Small Cap Stocks

Introduction

Note: As of this writing, Globix (AMEX: GEX), was trading at about $4.60 per share.

In this post we are going to take a look at Globix Corp. (AMEX:GEX), a post-bankruptcy Internet services stock, that provides IP Transport solutions over a wholly-owned and operated high-bandwidth fiber optic network. Though we are not terribly excited by Globix´s risk/reward ratio at current share prices and do not own shares in the company, we thought a review of the company would be interesting to those looking for additional plays in the hot IP services sector. Furthermore, we think that the valuation of GEX provides some interesting insights into the potential upside in FiberNet Telecom (FTGX), another IP transport stock we´ve been writing about for some time.

Business Summary

Globix was a former high flyer back in the first Internet Bubble. However, under the weight of significant leverage and the collapse of the telecom sector, the company declared bankruptcy in 2002, after suffering cumulative net losses of hundreds of millions of dollars. Following its emergence from bankruptcy in 2002, the company significantly restructured operations.

In 2005, Globix acquired NEON Communications, another former telecom high-flyer that traded for over $150/share before declaring bankruptcy not long thereafter. Following some major divestitures in 2006, Globix, through its sole subsidiary NEON Communications, is now a provider of IP transport services to telecom carriers (i.e. local, long-distance and wireless telcos) and a limited number of higher education and financial institutions in the Northeast and mid-Atlantic regions. The company’s network stretches 4,800 route miles and over 230,000 fiber miles from Maine to Virginia. The company offers lit fiber (i.e. with network equipment installed) and dark fiber (without network equipment installed) services, and also provides co-location services through its data centers.

In the full year of 2006, revenues from the transport segment, Globix´s only remaining business, were $66.4m, up 25% over our annualized figure for 2005. In the most recent quarter, about 90% of revenues were derived from lit fiber leases, which are booked long-term and billed ratably over the term of the lease, providing a highly predictable revenue stream.

What Changed?

In a former life, Globix was a full-service Internet Service Provider (ISP), providing hosting and streaming services in addition to bandwidth and co-location. Globix entered the IP transport business when it acquired NEON in 2005 for $113m.

Following a strategic review in 2006, the company opted to divest the US and UK hosting businesses and the NYC real estate related to that business in order to focus exclusively on the IP transport business through its NEON subsidiary. Proceeds from the above sales were used to pay off nearly all of the company’s debt, and left a good amount of cash on the balance sheet as well. In essence, starting in 2007, we are looking at a radically different company than that which existed even a year ago.

The People

Following the divestiture of the company´s hosting operations in 2006, Globix has installed a new senior management team, primarily composed of former senior officers of NEON.

The current CEO and President of Globix is Kurt Van Wagenen. Mr. Van Wagenen joined NEON Communications in 2001 as Vice President of Network and Operations. In 2005, NEON merged with Globix and Mr. Van Wagenen was appointed Chief Operating Officer of the NEON business and later President and Chief Operating Officer of the entire company. From 1986 through 2001, Mr. Van Wagenen was employed by Verizon and its various predecessors in several positions of increasing responsibility. Mr. Van Wagenen holds an M.B.A. from Harvard Business School and a B.S. in Engineering from Rensselear Polytechnic Institute. He is also a Chartered Financial Analyst.

When Mr. Van Wagenen was hired by GEX as CEO he was awarded 125,000 option shares at $4.17 per share.

The current Chairman of the Board of Globix is Ted S. Lodge. He joined the Board of Directors on October 28, 2005, at which time he was elected Chairman of the Board of Directors and Executive Chairman. Since April 2005, Mr. Lodge has been the principal of Lodge Special Situations LLC, a firm providing special situations advisory services to private equity and hedge funds and companies. From December 2001 to April 2005, Mr. Lodge was president, chief operating officer and counsel of Pegasus Communications Corporation, where he also was at varying times from 1996 to 2001 executive vice president, senior vice president, chief administrative officer, general counsel and secretary. On June 2, 2004, Pegasus Satellite Communications, Inc., along with its subsidiaries through which the primary operating businesses of Pegasus were conducted, filed voluntary petitions to reorganize under Chapter 11 of the U.S. Bankruptcy Code in the U.S. Bankruptcy Court for the District of Maine.

Globix´s largest shareholders are various funds, some of whom have acquired stakes in recent months.

Overall, we are not too excited with GEX´s management. None of the company´s officers have had experience in managing a publicly-traded company that enhanced value to shareholders. At the same time, however, the current management team has significant operating experience in Globix´s current business.

Basic Capitalization Statistics

Based on the latest 10-Q, Globix has approximately 50 million shares outstanding on a fully diluted basis. Cash, including restricted cash, stood at about $36 million. Debt was a mere $3 million. Additionally, the company has about $14m in cumulative convertible preferred stock, which we will treat as debt for the purposes of this capitalization review. A description of the Preferred Stock, as per the latest 10Q: Globix has designated 4,500,000 shares of 6% Series A Cumulative Convertible Preferred Stock (“preferred stock”), of which 2,971,753 shares were issued in the acquisition of NEON. Each share of preferred stock is convertible into one share of common stock at the option of the holder, is entitled to one vote, has a liquidation preference of $3.60 per share plus accrued dividends, and is senior to the common stock of Globix.

Taking the above figures and using the current price of about $4.65 per share, we reach an Enterprise Value for Globix of about $215 million.

We would also note that company appears to have at least $140 million in usable NOLs. This tax asset should of course be taken into consideration when valuing the company. However, given the difficulty in valuing NOLs, we prefer to omit this factor from our EV calculation.

Relative Value Summary

In 2005, 7 months of post-acquisition NEON operations yielded revenue of $30.6m, which we can annualize to about $52.5 million. As noted above, in the full year of 2006, revenues from the transport business, Globix´s only remaining business, were $66.4m, up 25% over our annualized figure for 2005.

Based on these numbers and the EV mentioned above, Globix is currently traded at an EV/2006 Sales multiple of about 3.2.

On a go forward basis, with the increasing bandwith demands coming from Internet video, we think it´s realistic to assume double-digit top-line growth for GEX, for at least the next 3 to 5 years. In fact, Globix just reported Q1 revenue of $18.1m, representing growth of 18.5% year over year. In addition, the company reported EBITDA from continuing operations of $2.6 million in the most recent quarter.

Based on our industry outlook and using the most recent numbers, we feel comfortable estimating top-line sales for Globix at about $75 million for FY 2007. EBITDA should come in at about $11 million for the year. These estimates imply that GEX is currently trading at 2.8X EV/2007 Sales and 20X EV/2007 EBITDA.

Because of some recent acquisitions of other IP Transport companies by Level 3 (LVLT), there are some good comps by which to judge GEX´s relative valuation. For instance, according to LVLT, LVLT purchased TelCove for about 3.3x EV/sales, and Looking Glass was bought for approximately 2.3x EV/ sales. From what we can gather, LVLT itself is currently trading at nearly 5X EV/Sales. The company´s complex balance sheet makes valuation difficult, however.

Overall, when looking at recent M&A valuations, it would appear that Globix´s stock is probably about fairly valued, assuming our estimates are correct.

Risk Analysis

Without any significant debt, and with a nice cash position, Globix doesn’t seem to face much financial risk on a go forward basis. From a business perspective, it is also hard to see how the company is at much risk, given the growing demand for bandwith. In fact, the only real red flag here is that a substantial amount of cash from the company´s operations will have to go toward cap-ex to maintain and extend the NEON network. To be conservative, we estimate maintenance cap-ex at about $20 million per year. As such, the company is not yet free cash-flow positive, though it´s possible the company will begin generating FCF later this year.
In terms of setting a downside price here, we note that the CEO´s options are priced at $4.17 per share. More importantly, though, NEON was purchased for $113 million or $2.26 per share. Adding back net cash per share of about $0.40 and assigning minimal value to the NOLs gives us a downside price of about $3.50/share, or nearly 25% downside.

Return Analysis

On the upside, it´s possible that GEX will significantly exceed our estimates either because of accelerated top-line growth or acquisitions (i.e. the company notes in its filings that it is looking to make acquisitions, which makes sense given the NOL position). In addition, continued investor fascination with IP transport stocks, could result in higher valuation multiples for the all stocks in the sector. Assuming such scenarios, it´s conceivable that the company could trade at about 4x sales, or about $6.50 per share, for about 40% upside.

Conclusion

Considering the above and weighing each scenario, we don´t find GEX´s shares to be exceedingly attractive at current levels. However, given that the IP services sector remains “hot”, GEX is definitely one stock to keep your eye on in case of an unreasonable sell-off. The stock remains off the radar of Wall Street and not one sell-side analyst is covering the stock.

Finally, if you´ve been waiting for some FTGX commentary, we would note that GEX, given its business model and size, is probably the best publicly-traded comp for FTGX that we can currently find. Based on our FTGX estimates, and applying GEX´s multiples, as described above, we reach a fair relative valuation for FTGX of about $13 to $15 per share.

Please Note: We do NOT hold a position in GEX. However, we may trade in the stock at any time. All ideas, opinions, and/or forecasts, expressed or implied herein, are for informational purposes only and should not be construed as a recommendation to invest, trade, and/or speculate in the markets. Any investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk, financial or otherwise.

Special thanks to Toby Shute for contributing to this post.