I just received a report this morning from Kaufman Bros., L.P. rated PSIX as a short and long term BUY. (Note: Kaufman Bros., L.P. is a research-based, full service investment bank, securities trading firm, and brokerage operation serving the emerging growth marketplace.)
The following is from the report:
COMPANY DESCRIPTION
PSINet (PSIX) is a global facilities-based Internet Protocol (IP) data communications carrier focused on business and government accounts. The company was the first independent commercial Internet service provider (ISP) in the world. PSIX's offerings include high-speed corporate LAN connectivity services; managed security and guaranteed Internet and intranet electronic commerce services; Web hosting services; and services for other carriers and ISPs. PSIX operates an international state-of-the-art frame relay-based, IP-optimized network that connects to ISDN, ATM, SMDS, and wireless/satellite systems. The network serves over 27,000 corporations and has more than 400 points of presence (POPs) throughout 10 countries. PSIX has subsidiaries in Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Switzerland, and the U.K. and is currently rolling-up the fragmented ISP market in the United States and abroad. The company went public in May 1995 (3.8 million common shares priced at $12) and completed a secondary offering in December 1995 (5.0 million common shares priced at $23).
IXC DEAL GIVES PSINET A FIBER BACKBONE
In 1Q98, PSIX entered into a strategic partnership with IXC Communications, a provider of long-haul transport services via an intercity fiber optic network that spans the United States, in order to obtain a state-of-the-art fiber backbone. Under the terms of the arrangement, PSIX issued IXC roughly 10.3 million common shares in exchange for 10,000 route miles of OC-48 capacity. PSIX expects to take delivery of transcontinental OC-12 fiber segments during 2Q98. These segments represent the first leg in the construction of PSIX's network (10,000 miles of OC-48 is equivalent to 40,000 route miles of OC-12). The OC-12 backbone, stretching from California to New York, is capable of transmitting 622 million bits per second and is equal to the highest speed backbone in use anywhere on the Internet. IXC intends to deliver the bulk of the network to PSIX during 1998 and 1999. The transaction, which closed on February 24, 1998, should allow PSIX to migrate significant amounts of traffic onto its own network during the next several quarters. Moving traffic "on-net" should favorably impact PSIX's cost of services and facilitate the company's progress towards positive EBITDA and profitability. Separately, the partners entered into a sales and marketing agreement in order to offer each bundled telecommunications services to their respective customer bases.
A SPECIAL SITUATION
Special situations come about through one or more of the following: new products, increased profit margins, insider buying, tenders and takeovers, mergers, acquisitions and/or divestitures, reorganizations and recapitalizations, hidden assets, new technology, new management, new markets, and unfavorable press.
In our opinion, PSIX meets each of these criteria.
The company is currently introducing new, innovative Internet products and services to the market. For example, PSIX is offering enhanced Web hosting services, Internet fax services, and wireless Internet access.
PSIX recently forged an alliance with IXC Communications to obtain 10,000 route miles of OC-48 capacity. We estimate that PSIX will experience y/y increases in gross margins as it migrates increased amounts of traffic onto this fiber optic network. The bulk of the network is scheduled for delivery in 1998 and 1999.
Management has been purchasing stock during the past few months. We think this activity testifies to the positive outlook for the organization.
The company has been receiving takeover offers. For example, USinternetworking, a private entity, recently offered PSIX shareholders $10 in cash for each PSIX common share. That offer was withdrawn in late February 1998 because of management's intent to keep PSIX a stand-alone entity. We think the proposal gives significant visibility to the notion that PSIX is an attractive takeover candidate at current levels.
Because PSIX is the only remaining publicly-traded, independent, facilities-based, commercial ISP, we think a sizable scarcity premium should be attached to its common shares. Other commercial ISPs have been purchased by domestic carriers during the past few years (MFS purchased UUNET in 1996 - both of these entities were later purchased by WorldCom for roughly $14 billion; GTE purchased BBN in 1997; Intermedia Communications purchased Digex in 1997; Frontier Corp. purchased privately-held Globalcenter). These purchases represented price/annualized quarterly sales ratios of 2x-10x and were completed at substantial premiums to the trading ranges of those entities at the times of closing).
During the past few years, PSIX has been divesting non-core operations, including a computer software business (InterCon Systems sold to Ascend in January 1997) and consumer Internet access dial-up accounts (Pipeline business sold to MindSpring Enterprises in mid-1996), in order to focus on the commercial side of the Internet access market.
PSIX has steadily tapped the capital markets to support growth. However, the company's common stock currently trades below the prices of its IPO in May 1995 (3.8 million common shares priced at $12) and secondary offering in December 1995 (5.0 million common shares priced at $23).
We think PSIX's greatest hidden asset is its recently signed agreement to obtain 10,000 route miles of OC-48 capacity from IXC Communications. We think this backbone will help PSIX transform itself into a viable independent ISP with network infrastructure in the United States and abroad.
We estimate that PSIX could benefit by deploying Internet (IP, for Internet protocol) telephony technology to become an alternative provider of telecommunications services to businesses and governmental entities.
The company has been employing new management at the corporate and operating levels in order to position itself for planned rapid growth. We think this new management team has the depth and breadth necessary to make PSIX a significantly larger entity.
In coming periods, PSIX intends to expand into new markets, build critical mass, and capture increased share of the growing global market for Internet access services.
In the past, PSIX focused primarily on achieving positive EBITDA. However, in recent periods, the company has traded short-term profitability for long-term growth. Key components of PSIX's long-term strategy for success include a steady build-out of company-owned facilities, expanded sales and marketing efforts, constant mergers/acquisitions of ISPs in the United States and abroad, and a strengthening of the company's balance sheet to support planned rapid growth.
We think PSIX is a special situation that is significantly undervalued at current levels. Therefore, we are initiating coverage of PSIX with a "BUY/BUY" recommendation. Our discounted cash flow valuation generates a 12-month target of $18.
VALUATION
To derive a target public market value for PSIX, we modeled the company's financial results into the year 2002. Key assumptions of our earnings model include:
Y/Y revenue growth as follows: 1998-90%; 1999-80%; 2000-50%; 2001/2002-40%. During the next several quarters, we estimate that PSIX will sustain internal growth of roughly 40%-45% and external growth of roughly 40%-45%. The company intends to remain a stand-alone entity and act as a consolidator of the commercial-oriented Internet access marketplace.
Gross margin expansion from the low-20%'s in 1998 to the high-40%'s by 2002 as a result of continued migration of traffic onto the company's 10,000 mile OC-48 backbone.
Selling, general and administrative (SG&A) expenses as a percentage of revenues of 40% in 1Q98 tapering to the mid-20%'s by the year 2002 as the company benefits from the substantial operating leverage inherent across its various business lines.
Depreciation and amortization driven by capital expenditures of $90MM in 1997; $290MM in 1998; $100MM in 1999; $130MM in 2000; $100MM in 2001; and $100MM in 2002.
Interest expense driven by substantial debt financings during the next 12-18 months. We estimate that PSIX will remain free cash flow negative as it continues to build-out its Internet infrastructure in the United States and abroad. Given these circumstances, we believe PSIX will require roughly $400MM-$500MM in debt facilities during the next several quarters to fund expansion of its growing Internet infrastructure.
No income taxes payable over the next several years due to the company's substantial net operating loss carry-forwards (NOLs). We believe the net present value (NPV) of PSIX's NOLs provide upside to our target public market price because they shield the company's earnings from taxation in 2002 and beyond.
Y/Y dilution of the company's share base of roughly 5% due to the exercise/issuance of employee stock options, the potential for mergers/acquisitions, and conversion of the company's outstanding preferred equity into common shares at the end of the year 2000.
Given these assumptions, we estimate that PSIX will sustain a compound annual growth rate (CAGR) in revenues over the next five years of roughly 56%, leading to 2002 revenues, EBITDA per share, and EPS of $1.1 billion, $4.29, and $1.87, respectively.
Our discounted cash flow valuation, which uses an estimated weighted average cost of capital of 15%, generates a 12-month price target of $18. |
