EP46: Sprint To The Finish
New Ideas From Investment Professionals
Welcome back, subscribers!
Investment managers have begun sending out 2Q letters, and we’re excited to share the best of what we read.
Today we have pitches for a telco company, a beaten up retailer, a niche European manufacturer—plus two more interesting ideas.
If you like what you see, please forward to a friend or colleague!
Disclaimer: Nothing here constitutes professional and/or financial advice. You alone assume any risk with the use of any information contained herein. We may own positions in the securities listed. Please do your own due diligence.
To the investment managers who read this, you can send us your letters at elevatorpitches@substack.com or on Twitter (and Threads!) if you’d like to be included in a future issue.
Let’s get to it.
Alphyn Capital Management initiated a position in telecommunications company, Cogent Communications (CCOI). Will Cogent’s acquisition of Sprint’s wireline business for $1 pay off for shareholders?
Cogent Communications – new position
I initiated a position in Cogent Communications, led by Dave Schaeffer, a remarkable founder-operator with technical acumen, astute business sense, and a long-term ownership mindset. Schaeffer has shown a propensity for making transformative bets while effectively managing risk and allocating capital shrewdly.
In 1999, Schaeffer secured $500 million to build an affordable, all-fiber internet network. The telecom market’s collapse in 2000 allowed Cogent to buy 13 companies, built at an initial cost of $14 billion, for just $60 million. Over the last few decades, Cogent has grown into a $3 billion company, producing $600m in revenue and nearly 40% EBITDA margins. Revenues have increased by 10% annually, and margins have expanded by 200bps annually. As a result, Cogent produces significant cash flow, which it has used to return over $1bn to shareholders; it has repurchased 22% of shares outstanding and increased dividends for the last 41 sequential quarters, with a current dividend yield of ~5.75%.
Cogent is a strong business in its current state. However, my interest was piqued by the exceptional potential behind Cogent’s recent acquisition of Sprint’s former wireline business, which it is purchasing from T-Mobile following the acquisition of Sprint. At its peak, the Sprint business generated an impressive $40 billion in revenue and $16 billion in EBITDA, employing around 70,000 individuals. The initial capital investment to build the network was approximately $20 billion. Unfortunately, due to neglect, the business has declined to about $440 million in revenue, with an EBITDA loss of around $300 million and a workforce of only 1,320 employees.
Cogent is buying the business for $1 and will receive ~$760m in payments from T-Mobile over the next 4.5 years to cover expenses while it integrates the company and restores it to profitability. Dave Schaeffer believes he can turn the $300m loss into a $90m profit. The acquisition opens potential new revenue streams that could see the company 3x revenue and 5x free cash flow over the next few years. The market is not crediting the company for the transformational potential of the deal, while the T-Mobile payments significantly de-risk the acquisition.
Business
Cogent provides internet access and data transport over fiber optic, IP data-only network, carrying over 22% of global internet traffic across 51 countries and 219 markets. Its customer base can be broadly divided into two categories:
• Corporate customers - small to medium-sized businesses located in Multi-Tenant Occupied Buildings (MTOBs) in North America contribute to ~56% of the company's revenues.
• The "netcentric" division, primarily large streaming, gaming, and access companies, account for ~44% of revenues but constitutes 96% of the traffic.
The core of Cogent’s Corporate service comprises its “on-net corporate” services, accounting for 35% of revenues; Cogent directly connects its corporate customers to its expansive network, including 61,000 miles of inner-city fiber and an additional 17,000 miles of metropolitan fiber.
Cogent connects roughly 1,820 skyscrapers directly to its network, totaling nearly 1 billion square feet. They install equipment in the basements of these buildings, extending infrastructure upwards to establish direct connections with the building’s business tenants. On average, these buildings are 550,000 square feet and 41 stories high, housing around 51 businesses, of which typically 7 are Cogent customers.
Cogent also offers “off-net corporate” services, contributing 21% of revenues. These cater to secondary offices that are typically 19k sq ft in size with four tenants, locations where it isn’t economically feasible for Cogent to provide direct access. This service is exclusively available to existing on-net customers with secondary offices. Cogent provides “last mile connectivity” and has relationships with 90 different off-net providers, offering access to over 4 million buildings.
This division’s clientele primarily comprises law firms, financial services firms, advertising and marketing firms, healthcare providers, educational institutions, and other professional services businesses. These firms require high bandwidth (100 Mbps to 400 Gbps), and secure and reliable internet connectivity. Cogent prices its services in line with competitors but offers 3x the reliability and 30-60x the bandwidth.
The physical equipment installed in the buildings and the appealing quality-to-cost ratio give Cogent substantial competitive advantages, especially in the on-net corporate division.
Historically, the business has grown by 11% per year. There is room for continued growth within its existing businesses, which currently secure less than half (40%) of new proposals. Moreover, there are over 93,000 MTOB tenants worldwide, presenting a significant opportunity for expansion.
Approximately 44% of Cogent’s revenue, accounting for 97% of its traffic, is generated through the sale of bulk internet connectivity to roughly 1,415 carrier-neutral data centers (CNDCs). The company terms this “netcentric” division, serving major clients such as streaming services, gaming companies, and internet service providers (ISPs, ILECs, etc.). The company offers services at a 50% discount relative to its competitors, reinforcing its competitive standing within the market.
Cogent is one of only 24 Tier 1 networks worldwide, which means it can exchange traffic with other networks settlement-free, conferring a significant cost advantage.
Operating under the belief that internet connectivity is a commodity business, Dave Schaffer, Cogent’s founder, established the company with a focus on simplicity, allowing it to become a low-cost operator. The network runs on a single fiber pair, eliminating the need to manage legacy systems while positioning the company to benefit from the rapid advances in optical technology over the last 15 years. As fiber optic capacity increased and the cost to transport data fell, Cogent has reduced fees charged to customers on a per-routed bit-mile cost.
New transaction
Cogent is buying the business for a nominal $1, but importantly will receive $700m over the next 54 months, structured as a 100% margin supply agreement, $25m of restructuring/severance costs, and a $100m blanket indemnification from T-Mobile for any unforeseen liabilities. The supply agreement is front-loaded, with $350m due in the first 12 months, and $350m over 3.5 years, to fund operating losses while Cogent restructures and assimilates the business.
T-Mobile has been trying to shed the unit for years, and hiring a consultant revealed that shutting it down would cost over $1.5 billion. This agreement provides a politically acceptable way for T-Mobile to divest from a lossmaking business without resorting to job cuts, which could be a sensitive issue after its merger with Sprint.
The opportunity for Cogent is twofold. First, it plans to trim unprofitable revenue streams (from 28 products down to 4, the maniacal focus on simplicity again) while retaining long-standing enterprise customer relationships. It will migrate most of Sprint’s traffic onto its network, saving significant 3rd party carriage costs. Approximately 93% of Sprint’s services are delivered using third-party networks. Cogent, by contrast, will be able to have 75% of Sprint’s traffic on its network. As a result, Cogent expects it can take a declining, cash-burning business and generate $440m of stable revenue with a positive $90 million EBITDA.
The real value of this acquisition lies in its potential to provide optical wavelength services. Wavelengths offer dedicated point-to-point connections with customer-specific and dedicated spectrum frequencies. They cater to high-bandwidth users seeking enhanced security, privacy, and independent links that are not reliant on the internet. Think of Amazon AWS connecting data centers. Customers value redundancy and alternative routes to mitigate failures and outages. Potential customers include hyper scalers (Amazon, Google, etc.), Tier 2 internet service providers, and the top 100 corporations aiming to establish proprietary networks.
Sprint’s substantial assets include 19,000 intercity and 1,100 metropolitan fiber miles and 1.6 million square feet of data center space. Notably, many of these fibers run along railroad rights of way, providing unique routing advantages for wavelength clients. Combining these assets with Cogent’s metro network and its extensive network of 800 carrier-neutral data centers (compared to Sprint’s 24), Cogent can offer twice as many routes as its competitors.
The cost of replicating such infrastructure would have amounted to billions of dollars for T-Mobile, with the resulting profits being relatively insignificant. This acquisition taps into a $2 billion total addressable market, growing 7% per year, which two slow-moving incumbents currently underserve. Cogent’s competitive advantages include the ability to eventually provide service in 17 days versus 3+ months for competitors, a focused sales force, and a negative cost basis on the network. This advantageous position enables Cogent to price aggressively and set its sights on capturing a quarter of the market within seven years.
The table below provides a comparison of Cogent’s results for 2022 with the pro forma numbers for the “legacy Sprint” deal. It includes an additional $440 million of revenue, assuming full integration on day one without any payout from T-Mobile. Additionally, estimates for 2028 are provided for Cogent alone and the combined business, considering the maturation of all new revenue streams.
The potential for substantial free cash flow (FCF) accretion is evident, and not reflected in the current $65 share price.
Risks/mitigants
The thesis may take a year or so to start working. The shift towards remote work has impacted growth at the corporate division. Historically this segment grew at an annual rate of 11%; with Covid, it shrunk by 9% and is now effectively at zero growth. The decline in this segment might take time to normalize, but Cogent believes it will eventually return to its growth trajectory. In the interim, the market could negatively perceive the company if it takes longer than expected to normalize, and synergies from the Sprint deal have yet to kick in.
There are always execution risks with any large M&A deal. However, in this case, the payment from T-Mobile grants Cogent the necessary time to navigate the integration process.
There are no guarantees that the wavelength business will take off. My research indicates a significant pent-up demand, considering the continuous growth of data and the need for route diversity. Moreover, as proof of concept, the company has already begun limited-scale cross-selling activities.
Sprint’s fiber infrastructure is over 20 years old. Cogent argues that these fibers are buried deeper than modern fibers with reinforced sheaths. Combined with routing along railway lines, are offer superior quality and are less prone to cuts and damage over time.
The company has experienced increased salesforce churn since the onset of the pandemic, with the work environment presenting challenges. Ensuring alignment within the salesforce and effectively promoting the new services will be critical to the future success of the acquisition.
Lastly, Schaeffer maintains tight control over the business and is involved in all aspects, from strategy to deal negotiations. While this concentration of power has been beneficial thus far, it presents a key man risk.
Palm Valley Capital Management started positions in Advance Auto Parts (AAP) and TrueBlue (TBI). AAP’s operations have lagged far behind peers AutoZone (AZO) and O’Reilly (ORLY), but there’s a price for everything. With AAP falling from ~$230 to ~$70, is that price now?
We acquired small stakes in two new names during the quarter: Advance Auto Parts (AAP) and TrueBlue (TBI). Advance Auto Parts is an automotive aftermarket parts provider serving professional installers and do-it-yourself customers. Palm Valley briefly owned the stock during the 2020 lockdowns, when the shares quickly reached our valuation. Advance has almost 5,000 U.S. locations. Margins for the business have been inferior to those of O'Reilly (ORLY) and AutoZone (AZO), two leading competitors. This is due both to customer mix and operating efficiency.
The shares of Advance plummeted from a high of $230 reached in January 2022 to the $60's in June 2023. Profitability is being negatively impacted by pricing decisions designed to bolster market share in the professional sales channel.
As a result, the firm reduced earnings guidance and its dividend. Auto parts retailers have historically been recession-resistant and are benefiting from the expanding average age of vehicles. While there remain risks, such as growth in electric vehicles that require fewer parts, we believe Advance's stock is cheap based on normalized earnings. Furthermore, we expect its balance sheet to improve later this year as inventories decline and operating margins rise.
TrueBlue is a leading provider of staffing and recruitment solutions for blue collar manufacturing, transportation, and warehouse roles. While overall U.S. employment remains very strong, demand for contingent workers has turned lower since the end of last year. Investors have pushed the stocks of public staffing firms sharply lower, and the industry appears to be one of the few that is pricing in a recession. After the company recently posted a first quarter 2023 loss, TrueBlue's shares fell to the lowest levels reached since the 2020 COVID lockdowns. Management expects profitability to rebound sequentially in the seasonally stronger second quarter. While we expect operating performance to further deteriorate in 2023 with a weakening economy, TrueBlue has historically remained profitable even during tough times. The company carries no debt and has been a reliable generator of free cash flow. The stock was trading for 7x operating profit and 9x normalized free cash flow at the time of our purchase.
Fairlight reviewed their investment in Spirax Sarco (SPX.L), a UK-based manufacturer of steam systems that’s been in business for over 130 years.
Spirax Sarco: A business we hold in high esteem
Spirax Sarco, a global leader in steam systems A current holding that exemplifies the capacity for a smaller company to have the quality characteristics of a long track record and a mature, proven business model is Spirax Sarco, a UK based manufacturer of industrial steam systems and pumps. The business has been in operation for over 130 years, tracing its origins to a small firm of merchants (Sanders, Rehders & Co. or ‘Sarco’) founded in 1888 who imported German made steam traps into the UK. Today, the business employs over 8,000 people, serves 100,000 customers and has over 1,500 different products.
While steam systems may sound unexciting, they form a critical part of industrial manufacturing infrastructure in any use case that requires transfer of heat. Almost every food and beverage facility worldwide would require a steam system for example, and Spirax is the world leader in this niche. Spirax also enjoys the favourable industry characteristic that steam systems require; regular maintenance and replacement parts which provides a valuable source of recurring revenues.
As is often the case, the financials generated in a boring niche are exciting to Fairlight with Spirax boasting a track record of unbroken dividend growth stretching over half a century (see Figure 1) and an operating profit margin today of 25%.
What history can tell us about the future
The great challenge of investing is that all our knowledge and experience relate to the past, however all our decisions pertain to our view of future events. While history cannot predict the future, it is the experience of the Investment Team that it is a reasonably strong indicator (we have discussed the tendency for quality to persist in the past here). One heuristic that can be used for forecasting the longevity of an object is Nassim Taleb’s Lindy Effect, which states that the most probable future life span of an object is equal to the time it has already existed. Put simply, the longer something has been around, the more likely it will continue to persist into the future.
With the Lindy Effect in mind, it is instructive to revisit the history of Spirax Sarco. In its early days Sarco relied on the importation of German steam traps, however with the outbreak of the First World War the business was forced to design and manufacture its own. This initial design, the “Sarco No. 9 steam trap” was hugely successful and remained in production for over half a century. The design has since been further improved and as part of a recent factory tour Fairlight was able to witness steam traps still being produced today, over a century later. As longterm investors we take comfort in the knowledge that this business and its products have survived and prospered through booms, busts, world wars, technological upheaval and if the Lindy Effect is to be believed, will likely do so again for the next hundred years.
Competitive advantages in a historical context
An important part of Fairlight’s investment process is the evaluation of competitive advantages and culture. Given the intangible nature of these characteristics and our role as outsiders, a key risk is the misappraisal of their strength or sustainability, especially with the tendency for management teams to exaggerate and be overly promotional. In Spirax’s case, the multi decade, consistent execution of the same strategy provides inarguable proof points as to the strength of both the culture and competitive advantages. Today, Spirax’s key competitive advantage is its 1,200 strong sales force of technical engineers who provide advice and support to customers throughout the purchasing process. The assembling of this sales force around the globe has taken decades with the early roots of this direct selling strategy tracing back to the 1930s:
“Our whole policy has been to build up an organisation of technical representatives and engineers, capable of giving advice to steam users on all aspects of their plant and equipment.” - Spirax News (1939)
Culture, growth and greenwashing
Despite being in operation for over a century, we believe Spirax still has a long runway of growth ahead as an important contributor to global decarbonization efforts. The raising of steam by burning fossil fuels is a major contributor to global carbon emissions. In order to meet net zero targets corporations around the world will need to electrify their boilers and increase the efficiency of their steam systems; products and advice that Spirax offers. While some companies talk loudly about their environmental credentials to greenwash their stock prices, Spirax has an energy saving culture and track record of practical applications that date back far before global warming was cool. In 1907 the business was initially named the ‘Sarco Fuel Saving and Engineering Company’ and during the Second World War Spirax was engaged by the UK Government as the nation’s foremost experts in fuel efficiency to give lectures across the country to factory managers:
“Remember, ships were being sunk and lives lost bringing oil to this country to be wasted in boilers and process plants and heating systems. At the end of the war our engineers were the most knowledgeable group of specialists in the use of steam to be found in the world.” - Lionel Northercroft - Spirax Sarco Managing Director (1939 - 1968)
Finally, this quarter, East 72 Dynasty Trust included a detailed review of Bollore, the French holding company with an eclectic mix of media and transportation/energy logistics assets. For US-based investors who are unfamiliar with Bollore, the company is reminiscent of John Malone’s Liberty complex and its nesting doll of public company ownership stakes. We include East 72’s brief summary below but encourage you to read the entire thing.
We conclude, working from the bottom up that:
Universal Music Group is an astounding business and is marginally undervalued (by ~25%) against cohorts of high quality annuities; however, especially if there are changes in the Bolloré structure, it will become more important to Bolloré itself, and both it and Vivendi represent significantly discounted entries.
Vivendi has rightly been heavily discounted to the degree that on a sum of the parts basis, the shares value the core Canal+ and Havas income streams at ~1x EV/EBITDA in 2023, assuming a net nil contribution from the other smaller businesses. But optimising Vivendi may require significant debt commitments. The “puppeteer” appears to exhibit a significant influence from outside. We have a small position in Vivendi and could see a scenario where Bolloré will eventually bid (don’t hold your breath, it will be well into 2024). Forget the recent share sales – there are many Bolloré precedents of selling then repurchasing (Havas, notably). But it has to be recognised that Vivendi shareholders have not been that well treated by Bolloré (or their predecessors) and the company is the most remote from the centre of the Bolloré Galaxy.
Bolloré itself (owned by E72DT) is ridiculously underpriced, partly as a result of the continued misunderstanding of the Treasury control loop, but also the lengthy appraisal process of selling Bolloré Logistics to CMA CGM which liquifies the group to the tune of a further €5bn. If it fails to complete, some of the analysis postulated will look foolish and the patriarch’s legacy won’t be easily completed. If it is consummated, we value Bolloré at ~€13/share before applying any kind of conglomerate discount. If the patriarch is willing to countenance a heavier GROSS debt load adjacent to his favoured exposure in the Galaxy (Compagnie de L’Odet) an acquisition of Vivendi once the logistics deal completes and the assorted conditions of Vivendi’s 57% Lagardère purchase are met.
Compagnie de L’Odet (ODET) (owned by E72DT) the group holding company, in our opinion, does not currently trade at a major discount to the market price of Bolloré. ODET is a 100-bagger since the 1992 backdoor listing into SEPA, is still the patriarch’s favoured exposure and hasn’t been adulterated with other holdings to any extent. Of course, the discount to real value blows out dramatically as the more realistic view of the pricing of Bolloré shares is applied, and also trades at 60% below a sum of the parts valuation. We can calculate a value of ODET at ~€3750/share on a sum of the parts basis, and haven’t been blind to recent “aggressive” (by ODET standards) accumulation by its immediate parent, Sofibol.
Until next time! - EP