By Buckley Capital Management :
Following the recent Wolfpack shor t report , we completed our own analysis to analyze the contentions raised, spoke with management and other industry sources, and want to post our own conclusions. The report can be found at: https://wolfpackresearch.com/gtt-a-broken-roll-up/ The report centered on a lack of free cash flow and recent weak organic growth. Our analysis shows the FCF conclusions and organic growth declines stated in the report are significantly overstated, as well as misleading. Wolfpack uses unadjusted numbers instead of run rate adjusted numbers, including recent acquisitions, to skew the math. When you do a very large acquisition, there are many real one-time costs which should be factored into your financials because they are non-operational and temporary in nature. Short reports are often written to present a one-sided argument, omitting relevant facts that would otherwise discredit your thesis, we believe this was the case here. While some of the analysis in the report is technical correct, a reader must understand the specific context in which it is presented and equally important, understand what important information the authors omit to fit their narrative. In our report we try to address the most material mischaracterizations and omissions; please do not view this as exhaustive of our disagreements with the recent short report.
Free Cash Flow Analysis:
We believe the short report did not accurately portray GTT's free cash flow. The FCF analysis in the report used GAAP numbers, with all the temporary non-operational charges and presented the numbers in a way to imply that these charges will remain constant in the future and did not account for temporary swings in working capital. Given that these non-operational charges are winding down (which we highlight later in the report) and swings in working capital will reverse, we would like to present our view of GTT's FCF. Our math is simple. In 2019, GTT should generate about $500 million in adjusted EBITDA, pay $175 million in cash interest expense, approximately $5 million in taxes, $115 million in capex, and have a $25 million negative swing in working capital. All in, this leads us to $180 million in free cash flow. On the most recent share price, this is a 22% FCF yield on the equity. In FY20, margins should increase as they get the full synergies from the recent acquisitions. Assuming no acquisitions and ~2% organic growth, we get to $1.850 billion in FY20 sales. At a 29% EBITDA margin, that yields $536 million in adjusted EBITDA and $220 million of FCF in FY20, putting the shares at a forward FCF yield of ~25%. This is a recurring revenue business, with no debt maturities until 2024 and interest coverage of 3x; hardly a business that is under stress.
Organic Growth Analysis:
Organic growth is easy to model as it is a function of 3 factors: churn, sales rep headcount, and sales productivity. Given salesforce hiring, we believe GTT will regain positive organic growth in late H2 of this year. GTT will hire anywhere between 5-10 sales reps on a gross basis per month, and 3-5 on a net basis per month. Thus, by the end of the year, GTT will be at ~350 sales team members, which gives them a comfortable cushion above the ~325 sales reps they need to be growing organically.
At $150 million in revenues and average 1.5% monthly churn, GTT churns $2.25 million in business per month. Each sales team member generates on average $7,000 in new monthly recurring revenue (MRR). Our discussion with a former GTT sales rep suggest the $7,000 per month number may even be conservative and he speaks highly of Ernie Ortega, the company's newly appointed Division President, Americas and believes he will have a major impact. At 325 sales reps, 1.5% monthly churn, and $7,000 in MRR, GTT generates $2.275 million in new revenue, slightly more than the $2.25 million that it churns. However, churn and rep productivity might fluctuate slightly quarter to quarter, and new reps will take some time to ramp up, therefore 350 sales reps gives us significant headroom to account for that, and we are confident GTT will be growing once it reaches that level. The former GTT sales VP also said new GTT sales reps take 3-6 months to fully ramp up, making our 350 sales rep number for breakeven very conservative. We provide a more detailed analysis of this below.
We think investors are myopically focused on quarterly organic growth fluctuations of -1% to +1%, thus missing the true GTT investment case. GTT has always been acquisitive because acquisitions generate the highest returns on capital. Regardless, we believe GTT will reach sequential growth by Q3 of this year.
GTT's FY21 Objectives:
Investors are confused by how GTT will hit their FY21 run rate financial objectives and de-lever to 4x net debt/EBITDA. Below is our analysis to walk you through how it will happen.
Today, GTT generates ~$1.8 billion in revenue. In FY20 they will likely grow at ~2% organically, and then by 3-4% in 2021. That adds ~$100 million in revenue, to ~$1.9 billion (notice how immaterial organic growth is despite investors heavy focus on it). The other $1.1 billion of revenue will be acquired. Below, in a general sense, we show where the capital will come from for those acquisitions.
If the company hits $900 million in run-rate adjusted EBITDA and aims for 4x leverage, that equates to $3.6 billion in net debt. Therefore, they can take on another $500 million in debt over the next 3 years and still de-lever to 4x. Additionally, GTT should generate ~$650 million in FCF over the next 3 years, which will be used for acquisitions. So, from debt and FCF generated, they will have ~$1.2 billion to use for acquisitions in the next 3 years. They will need to acquire about $310 million of adjusted EBITDA, at 5.5-6x adjusted EBITDA, through acquisitions over the next 3 years, this will cost $1.7-1.8 billion. The remaining $500-$700 million in capital for the acquisitions will be issued in equity. By FY21, we see ~70 million shares in issue, depending on what price the shares are issued.
From a valuation perspective, the shares are trading at an EV/EBITDA multiple of ~9x on consensus FY19 numbers (with only partial synergies from the Interoute transaction realized) and about 8.3x on full synergized FY20 numbers. This valuation is significantly below the company's historical 12x-14x multiple. GTT's valuation is meaningfully below recent private market transactions in the industry. Zayo was recently acquired for a multiple of 11.3x EBITDA, Masergy was acquired at 18x EBITDA, and the Interoute transaction, which was widely reported to have been closely contested with three bidders who bid within 1% of the purchase price, was also at 11.3x EBITDA. Given GTT's higher growth than Interoute, we believe a premium to this valuation is warranted. 11x FY20 EBITDA of $550 million translates into a share price of $53/share - a reasonable target price for the shares in one year given it would be 12-14x FCF.
In FY21, GTT will have a run rate of $900 million in EBITDA, $3.6 billion in net debt, and approximately 70 million shares. We use a valuation of anywhere between 8x (our bear case, 8x is a multiple for dying telecom businesses) to 12x (our base case) to 14x (our bull case) which assumes GTT gets back to mid-single digit organic growth. No matter what EBITDA multiple we use, we come up with a very attractive IRR. By FY21, upside at a depressed 8x multiple is 4x, at a 12x multiple is 8x, and at a 14x multiple is 10x. Looked at another way, GTT will generate $5/share in FCF in FY21, at 15x FCF GTT would trade at $75/share, at 20x FCF GTT would trade at $100/share.
Addressing The Wolfpack Short Report:
Above is a summary of the key points in our investment thesis. Below is a more detailed analysis of each point, as well as counterpoints to the Wolfpack report.
Organic Growth: GTT's organic growth has been disappointing relative to both internal and investors' expectations, but our calculations show the 8.7% and 7.7% declines stated in the report for FY17 and FY18 respectively are overstated. We estimate a currency adjusted decline of 4%-5% in the FY17 - FY18 period, which management believes is more accurate. Noteworthy, Q1 FY19, which was a clean quarter with no acquisitions, showed a sequential 1% decline, reinforcing our view that 4-5% in FY 18 is the right number. We believe GTT will be growing organically by Q3 FY19.
Understanding the factors behind the decline in organic growth is needed to ascertain the likelihood of recovery by year end, with the goal to rebound to mid-single digit levels. Three factors negatively impacted organic growth in FY17-FY18: 1) integrating large scale acquisitions with negative revenue trajectory at the time of acquisition, 2) negative currency swings, and most importantly 3) a deceleration in sales headcount hiring, which is also below target.
Consistent with the growth of the company, the scale of the acquisitions in the last few years has increased significantly (especially Hibernia, Global Capacity and Interoute). Each of these acquisitions had slightly declining revenue growth at the time of acquisition. Therefore, it took GTT greater time with each acquisition to rebalance and retrain the salesforce to reverse the declines.
From a currency perspective, roughly half of GTT's run rate is denominated in Euros so swings in f/x rates significantly impact revenue. The Euro has declined ~6% since the Interoute acquisition closed, with larger inter-quarter swings. As such, negative currency translation swings worked against GTT's reported revenue growth and need to be considered as part of any analysis of organic growth.
Euro/USD (5/1/18 to Present)
The last factor, and likely the most influential on the weakening organic growth, was the deceleration in sales hiring, which is below goal. During FY14 - FY17 GTT grew the size of the sales force by about a 38% CAGR, which was consistent with the company's growth. During this period, the company reported revenue growth about consistent with expectations. However, net sales rep growth began to slow in FY17 relative to the size of the company and then stalled in Q2 of FY18, with increases beginning again in Q1 of this fiscal year. This is tied to the combination of: 1) management turning its focus to integrating Interoute and 2) some elimination of the Interoute sales force; tied to deprioritizing cloud computing.
Source: Buckley Capital Partners
At the June 4, 2019 Credit Suisse investor conference, CFO Mike Sicoli commented on the decline in sales hiring:
"The only thing I would say that was not as good as I'd hoped was kind of the point I made before about the sales force, the number of reps we ended the year with. This time last year, we had thought maybe we'd be at 350 at the end of '18. And inevitably, we slowed our own hiring during that large integration process. We did terminate about 1,000 people. So when you're going through terminating roughly 1/3 of the organization, it's hard to keep the pace of hiring new people, right? So that was part of it. But the bigger issue is we didn't yield as many quota-bearing reps on the Interoute side as we initially thought. They had, as Rick mentioned, this cloud services pivot. They have more reps focused on cloud services than we initially thought. And they also hadn't been calling the bottom 10% of their population aggressively at all. And so there were more people at the end of the day that we ended up terminating or who left than we had initially thought. And so we were behind this -- all the second half of last year really from a headcount standpoint, which is -- explains why the trajectory so far this year continues to be negative."
This is important because increases in the sales force drive incremental revenue to offset the natural customer churn in the business. Our analysis shows a strong correlation between growth in sales reps and increases in organic revenue growth. CFO Mike Sicoli further commented:
"As it relates to the sales force and productivity, the math is pretty simple for us, right? So I'll start with the churn rate first. We've talked about our churn being in the mid 1% range. That's a monthly number, ranges from 1.4% to 1.6%, but on average, 1.5% is a good sort of rule of thumb . If you take 1.5% times our monthly revenue of last quarter of $150 million, you have $2.25 million a month of churn. And we had, at the end of the quarter, about 320 reps and our average productivity per rep was around $7,000 new monthly recurring revenue a month. So 320 times $7,000 is $2.24 million. So slightly below the run rate of churn. So even as of the end of the quarter, we haven't quite gotten back to the point yet where the organic side of the equation was delivering positive net installations. But we've been working hard to get that rep count back up to that sort of 350 level that we've targeted by the end of the year, which then when you take 350 and run that math through, you're consistently positive."
Management is adding 3-5 net sales reps per month, and should be at ~350 reps by year end. At an average of $7,000 in revenues per rep per month, the breakeven to offset $2.25 million in churn is about 325 reps. Churn and rep productivity can vary quarterly, and we are optimistic that 350 reps affords a safety margin to organic growth to increase consistently positive.
We looked at the ratio of incremental revenue from new sales reps compared with the historical 1.5%/month churn and observed a correlation. While GTT was aggressively growing the salesforce in FY14-FY16, the new revenue generated by reps - monthly churn was always positive. Beginning in FY17, coinciding with the first of three major acquisitions and a slowdown in the rate of growth in the salesforce, the ratio turned negative up to the present.
Below is a chart of incremental monthly revenue per rep (the number of reps multiplied by average productivity per rep of $7,000/month) minus predicted churn:
Offsetting Normal Churn
With Sales Rep Additions
Rev - Churn
Per Rep (( M ))
Churn (( M ))
Per month(( M ))
Source: Buckley Capital Partners
If you plot forward and use consensus Q4 estimates, and the company's goal of increasing the headcount from 300 to 350 by year end and assume churn remains stable at 1.5%/month, the ratio turns significantly positive. This is consistent with management's target "to return to rep-driven growth this year" . Noteworthy, management appears to have a clear focus on growing the sales headcount during the remainder of this year and into the future.
Note the following comments from CFO Mike Sicoli, from the same June 4th conference:
"But as I mentioned earlier, the 350 is just a way station along the way, right? That just gets us back to positive and that's all we are focused on right now, most important initiative we have in the company. And as I mentioned in an earlier meeting, it's 1 through 9 on our top 10 list, right, of things that we are focused on in the business today. But the real size of the sales force should be significantly greater because of the market opportunity and our position…...And returning to, first, low single digit organic growth and then as we continue to grow the sales force to 400 and 500 to try to emerge back to mid- to high single-digit organic growth as a business"
But, why are investors so focused on organic growth as the key metric for increases in GTT's overall profitability and intrinsic value? We agree it is important; however, historically the most important variable fueling GTT's outstanding growth in profitability over the last decade has been the company's ability to grow through M&A. The chart below shows the growth in adjusted EBITDA & FCF over the last five years (59% and 57% respectively). Assuming over the same period organic growth (with scaling benefits) increased at a 10% CAGR, this would only contribute 9% of the incremental increase in profitability and FCF for the five-year period. The remaining 90%+ of the increase in cumulative incremental profitability & FCF comes from M&A related growth activities. This illustrates the importance of M&A activities to GTT's long term growth and intrinsic value. Management states its funnel for future acquisitions remains full, and we believe it will continue to be the primary growth catalyst for the company going forward.
Source: GTT May 2019 Investor presentation
While organic growth has been disappointing there appears to be reasons for the shortfall and path to improvement. The recent declines in organic growth do not appear to be a sign of a weakening in the company's competitive position or market opportunity and won't be the primary driver of growth in profitability, FCF, and intrinsic value.
Net Installations: In the report, the authors calculate net installations using reported revenue numbers to get to organic growth. In actuality, net installations are a factor of monthly installations with recurring revenue minus churn. Furthermore, comparing FY17 and FY18 is akin to comparing apples-to-oranges, as FY17 small acquisitions were included in the bonus calculation and excluded in FY18 given it did not meet the threshold and had no weight in the bonus calculation.
Depreciation & Amortization: The report stated " GTT inflated its operating profit by almost $80 million in 2018 by significantly stretching its depreciation and amortization periods and revaluing acquired assets. Had they not made these adjustments, GTT would have reported an operating loss of almost $40 million last year. "
Yes, there were some changes in the company's depreciation schedule for both its fiber optic cable and duct as well as its fiber optic network equipment categories during the stated periods in the report. However, our analysis shows the reasons for these changes are clearly different from those implied in the report. For example, there is no discussion in the report whether the depreciation schedule for all or only part of the optic cable and duct assets were changed. Moreover, it appears that their analysis and conclusion assumes no changes were made to what the assets in this category consisted of. However, from Q3 to Q4, which coincides with the closing of the Interoute acquisition, the name of the category in the 10-Q changed from "fiber optic cable" to "fiber optic cable and duct". The reason for this is that while GTT did not have any duct assets, Interoute did. Based on management discussions, fiber optic cable is still depreciated over 20 years and the duct is depreciated over 40 years. Likewise, the same is true regarding the statement that "GTT extended the depreciation period for its "network equipment" from "5 years" to "3 to 15 years" without explanation." A quick look at the 10-Q and 10-K filings reveals that the name of the category was changed from "network equipment" to "fiber optic network equipment". Noteworthy, this change coincides with the Hibernia acquisition, which added new fiber optic technology assets to the company's portfolio and was responsible for the change. Thus, when the changes are viewed with this information, one can see that there was no nefarious intent by management. So, the contention that GTT changed its depreciation schedule for fiber optic cable and network equipment to enhance its financial results, and that the company's accounting is different from every other fiber comp is at best dubious. Before making the previously stated accusation, simply checking with management could have provided the information to refute this claim.
Additionally, the authors suggest that GTT tried to reduce reported D&A to increase profitability. However, the numbers show the opposite. The below table analyzes both depreciation and amortization on both an absolute basis and a function of revenues and PP&E. During the post Q3-FY18 period when the years in the depreciation schedule changed, both depreciation expenses rise in dollars and as a percent of revenues and PP&E.
Reported PP&E and D&A
% of PP&E
% of Rev.
% of Rev.
% of PP&E
% of Rev.
Source: Buckley Capital Partners
Ultimately, GTT management has nothing to gain by gaming D&A, as this is excluded from adjusted EBITDA and FCF, and are two of the most important financial measurements that investors gauge to value the share price.
PP&E Adjustments: Regarding the change in PP&E, the short report is comparing the initial 8-K, which contained very high level purchase price allocation estimates based on GTT's historical experience, to the post-close 10-Q, which was based on the detailed analysis of Interoute's assets by their valuation consultants. The change was significant, but only because the initial estimate proved to be too low on the physical assets, which makes sense given that Interoute had a lot more physical assets than any other acquisitions they have done previously.
Operating Cash Flow : The report states " GTT's trailing 12-month cash conversion rate (OCF/Sales) is 5.1%. With management's guidance of capex at 7% of revenue, it is mathematically impossible for GTT to generate positive free cash flow".
This statement levers very heavily on trailing 12-month cash flow and a temporary swing in Q1-FY19 working capital, which creates a distorted picture of the underlying cash flow dynamics of the business. Importantly, ttm profitability includes $81.8 million of non-operating restructuring, severance, transition and integration costs (all cash charges) tied to Interoute and other acquisitions. Not stated in the report and highlighted below, these non-operational acquisition related special charges associated with the Interoute acquisition peaked in Q4-FY18 and are winding down, with ~$27million remaining in FY19, and should be almost completely gone by year end (barring any new acquisitions in FY19). Thus, GAAP and adjusted FCF are beginning to converge.
Source: Buckley Capital Partners
Also, ttm operating cash flow includes a $53.7 million temporary swing in accounts receivable due to Interoute transitioning to GTT's billing and collections system. These receivables should be collected in the next two quarters, which will positively impact cash flow over the remainder of FY19.
Adjusting the ttm OCF/sales number for the temporary swing in accounts receivables increases the ratio to 8.5% and adjusting it further to eliminate the non-operational acquisition related charges increases results in a 13.4% increase. Plus, profit margins have steadily improved over the last couple of quarters, post the Interoute acquisition. Using annualized Q1-FY19 OCF (which includes $18.1 million of non-operational charges), and eliminating the $53.7 million temporary swing in accounts receivable, shows an OCF/sales ratio of 16.6%. Finally, adjusting further for the non-operational charges, shows a ratio of 20.9%.
Executive Compensation: The report states: " GTT's executive compensation structure has, in our opinion, incentivized value destruction. GTT's top three executives were awarded record compensation of $18.3 million and $19.3 million in 2017 and 2018, respectively………Since the beginning of 2017, GTT's top three executives have sold $13.1 million of stock on the open market. These same executives have never made an open market purchase of GTT stock, that we could find. "
While the numbers are factually correct, there is plenty of room for disagreement relative to the comment in the report that the compensation structure is value destructive. Additionally, the report paints a one-sided picture of this issue and does not highlight some facts that run counter to the claims/opinions.
What is not mentioned in the report is that:
- The company's compensation structure changed in FY17 to be weighted in favor of share-based compensation, aligning management with shareholders. The following table highlights these changes:
Breakdown of Total Compensation
Source: GTT Proxy filing 4/26/19
2) the stock awards were all at prices higher than the current share price, so they are aligned with shareholders in wanting a higher share price. The following table shows the awards for CEO & President Rick Calder (who's range was $27.00 - $51.35):
Source: SEC Form 4 filings
3) The report states: "These same executives have never made an open market purchase of GTT stock, that we could find" . However, what is not mentioned is that Chairman Brian Thompson made open market purchases of stock in August & November 2018 of a total of 21,200 shares and in March 2017 of 7,350 shares at prices in the $33-$34/share range.
4) Despite the sales by management highlighted in the report, the personal holdings of these executives have not declined over the last few years, but in many cases have increased (aided by the FY17 change in compensation structure). This is illustrated in the charts below:
Short interest as a percentage of the float is dangerously high at 13.57 million shares. The total days to cover now is 29.8 days. We believe a short squeeze is imminent.
Major Risk to the Thesis:
Changes in the churn dynamics of the business could impact the ability for GTT to return to organic growth. Given the highly recurring nature of the business, we see no reason why churn levels should change.
We believe the current issues that have negatively impacted organic growth can be corrected and are not indicative of any lessening of the future market opportunity. When sales head count increases expected through the remainder of FY19 begin to offset the traditional churn in the business, we expect revenue growth to resume later in the year, consistent with management's guidance. This will be a near-term catalyst for the shares and could help return the shares back to their May 2019 share price of $40+/share. As non-operational acquisition related charges begin to diminish in 2H FY19, and lead to improved real FCF and a reduction in leverage, this should also help improve investment sentiment. Longer-term, we believe the large funnel of potential accretive acquisitions will continue to fuel healthy growth in profitability, FCF and intrinsic value. We believe that larger acquisitions will likely be more spaced and only be pursued when management's confidence is high that synergies from prior transactions are realized and factors are in place to drive underlying organic growth. Based on achieving management's FY21 run-rate objectives, we expect GTT to be worth between $75-$100/share vs ~$15/share today. Additionally, we believe management might put the business up for sale given a large shareholder is now on the board, and believe the stock would likely double just on the announcement of strategic alternatives.
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