Paine Webber's John Hodulik / Soo Kim
CNCX: Initiating Coverage with Neutral Rating
October 7, 1999
KEY POINTS
* Concentric leverages its Tier I backbone, 19 super-pops and 144
secondary and tertiary pops, hosting facilities and integrated platform to
offer small businesses customized IP solutions. We are initiating coverage
of the company with a Neutral rating and a 12-month price target of $20 per
share based on our DCF analysis.
* Concentric has an aggressive three-tiered marketing strategy
targeting a large addressable market. The domestic market for Concentric's
services is expected to grow at a rate of 90% per year for the next five
years, reaching $10 billion by year 2002.
* The company is focusing on the roll out of digital subscriber line
(DSL) services to expand its customer base. Its impressive partner list
should help drive the top-line while providing cross-selling opportunities
that boost profitability.
* We believe Concentric is well positioned to take a sizable share of
this market and has the leadership necessary to capitalize on the attractive
opportunities that exist in the space. However, concerns regarding the
company's near-term growth stemming from longer sales cycles in the VPN
business and exposure to WebTV have caused us to take a more cautious
approach to Concentric shares at this time.
overview
The failure of the incumbents to respond to opportunities created by the
adoption of the Internet as a dominant vehicle for business-to-business
communications has opened the door for emerging carriers to take share. The
Internet infrastructure providers have filled the gaps and are well
positioned to increase their percentage of the business market's
telecommunications bill as we move from a voice-centric to a data-centric
world. In doing so, they are staking out a claim to the upper end of the
telecom value chain.
Concentric is a leading nationwide Internet service provider (ISP) offering
small and medium-sized businesses expertise in network management and
facilities based services such as Wide Area Networks (WANs) and Virtual
Private Networks (VPNs). In addition, it currently operates three data
centers nationally with approximately 21,000 useable square feet aimed
primarily at the shared hosting market. The company originally offered dial
up access to consumers but over time has incorporated high-speed access,
hosting and value added services. It currently competes with small "mom and
pop" shops for access and hosting services and with larger companies such as
MCI WorldCom, GTE, Verio and PSINet for more sophisticated services.
We believe Concentric's turnkey solution, impressive partners and aggressive
"cross pollination" strategy should allow it to capture an increasing market
share in the highly fragmented ISP market. However, the company's exposure
to revenue growth from WebTV and longer sales cycles in the VPN business
have caused us to take a more cautionary stance despite the company's
attractive valuation. We are initiating coverage of the company with a
Neutral rating and 12-month price target of $20 per share based on a DCF
analysis.
Background and alliances
Concentric was founded in 1991 and offered dial up services for the consumer
market in 1994. In 1998, the company made three strategic acquisitions,
Internex, Deltanet and AnaServe, to ramp up its technical expertise,
facilities build-out and network platform. This string of acquisitions was
most recently followed by the purchase of Internet Technology Group to
expand the company's reach into Europe. This $215 million acquisition has
not been incorporated into our model but is expected to close in the fourth
quarter.
The company has received strategic investments from Microsoft, Williams
Communications and SBC Communications. Microsoft is one of the largest
backers of the company, controlling 4% of Concentric shares on a diluted
basis. On June 22nd, Microsoft invested $50 million in the company to
launch a Microsoft Network co-branded hosting services. This is in addition
Concentric's contract with Microsoft to provide VPN service for Microsoft's
subsidiary, WebTV. This contract was recently extended until December 2002
with a wind down year of 2003.
Concentric has a 10-year agreement with Williams Communications to purchase
$175 million in network capacity in exchange for $35 million in Concentric
services. The capacity should lead to margin expansion by allowing the
company to capitalize a portion of its operating expenses over the next few
quarters as it lowers its reliance on leased circuits. This agreement also
requires Williams to resale $38 million in Concentric services.
Its third major partner, SBC Communications, owns roughly 7% in Concentric
equity with an option to purchase an additional 1% within the next two
years. These agreements improve the company's distribution, provide major
sources of revenue and enable the company to rapidly expand its facilities.
It has also given the company significant backers that have helped to
eliminate much of the funding risk other companies in the market face.
strategy
Concentric's strategy hinges on offering small businesses the tools
necessary to conduct business over the Internet. Digital subscriber lines
(DSL) service is central to the company's strategy for building its customer
base. The company hopes to aggressively market this inexpensive high-speed
access service to business customers then up-sell more sophisticated
products like VPNs and web hosting applications. Concentric has invested
$20 million in Covad and Northpoint, two major wholesale providers of DSL
connectivity, which will allow it to offer competitive service on a
nationwide basis. The company currently offers DSL service in 18 major
metropolitan areas and expects to reach 20 cities by year-end. We expect
Concentric to grow its DSL customer base to just under 10,000 in 1999, and
close to 30,000 by year-end 2000.
On the hosting side, the company recently agreed to purchase 9 Net Avenue
giving the company four data centers in San Jose, Chicago, Southern
California and New Jersey on a pro forma basis. As a result the company has
become the second largest web hosting provider with approximately 104,000
sites. The data centers support an integrated platform with customized
hosting and application services that dramatically reduce the time to market
for small businesses wanting to create a presence on the Web. Each facility
is monitored on a 24x7 basis and has been built with redundancy to prevent
down time during a power outage or data connection.
Concentric markets these services through a comprehensive three tiered sales
strategy tailored to up-sell its services to small businesses. The company
currently has roughly 70 tele-marketers that mass market the access
services, over 40 value added resellers (VAR) and approximately 20 direct
sales persons focusing on cross-selling additional services such as hosting,
e-commerce, VPNs. This "cross pollination" should allow it to effectively
penetrate the small business market.
recent results and projections
In the second quarter, Concentric generated net revenues of $32.8 million
versus $30.1 million in the first quarter, equating to a sequential growth
of 9%. This represents a substantial slowdown versus the 20% growth the
company experienced in the first quarter and was largely the result of a
seasonal slowdown at WebTV, which accounted for roughly 26.3% of total
revenues. Seasonality may also effect the third quarter and contribute to
the variability of the business as a whole.
We expect gross margins to be essentially flat for the third and fourth
quarters as the company continues to build-out its service delivery platform
then expand as higher margined service make up an increasing percentage of
the revenue mix. The company should hit its EBITDA loss inflection point in
the third quarter of this year and start decreasing losses until it hits
EBITDA positive in the third quarter of 2000.
management
The company is led by Henry R. Nothhaft, President and CEO. Mr. Nothhaft
has 26 years of "hands on experience" in telecommunications and has held
senior level positions at GTE Telenet, DSC communications and David Systems
prior to joining Concentric. John K. Peters is the EVP in charge of
technology initially started out as a consultant was later be promoted in
June 1995. He has been with Concentric for four years and has accumulated
20 years of technical experience with GTE Telenet and PacBell. Michael F.
Anthofer, Concentric's CFO, has been with the company since January 1996 and
brings over 21 year of experience in similar capacities at Memorex-Telex and
Meridian Data. Together, we believe the executives at Concentric have the
experience to successfully execute its strategy.
Valuation and conclusion
Our valuation is based on a discounted cash flow analysis employing a 15%
cost of capital, a 10x 2008 EBITDA terminal multiple and 30% public market
discount. The resulting target 12-month target price is $20 per share. At
roughly $880 million in total enterprise value, the company trades at just
3.5x our estimate for revenues in 2000 and 2.2x our estimate for 2001.
These multiples compare with 4-5x 2000 revenue estimates for the business
focused ISPs and the double-digit multiples for many of the leading Web
hosting providers, making Concentric shares appear attractive.
Concentric has simplified the process for small businesses to get online.
Its integrated platform incorporates scalability and high quality customer
service that differentiate it from its competition. However, we believe the
company's dependence on WebTV, longer than expected sales cycles in the VPN
business and exposure to "commodity" type services presents investors with
substantial risks even at these levels. Thus we have adopted a "wait and
see" attitude and are initiating coverage of Concentric with a Neutral
rating and a 12-month price target of $20 per share based on our discounted
cash flow analysis.
Risks
Risks include regulatory change, management's ability to execute, continued
dependence on the capital markets, increasing competition from larger,
well-financed carriers and technological change.
Recent results
3Q98 4Q98 1Q99 2Q99 3Q99E 4Q99E
Revenue $21.6 $25.1 $30.1 $32.8 $37.2 $45.2
EBITDA (8.6) (8.0) (7.9) (8.8) (9.3) (8.5)
EPS (0.89) (0.87) (0.74) (0.65) (0.67) (0.66)
Source: PaineWebber and company data.
Comparable Table - Web hosting and colocation providers
VRIO CNCX DIGX EXDS[2] GBIX ISLD
Price $31.88 $17.25 $24.63 $69.50 $48.56 $28.38
Shares f.d. 86.2 46.8 63.6 103.2 11.3 40.2
Market cap. 2,586.5 839.5 1,542.3 7,063.4 541.5 1,036.6
Debt, net 369.0 41.0 (156.1) 224.3 6.4 (34.6)
TEV $2,955.5 $880.4 $1,386.2 $7,287.7 $538.3
1,002.0
Rev. 2000E 400.8 248.7 105.1 455.1 44.0 46.0
Rev. 2001E 589.2 399.1 194.4 750.8 97.0 74.0
TEV/2000E 7.4x 3.5x 13.2x 16.0x 12.2x 21.8x
TEV/2001E 5.0x 2.2x 7.1x 9.7x 5.5x 13.6x
Source: PaineWebber and company data.
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