…continuation of discussions on multiples…
A business is worth what its cash flows, appropriately discounted, are really going to be–and so goes my definition of Intrinsic Value. But until crystal balls are invented, we will need to recognize that our ability to predict future cash flows is limited. In the nearer term, financials can be forecasted accurately–and these forecasts should be the foundation for valuing a business. Once you get past a certain time–three quarter’s in my opinion–the discussion can shift to multiples.
In an earlier post, I explained why EBITDA, not Cash Flow, should be used in a capital intensive business like telecom. EBITDA is a better indicator of a company’s propensity to produce free cash flow. But when choosing an EBITDA multiple, the thought process must turn to how EBITDA translates into cash flow. Let me start out with using Zayo Bandwidth’s business to illustrate the thought process.
The “Bandwidth Business” uses fiber networks to deliver wavelengths and SONET/OC-n services to carriers and other big bandwidth hogs. It is a capital intensive business. In slow revenue growth environments, capital is required to maintain the network and augment bandwidth. In a fast growth environment, capital is the fuel of growth as construction of laterals and major augmentation of electronics is required to meet the rapidly growing demand.
In the “Bandwidth Business,” EBITDA is actually higher in lower growth periods than higher growth because low growth means less sales and service activation expenses. During lower growth periods, free cash flow is materially higher, as the capital program is also lower. To think through multiples, it is important to think through the economics of the business in lower growth environments. To illustrate, I will define a generic “Bandwidth Business”, using Zayo Bandwidth and similar businesses as context.
Per my methodology, I will focus on 4Q09, which is three quarters from now. Annualized 4Q09 revenue is $100M (hypothetical assumption to make math simple). Further assume that annualized EBITDA is $40M which is 40% of revenue and annualized Capital is $35M; therefore Operating Cash Flow is $5M. Finally, assume this business has been averaging about $200K of sales each month resulting in about a 15% revenue growth rate. Digging deeper, note that $100K of this revenue has rapid payback characteristics as it is largely on-net. Only $10M of the $35M of capital is to support this lower-hanging-fruit of $100K whereas the remaining $100K of harder-to-reach sales requires $25M of capital.
What if we only took the low-hanging-fruit of $100K? 4Q09 revenue would be slightly lower–perhaps $96M. But EBITDA would be slightly higher, say $42M, as we would have less sales and service activation costs. Our growth rate would shrink quite a bit, perhaps from 15% to 5%.
Would value be higher or lower in this slower growth scenario? Well, unless we are making bad decisions on the longer-payback sales, the value of the business would be higher in the more rapid growth scenario. But by removing the distortion of the longer-payback sales, we end up with more clarity for understanding how to choose an appropriate multiple. So, what would be an appropriate EBITDA multiple for the following business:
- $42M EBITDA
- Growing at 5% a year
- $10M Capital
Tomorrow will be the answer…
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