likely end game for the company). I believe GTT could sell for more than twice its current price, should the board put the company up for sale. However, I prefer GTT to remain public, as I believe the shares will compound in excess of 20% over the next few years. Relative to private market valuations, I note that in December 2016, Masergy, (smaller in size and not growing profitability as rapidly as GTT), was acquired by Berkshire Partners at a trailing 12-month EBITDA multiple of  ~14x. M&A activity in the telecom industry has heated up as organic growth among some of the major players has slowed and many are looking to acquire growth or move into new sectors via acquisitions. The amount of major players has become smaller, with only a few public multi-billion dollar telecom companies left. The most recent example of this is the reports that Zayo Group Holdings (ZAYO) has received interest to be acquired from a group of investors including funds managed by Blackstone Group LP and Stonepeak Partners LP.  With GTT’s acquisition of Interoute and the company fast approaching its $2 billion revenue goal, the company now has the scale to move the needle for global providers. Possible acquirers of GTT include:

•             Global telecom operators (i.e. BT or Deutsche Telecom), looking to increase their US presence;

•             Cable operators, looking to move up from the SMB market to the enterprise;

•             Asset-owned telco’s looking to bolster their salesforce to better leverage their fiber investments;

•             Private equity

I believe the end game for GTT is an acquisition by one of the growth-starved large communications or cable companies. Thus, there are multiple ways for investors to win.

Why Does This Opportunity Exist?:

The current opportunity to invest in the shares at a very attractive price has been created by the ~55% drop in the share price since March of this year due to integration concerns tied to the integration of Interoute and the general market selloff for companies with high leverage (leading to an increase in the short interest).

Source: S&P Capital IQ

However, despite recent comments from management that the integration of this acquisition is on plan to generate the expected synergies, the shares have declined significantly. The following are management’s comments from their November 8th conference call, suggesting the integration is on plan and the company should receive at least, if not more than, the expected $100 million in synergies:

“We made meaningful progress on the integration of our largest strategic acquisition, Interoute. We completed the organization integration in September, and we expect the majority of those employees currently on transition to leave the company by year-end with the remainder leaving throughout the first half of 2019. The systems integration is also well underway as we consolidated all core business support systems to our client management database, in October. Network integration is also on track for substantial completion in the next few months. We expect to complete the Interoute integration in early 2019 consistent with our prior estimate of 3 to 4 quarters post close and continue to expect to achieve at least $100 million in run rate cost synergies once the integration is complete. It is important to note that our $100 million target remains unchanged, despite the recent weakness in the Euro and the Pound as we expect to outperform our initial estimates on a constant-currency basis”.

On December 4^th at an investor conference in New York, management repeated its prior comments indicating that the integration of Interoute is progressing “on track” and they are “very comfortable towards that $100 million target that we had outlined when we announced the deal”.

As highlighted in the stock price history chart below, in a favorable long-term appreciation pattern, the share have experienced periods of volatility associated with prior acquisitions.

Source: S&P Capital IQ

In addition to the recent ~55% drop in the share price, during the last 5 years, we have seen 3 other periods of share price weakness tied to acquisition integration concerns. In each case, the share price drop proved to be an excellent opportunity to purchase shares, with share advances of ~120%-155% in the following one year period.

Source: S&P Capital IQ

Our Valuation Matrix Show Significant Share Upside Potential:

Over its history, GTT has traded around 12-14x forward EBITDA on average, which corroborates with the private market values shown by the Interoute and Masergy transactions. As illustrated in our valuation matrix, using a 12x-14x multiple range, the upside potential in GTT today ranges from ~125%-200%.

Risks:

I see the largest risk in GTT as the business growing too fast and struggling to integrate their acquisitions. So far the team has successfully integrated a variety of businesses for a decade, but with any acquisitive business, this is always a risk.  Higher than average churn is another risk for GTT. I think this is mitigated by their consistent churn levels over time, which generally are in line with industry averages, but will closely monitor any elevated churn levels. GTT also has a substantial amount of leverage, again I think this is mitigated by the strong cash flow of the business and the fact that maturities start in 2023 and the business has a high level of recurring revenue, but I still watch the debt levels closely. 

Catalyst

• Success in integrating Interoute into the organization and achieving the targeted $100 million in synergies.

• Accelerating organic growth.

• Continuing to find, acquire and integrate new M&A into the company to grow intrensic value.

• Progress in moving forward relative to achieving managements new financial growth targets.

• A reduction in the short interest.

• An acquisition of the company.