Summary

We previously wrote here on GTT Communications (GTT) in March. In this article, we first summarize the opportunity, try to better explain the business model and customer value proposition, and discuss the new Head of Sales and CFO.

GTT Communications provides internet services to large corporations. Unlike its telecom competitors that focus on constructing and owning their network infrastructure, GTT prefers to just rent from others. This broker/reseller model provides GTT a cost advantage given the telecom industry cost structure (high upfront fixed costs and near-zero ongoing marginal costs) and deflationary economics (improvements in fiber and routing technology keep marginal costs below average costs and the average cost curve falling over time). These dynamics naturally result in consistently declining telecom prices but actually benefit GTT's reseller model via lower input rental costs. GTT also has a customer service advantage in that it can offer an unbiased one-stop-shop solution by combining the best parts of other networks.

GTT's unique model is misunderstood given legacy competitors (e.g., AT&T (T), Verizon (VZ), and CenturyLink (CTL)) have always and continue to focus on owning their networks. While GTT has a demonstrated ability to grow organically, it has mainly scaled so far via acquisitions. 2 of its recent transactions (Hibernia and Interoute) were large and created temporary integration-related issues that slowed new sales, increased churn, and created operational complexities that are now largely behind them. A short seller was able to capitalize on these issues with a false narrative that GTT has a broken business, can't grow organically, uses non-GAAP metrics to hide profitability, and will go bankrupt. As we will explain, its value proposition is clear and compelling. The integration-related issues, non-cash amortization expense, and non-recurring M&A charges (e.g., restructuring, severance, and deal expenses) are masking the high free cash flow generative nature of the model.

GTT has also built up a high debt load through its past acquisitions. When you consider the predictability of GTT's business (recession resilient and growing demand, combined with significant switching costs for large customers), the debt load is very manageable and an upcoming divestiture of some previously acquired network infrastructure assets will bring it down substantially.

The stock is trading at ~3x our estimate of 2020 free cash flow vs. a fair multiple of at least ~10x, and significant upside at its historical multiples of ~20-30x. The downside at these levels is low given the cheap valuation, attractive debt structure with little default or refinancing risk (no maintenance covenants and no real maturities until 2025), and an upcoming divestiture of non-core assets (trade for 20x+ cash flow). Catalysts to realizing value include an impending short squeeze, announcement of signed divestiture transaction, and continued positive operating momentum in FY20. Incentives are also aligned given management plus the board of directors own 47% of the total shares and other long-term shareholders, including the Sequoia Fund, collectively own another 24% of shares.

The telecom business is simple. While telecom companies have a confusing set of product names (e.g., MPLS, SDWAN, Ethernet, etc.) that seem to require many advanced degrees to understand, at a basic level, they are simply providing internet services. The different product names are really just differences in billing plans.

GTT focuses on selling internet services to larger companies. Their needs are very different from residential customers, who have 1 home and only use 1 provider like AT&T, Verizon, Comcast (CMCSA), or Charter/Spectrum (CHTR). Large companies tend to have 100s, if not 1,000s of locations globally where they need to get internet access. And just like consumers, they still want to work with only 1 internet provider, or at least as few as possible, to avoid the unnecessary complexity around receiving multiple bills, having multiple online network management portals, and dealing with multiple parties for troubleshooting/IT support. In short, these large companies prefer paying higher prices to 1 provider in exchange for a more convenient and simpler internet solution.

There are over ~6,000 global internet providers, each with its own geographic footprint of on-network, or "on-net" locations (customer locations where the provider owns the last mile cable connecting it to their core network) and no 1 provider having complete network coverage. This means that a larger company's primary provider must resell its competitors' networks to reach locations outside its on-net footprint. This is called an off-network, or "off-net" service (reselling from whoever owns the last mile cable). Here is where the challenge lies - no internet provider likes providing "off-net" services but their customers still need them to.

Providers don't like selling off-net because of the financial impact, namely the large and upfront costs needed to build their own networks. On-net services are much higher margin (no rental fees paid to competitors) and maximize the ROI of their own network infrastructure. They also have other reasons to hate providing off-net services: working with competitors is slow, manual/labor intensive, and increases sales and implementation lead times. This is due to 1) no uniform pricing or service delivery standards due to differing rules, technologies, and regulations across regions and even providers in the same geography; and 2) lack of transparency related to pricing and supply as providers treat this data as proprietary.

Additionally, even if a location is on-net for a customer's primary provider, the customer still might want them to go off-net if they don't have the right access type. Every provider focuses on different last-mile access options (e.g., fiber, coaxial, DSL, satellite, 3G/4G/5G). The best choice access option depends on a customer's preferences for cost, speed, performance, resiliency, and security.

The final problem relates to demand. With the ongoing adoption of cloud services, IoT, and software-as-a-service (SaaS), demand for internet access continues to grow rapidly (20%+ volume growth per year). This demand is also now coming from a more distributed set of locations. For example, unlike before, now even local sales offices need fast and secure internet, so they can use cloud/SaaS applications. Ultimately, this means more demand for off-net services.

In summary, here is the problem: large customers typically have many locations and want 1 provider to serve them in all geographies. At the same time, no 1 provider has complete on-net coverage and even though they don't want to sell off-net service, everyone must do so. And all of this during a time when customers' demand for off-net services is rapidly growing.

Enter GTT, who focuses specifically on solving this challenge for large companies. GTT prefers to rent its entire network from other providers, so effectively all of its services are off-net. It does this by using a proprietary, internally developed software it calls the connectivity management database, or CMD, that allows it to automate many of the off-net complexities, including network design, pricing, implementation, and management. While GTT has lower profit margins than its competitors, it avoids the large capital expenditures needed to building an expensive network (though it still needs some routing equipment at major locations and at customer sites). By focusing on renting, GTT also benefits from industry cost declines through technological advances in fiber optics and routing equipment that result in lower rental expenses over time.

Ultimately, GTT's model allows it to be unbiased about on-net and off-net access, and unbiased about which last-mile access option to use. It can piece together the best solution for large companies based on their needs/preferences and be the "one throat choke", something other providers can't do given their focus on building infrastructure. While GTT isn't a well-known consumer brand, it is among the top 4 ranked globally in terms of internet traffic volumes. This gives it scale advantages that make it one of the best performing, lowest cost internet networks around the globe. This means GTT can offer better service and lower prices than competitors.

Sources: 2019 GTT 10-K, THE RED THREAD: My Fortunate Life in Telecommunications (Book by GTT Chairman H. Brian Thompson), Telecom 101 (Detailed Industry Primer on the Telecom Industry), GTT Investor Relations, Woodmere Value Management Analysis

In June 2019, GTT hired a new head of US sales, Ernie Ortega. Ernie has a very successful track record of leading sales teams at other providers and has implemented a number of very positive updates at GTT. These include bringing in key sales leaders he has worked with before, as well as adding/refreshing processes for sales training, lead prospecting and management, account reviews, account management, and client experience initiatives. His initiatives have been very successful at past firms and are just now starting to bear fruit at GTT.

GTT has built up a large amount of debt related to its past acquisitions. GTT's new CFO hired this month has most of his pay tied to closing a divestiture transaction and significantly bringing debt down. When you consider the predictability of GTT's business (recession resilient and growing demand, combined with significant switching costs for large customers), the debt load is very manageable and divestiture will bring it down substantially.

A well respected and successful private equity firm Charlesbank disclosed a new investment in GTT and now owns ~7% of the company. This should accelerate a short squeeze, create a potential take-private transaction, and at least supports our view that GTT is very cheap.

The COVID-19 virus has impacted the overall M&A market and continued issues could delay a divestiture transaction. We think this hasn't really impacted the market for long-term infrastructure like fiber, data centers, etc. given the increased demand for bandwidth as people work remotely and general resilience of the asset class.

COVID could also impact revenue growth if certain types of large customers (e.g., retailers) go bankrupt. However, given GTT's relatively low market share today and its compelling value proposition, any issues should be temporary noise. COVID could even accelerate revenue growth if customers become hypersensitive to price and are more willing to switch to GTT for its lower prices.

We believe the temporary issues facing GTT are now behind them and have created an extraordinary buying opportunity for those willing to understand the complex story and situation.

Disclosure: I am/we are long GTT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Further Understanding GTT Communications' Business And Other Updates, Still Worth 3x+ Current Prices - Seeking Alpha