Introduction & Overview: by Alan J Weissberger

Zayo was founded in 2007, to “provide customers with enormous, exceptionally high quality bandwidth.”

The company has grown exponentially via acquisitions, taking advantage of transactional demand from hyperscale service providers for bandwidth infrastructure, with its meteoric rise driven by 37 acquisitions in its nine-year history. Zayo has assembled an attractive services mix, with potential for leveraging its dense metro, regional, and long-haul fiber networks.  

Late last year, Zayo acquired Allstream,  which provides bandwidth and telecom services to business and public sector customers across Canada. Allstream also operates colocation space in Toronto, Montreal, and Vancouver. “Within today’s Allstream is a robust collection of fiber networks, which are enormously valuable to both Allstream and Zayo customers,” explained Dan Caruso, chairman and CEO of Zayo.

“We will unleash the full potential of these assets by combining them with Zayo’s network and focus on providing high-quality and low-cost bandwidth to help fuel the growth of Canada’s economy.”

Zayo currently offers the following services/capabilities: hybrid cloud infrastructure as a service (IaaS), dark fiber, data center & colocation, Carrier Class Ethernet (10M to 100Gb/s),  IP services, mobile infrastructure, SONET, and wavelengths (on one or more fibers).

Zayo says they have 7.7M miles of optical fiber installed, 800 data centers connected, with 9,000 miles of fiber buildout underway.  The company claims its dark fiber is secure and scalable with virtually unlimited bandwidth. “You get fiber from us, you light it up with your own electronics and you maintain direct operational control of your network while leveraging our dense metro and long haul fiber network.”  

Industry bandwidth demand continues to increase, but Zayo’s ability to benefit from this growth, against technology shifts in wireline and wireless segments, could be gating factors.  In particular, the transition from hub and spoke enterprise networks to cloud wireline and wireless access could prove to be a challenge for Zayo.  See question 2. below for wireless industry shifts underway.

Analysis: by David Dixon of FBR & Co.

ZAYO has assembled an attractive mix of high-bandwidth services on its dense metro, regional, and long-haul fiber networks. Although industry bandwidth demand continues to increase, ZAYO’s ability to profitably benefit from this growth against technology shifts in the wireline and wireless segments is a concern.

ZAYO is a high-margin revenue growth story with potential technology related headwinds amid an unclear ability to integrate and maintain revenue momentum while extracting sufficient synergies from its largest and most complex acquisition to date. Based on our industry checks with major Canadian customers, there is a significant portion signaling an intention to change carriers.

Last week, management announced lower-than-expected annualized synergies of $60M (versus our expectation of >$100M) for Allstream, which suggests head-count reductions are behind schedule and interconnection savings are longer dated. Based on results to date, we see increased investment risk from ZAYO’s Canadian acquisition, which could warrant a lower implied valuation multiple.

Key Points (David Dixon):

■ Fiscal 3Q16 results recap. ZAYO delivered fiscal 3Q16 consolidated revenue growth of 40.3% YOY, to $478.0M, driven by the inclusion of Zayo Canada, versus consensus of $473.0M and our estimate of $477.0M. 

■ Organic revenue momentum on track, but weaker than expected, including Zayo Canada and Allstream. Including Zayo Canada and Allstream, ZAYO reported 2% pro forma recurring revenue growth and 5% constant currency (6% and 8%, respectively, excluding Zayo Canada and Allstream). Excluding Zayo Canada, gross installs were $5.9M, and net installs were $2.1M, driven by record low churn of 1.0%. Excluding Zayo Canada, management reported solid bookings of $7.0M and reiterated guidance of 3.0M in net installs by the end of 2016.

■ Allstream execution is an increasing concern. Last week, management announced lower-than-expected annualized synergies of $60M (versus our expectation of >$100M) for Allstream, which suggests head-count reductions are behind schedule and interconnection savings are longer dated. While management cited increased cross-border transaction opportunities within the core Zayo sales group, we are increasingly concerned about high-margin revenue contraction at Zayo Canada, from both gross billings and churn perspectives. Based on our industry checks with major Canadian customers, there is a significant portion signaling an intention to change carriers. In our initiation note, we highlighted key challenges that could drive slower revenue growth and higher churn: the (1) transactional, versus customer-based, sales platform; (2) entrepreneurial, versus mature, business culture; (3) lack of experience in voice and security services; (4) the transition to a reseller-based SMB business.

Q &A (David Dixon):

1. What is the impact of an architecture shift on Zayo’s business model? Do telecom and cable companies have sufficient metro fiber in place to deploy distributed compute networks?

We see limited competition from other dark fiber and mobile infrastructure providers but believe the real question is the impact of network technology changes underway on the outlook for demand for Zayo s products and services. In the metro fiber segment, we see a move underway within the telecom and cable segments toward distributed compute bandwidth and storage platforms, potentially on fiber infrastructure already in place. This will likely serve as the foundation for transferring data traffic from Internet content and applications from the core network to mini datacenters at the edge of the network in each metro location. This is similar to the content (not computing) challenge solved by Akamai in the early days of the Internet.

2. Are there wireless technology shifts underway disruptive to Zayo’s business model?   On the mobile infrastructure front, there are multiple trends underway:

(1) more heavy lifting by low-cost super Wi-Fi-like indoor, versus outdoor, LTE deployments on commodity servers;

(2) new cloud-based, shared spectrum bands; and

(3) the use of wireless back-haul and front-haul in lieu of fiber connections to cell sites.

3. Synergy potential is high at Allstream, but what is Zayo’s ability to execute its largest and most complex acquisition to date?

While Zayo expects $60 million in annualized cost synergies, we see key challenges, including:

(1) a horizontal-based, versus vertical-based, sales and profitability platform (Canadian enterprise customers may not transition well to a transactionalbased relationship);

(2) an entrepreneurial, versus mature, business culture;

(3) Zayo’s limited experience in managing a cybersecurity service portfolio, which may increase churn and lower revenue growth;

(4) similarly, management’s lack of experience in managing a mature voice service platform (still a key part of an enterprise customer solution), which may result in increased customer and revenue churn; and

(5) the transition of Allstream SMB business to a pure reseller, which may increase customer churn.