Hello! I took a little break from blogging in order to move and also to onboard a sudden rush of new Alluvial clients. Now both tasks are mostly completed, and I’m back to talk about one of my favorite “growth” companies. Before I get into the specifics, let me take a little time to discuss what I mean when I say “growth” company.
Most investors want the companies they invest in to grow. They want management to roll out new and improved products and service offerings, tap into new customer markets, and generally increase company profits and cash flow on a per-share basis. This typically requires diverting a portion of operating cash flow to capital expenditures and R&D, and investors generally accept this, as long as it’s done judiciously.
What many investors dislike is when companies repeatedly raise external capital in order to fund acquisitions. There’s good reason for this. Many of these companies engage in acquisitions with no clear economic rationale, over-pay, then screw up the integration process. The end result is an enterprise worth the same or less, but with each shareholder’s stake diluted. So why does this happen? In my opinion, it’s because running a business and engaging in productive M&A activity are two different skillsets, and not every manager has both. Many successful executives who have done a great job building a business via organic growth start to believe they have the magic touch, and begin empire-building.
However, there are some management teams that excel at both day-to-day business operations and at making productive acquisitions, and their track record shows it. One of these management teams leads GTT Communications. GTT operates a global fiber network that offers bandwidth and connectivity to a host of major companies and government organizations. GTT uses its network to provide a variety of internet services that make it easier for its customers to access remote servers and work seamlessly between locations world-wide. I’d be lying if I claimed to understand every last service the company offers, but it’s clear that these services are in great demand and increasingly essential for modern commerce and governance. Just how important these services are can be seen in how GTT’s revenues and profits have grown. Take a look at the quarterly revenue and EBITDA history stretching back to 2007. I don’t expect any slowdown in the growth in demand for GTT’s services for years and years to come.
It might not be quite clear from the graph, but GTT’s revenues grew from just $13.7 million in Q1 2007 to $49.2 million in Q3 2014. That’s a compounded quarterly growth rate of 4.4%. Annualized, it’s 18.7%. Along the way the company went from near break-even to substantially EBITDA positive.
The increasing demand for GTT’s services wasn’t responsible for the entire increase, though. You’ll notice a few sudden leaps in revenues from 2007 to now. GTT bought Colorado-based WBS Connect in late 2009 and Tinet in early 2013. Both of these acquisitions resulted in greatly increased revenues and improved margins, resulting from the company’s increased scale. Along the way the company also completed several other acquisitions, including nLayer and IDC Global. These acquisitions allowed GTT to broaden its service offerings and extend its reach globally.
Because these acquisitions required additional capital, GTT has repeatedly issued equity and taken on additional debt. Any time investors see a pattern of capital raises, they should ask “was it worth it?” After all, growth for growth’s sake is often detrimental. If returns from acquisitions do not cover the cost of the incremental capital required, shareholders’ investment is impaired. In GTT’s case, the answer is unequivocally “yes, it was worth it!” GTT’s strategy of raising capital to fund acquisitions has resulted in all-important scale. In other words, the increased asset and revenue base has allowed GTT to realize increasing EBITDA margins and returns on invested capital. The chart below illustrates GTT’s EBITDA margin and annualized EBITDA/Average Invested Capital from Q1 2007 to Q3 2014.
GTT’s EBITDA margin shows a steady climb from below breakeven to the mid-teens. Meanwhile, return on invested capital now surpasses 30%, indicating increasing capital efficiency. These are very, very healthy trends for a growing company and they support increasing equity values. And sure enough, equity value has increased. GTT shares went for $1.28 five years ago today, and are up almost ten-fold since.
I have some theories as to why GTT’s acquisitions have been so successful, but before that, let’s talk about valuation. Readers will notice I’ve mentioned only EBITDA thus far, and not operating income or net income. There’s good reason for that, and it has to do with GTT’s business model. When GTT purchases another company, it records a large value for the acquiree’s intangible assets, like customer lists and relationships. These intangible assets produce large amortization deductions, even though little ongoing capital expenditure is required to maintain their worth. This is a big advantage at tax time! GTT’s amortization charges wipe out a large chunk of operating income. After interest charges, the result is negative taxable income, though the company’s free cash flow is positive. Here’s a look at GTT’s depreciation and amortization vs. capital expenditures over time, as well as free cash flow versus net income.
Since 2007, GTT has recorded total depreciation and amortization of $54.7 million while dedicating only $21.5 million to capital expenditures. Over the same period the company earned a statutory net loss of $82.2 million, while recording free cash flow of $38.5 million, ex-restructuring costs and net investment in working capital. (I am trying to estimate GTT’s “steady state” investment needs, hence the exclusion of growth-related expenses and working capital investment.)
Since September 30, GTT completed a few important transactions that change the reported financial figures. First, the company spent $40 million to acquire American Broadband. American Broadband reported $55 million in revenues for the trailing twelve months. Nothing regarding the company’s profitability was disclosed, but I’ll err on the conservative side, estimating an EBITDA margin of 15% and incremental annual EBITDA for GTT of $6 million from the acquisition. In order to fund the acquisition, GTT recently completed an equity offering of between 3.5-4.0 million shares, raising $42.0-$45.2 million. The exact number of shares sold has not yet been released, so I’ll use the mid-point of each figure. Using these assumptions, GTT’s valuation looks like this:
That’s a lot of language and pro forma calculations to make a simple point. At the current market value, GTT offers a high single digit cash flow yield to the enterprise, even after accounting for capex. This wouldn’t be an unusual valuation, except for the fact that GTT’s organic revenue growth is nearly 10% and should remain so for many years to come. I am wary of valuing any company too generously, regardless of growth potential. Nonetheless, I think a yield of 5% would not be too aggressive, given GTT’s track record and prospects. That would equate to a share price of $18.99. A 6% yield would be $15.42.
Now, back to GTT’s deal-making prowess. What is it that has made the company such a successful acquirer? In my opinion, it’s nothing more than a highly incentivized management team with a long history of entrepreneurial success in the sector. Prior to the recent equity issuance, GTT’s management owned about 35% of the company, worth many times their collective annual compensation. GTT management’s personal fortunes are closely tied to the value of GTT stock. This gives them all the reason they need to avoid empire-building and careless use of shareholder capital, and instead remain laser-focused on completing only the transactions that will truly increase GTT’s value on a per-share basis.
Still, all the incentives and focus in the world are worth little if management simply lacks the talent for company-building through acquisitions. Fortunately, GTT’s leaders have strong pedigrees in the telecom industry. Between them, chairman/former CEO/largest shareholder H. Brian Thompson and current CEO Richard D. Calder, Jr. have spent time at MCI Communications, LCI International, Comsat International, Broadwing Communications and many other well-known telecom companies, all regular acquirers. I am confident that company leadership has a deep understanding of the markets that GTT serves and will continue to guide the company well.
In nearly every earnings report and transaction announcement, GTT’s management mentions a clear revenue and EBITDA target: $400 million in annual revenues and EBITDA of $100 million. That goal is still a ways off, but I suspect they’ll achieve it sooner of later and shareholders will do well along the way.
Alluvial Capital Management, LLC holds shares of GTT Communications, Inc. for client accounts.
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