“One of the most common questions we get from public market equity investors is, ‘Why the sudden rush to invest in fiber?’”
Jonathan Chaplin, Managing Partner with New Street Research, joined the Fiber Broadband Association for a recent Fiber for Breakfast where he shared his insight on how value will be created through the Lumen/Apollo deal.
Chaplin said there is a common perception that investing in fiber is bad business. Companies like Google, Verizon and others that have tried it in the past have seen uninspiring returns--at least that is a common perception, Chaplin explained--and have abandoned the projects midway.
But, Chaplin said, fiber multiples are high-and rising.
“Fiber is a long-lived asset serving a market with rising utility with an attractive market structure and high barriers to entry,” he continued. “The market structure with high barriers ensures that market participants enjoy pricing power. This, in turn, generates attractive returns.”
There has been a growing demand for these kinds of assets, Chaplin explained, particularly among sovereign wealth funds and other similar funds that can take on private equity like investment timeframes.
“These funds typically don’t expect a return in a quarter or a year, they might hold assets for a decade or more,” he added. “With money flowing into infrastructure-focused funds, investors with shorter timeframes can build assets knowing they have an exit within a few years.”
Apollo can buy assets today at 5 to 6 times EBITDA knowing that with some investment, they can sell it at 10 times EBITDA in a few years, Chaplin explained. That makes upgrading a very compelling case for Apollo.
“The demand for assets makes for a liquid market, which in turn makes it easier to deploy capital in the market,” Chaplin said.
Most new fiber deployments today are from ILECs upgrading from copper. In some cases, Chaplin explained, ILECs have sold off portions of their infrastructure to help fund investment in its remaining infrastructure.
“It will certainly be easier for Lumen to invest in fiber in the markets that they retain after monetizing a large block of assets,” he said.
Considering the Lumen-Apollo deal, Chaplin said the assets are all undoubtedly a mess, likely not having seen adequate levels of investment in years and, in some cases, in decades.
However, the assets that Lumen is keeping are more valuable, Chaplin points out. Lumen retained its markets that have mostly an urban/suburban footprint, with the bulk of its lines concentrated in six big cities: Seattle, Portland, Minneapolis, Denver, Salt Lake City and Phoenix.
Those ILEC assets sold to Apollo, by contrast, are far more rural and cover the southeast portion of the U.S.
Chaplin said based on New Street Research analysis, they think Lumen can upgrade nearly half of the lines they retained, or 10 million lines. Lumen, on the other hand, says it plans to upgrade 70% of its retained lines, or 15 million.
“Either our cost estimates are too high, or Lumen is willing to accept IRRs below 9% on some of the lines. We think it’s very likely to be the latter,” he admitted. “We estimate that if they upgrade 15 million lines, the average return for the entire project would be 11%-which isn’t bad.”
Chaplin said New Street Research also estimates that reasonably high densities will drive an average upgrade cost of $1,200 per home passed across the 10 million homes that look attractive, based on New Street’s model. That brings the total bill to an estimated $11.6 billion.
“Given balancing constraints and businesses under strain, we can see why Lumen might feel compelled to sell assets to fund the upgrade of what they’ve retained,” he said.
New Street Research estimates that only 2.3 million of the lines being sold to Apollo can be upgraded at IRRs of 9% or better.
“Lower densities mean a higher average upgrade cost of $1,500 per home passed,” Chaplin cited. “The average return for the project would still be a relatively decent 12%. The total project will require an investment of about $3.5 billion following the upgrade, and again, based on our preliminary estimates about a third of Apollo’s assets will be fiber, compared to close to half for Lumen.”
Assuming Lumen stops at 10 million lines, New Street Research estimates the project will be completed in six years and break even in seven years while Apollo will complete the project in three years and break even in four years.
New Street Research values the fiber and copper lines at close to $4,000 and $1,100, respectively.
Based on those values, Lumen’s business would be worth close to $50 billion once the upgrade is complete, with 75% of the value contributed by the fiber assets. It will cost Lumen $14 billion to upgrade the asset, giving a net value of $35 billion.
“Bear in mind, Lumen’s current enterprise value is about $35 billion. In other words, if they were to get credit for the full fiber deployment today, the company’s core business would have an implied value of zero,” Chaplin said.
If we assume the lines that Lumen upgrades are all being valued at $1,100, Lumen would manufacture about $13 billion in new value from the upgrade, or about $12 a share--which suggests a 100% upside for Lumen stock.
“The existing lines aren’t being given that value today, though, so the value creation opportunities are even greater than what we’re sharing here for Lumen,” Chaplin explained.
Looking at Apollo, New Street Research analysis shows Apollo assets would be worth $14 billion, with 64% coming from fiber, Apollo will manufacture about 2.5 billion in value.
“Subtracting the upgrade cost and the acquisition price of $7.5 billion in value, this isn’t a great return on $7.5 billion over three to four years,” Chaplin noted. “But when you consider that Apollo will likely use a big slug of debt to fund the acquisition, the return on equity could be very compelling indeed.”
Hear Jonathan Chaplin’s full presentation on the Fiber for Breakfast podcast.