Guy, a subscriber, comments:
I highly respect the job you did of analyzing Interap and showing how undervalued it was. FTGX also appears way undervalued and yet it has dropped over 10% since what I think is a pretty strong report showing the company is on the verge of turning things around financially.
However, there is a big difference between INAP and FTGX, in that Internap has very valuable IP. INAP holds numerous patents on finding and using the best possible route across the internet, which it uses for its unique performance IP offering as well as its FCP box. I don’t see anything equivalent with FTGX. Furthermore, Internap is a company with global scope, with PNAPs in England and Asia and Canada, as well as throughout the US. FTGX is a small company with presence in just two (admittedly important) markets.
Finally, what is the gross profit margin at FTGX and will this increase? And to what extent are they gaining new colo customers? The market certainly seems very skeptical of FTGX – for reasons I don’t quite understand. I know that you like to find company’s that represent little downside risk to capital but it looks like an investor in FTGX, even now, will have to stomach downswings of 10-20%. This is something that will keep my investment very small for the time being.
Envoy Global Research Responds:
We agree with Guy’s analysis. INAP is a different company than FTGX in certain ways, and it is not a perfect comp for valuation purposes. But, INAP and FTGX share one very important similarity: the colocation business. In our view, it is the colocation business that is driving profits at all these IP Services companies, including INAP (before the VitalStream acquisition), and therefore there does not seem to be a reason why FTGX should be trading at such a discount to its peers given the high valuations afforded by Wall Street to all of the colocation companies. At the same time, we are well aware that colo is still a small part of FTGX’s revenues (20%), and therefore one needs to apply a discount to industry multiples when valuing FTGX as a whole.
In addition, even though INAP may have valuable IP assets, we think that FTGX’s metro fiber assets are potentially more valuable than IP, given the always questionable legal status of IP. However, metro fiber, given its status as a real estate asset, is almost always beyond doubt. We doubt they are going to build any more major carrier hotels in NYC/NJ any time soon, so FTGX’s fiber and positioning is significantly more valuable than the current market price implies.
In any case, the best way to value FTGX is by comparison to other carrier’s carrier companies, such as Looking Glass and Telecove, both of which were recently acquired by industry giant, LVLT. While it is difficult to get exact EBITDA figures for these companies, since they were private and LVLT somewhat obscures the cash-flow data, the valuations based on revenues are more transparent. From what we gather, Looking Glass with $75 million in revenue was acquired for 2.2X Enterprise Value to Revenue (EV/R). Telcove, with $390 million in revenue, was acquired for over 3X EV/R. We believe that Looking Glass is the best comp for FTGX given its size and the almost exact same business makeup (IP Transport + Colocation).
Therefore, assuming $40 million in revenue for FTGX, and using the Looking Glass multiple, one is forced to conclude that in the event of an acquisition, FTGX would be worth about $9 per share. Even at a significant discount to Looking Glass, FTGX should be worth $6 or a slight premium to tangible book value. These prices also appear quite reasonable, as paying 2X revenue for a recurring revenue stream with a stable base of customers is certainly justifiable.
So why is FTGX trading down? Well, we plead ignorance when it comes to understanding the stock market’s short-term price swings. But, it is important to mention that in the micro-cap stocks that we follow, such major price swings are quite common. This is why we always only invest a small amount of our entire portfolio in each individual small cap opportunity and why we stay extremely diversified in these types of investments.
Some money managers insist that you need a concentrated portfolio of stocks to outperform the market, and while that may be true if you actually have a say in the business, such concentration will surely lead to ruin when investing in small caps as a passive investor. The stocks are just too unpredictable and at some point you will take a 50% haircut.
Furthermore, the notion that concentration leads to outperformance is simply wrong when it comes to investing in small cap, turnaround stocks. Our real-life experience, and that of other successful investors, is exactly the opposite. Extreme diversification will lead to significant outperformance when the right types of stocks are chosen and one pays careful attention to valuation. The bottom line is that one needs to stay very diversified in turnaround and restructuring investments, if one intends to profit from the huge returns that a portion of these investments will ultimately provide.
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