Citron Research Reports on Cbeyond Inc. (NASDAQ:CBEY)

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Citron asks:  Can Investors “See Beyond” market hype, and get to the cold truth about CBEY? 

Not truly a high-tech company, Cbeyond’s business model is in fact a sales organization selling a product that is no longer unique.  It provides bundled telecomm services to small to mid-size companies (generally 4 to 100 lines) in a package.  This includes business phone, long distance, internet, mobile phone, website hosting, voicemail, and optional services. Their business plan is centered on hiring a sales force of ambitious young people who actually go knocking door to door in office parks to solicit customers, incentivized by big commissions for reeling in new customers on three year contracts. 

Citron believes the growth story the company wants Wall St. to believe is pure fiction.  Adjust it to reality, and you have a low-or-no-growth company with sustainable market presence in only 3 or 4 cities, selling for a PE of over 100.  From this precarious point, the stock could fall by 2/3rds and still be seriously overpriced.

Cbeyond had noteworthy success during 2000 to 2002 as these bundled services were not commoditized yet and their aggressive sales strategy was paid off in the first three cities in which it started service- Atlanta, Dallas and Denver.  This was enough to create a positive enough earnings outlook to embark on an ambitious plan to roll out the same model in 9 more markets, with pushpins in the map for an additional dozen or so to follow.

Taking up this plan without critical review, the analyst community has simply assumed the company line that Cbeyond is on track to achieve similar penetration in every market they enter.  Most of the covering firms and the company’s “analysis” consist of taking the table of cities, multiplying the market size by 11%, and adding up the fantasized revenue.  Even the pessimistic Bank of America analyst, who yesterday downgraded the stock with a 12 target, makes the same broad-brush assumption that they will achieve 10% market share in the 10 new markets they are trying to add.  But other than Houston, CBeyond is at market penetration of 5% in just one city, 4% in another, and 2% or less in the other 4, which include their largest and most competitive markets.

Citron would love to know on what basis do either the company or the covering analysts have to believe that CBEY can achieve 11% penetration in new markets.

Citron believes CBEY is a single digit stock for the following reasons:

1) Tracking of market penetration in newer cities is lagging disastrously far behind Cbeyond’s original “big 3”. 

Astonishingly, the analysts still peg Cbeyond’s valuation based on the assumption they will capture 11% market share in every market they enter.  However, a more detailed analysis increasingly exposes the fallacy.  Cbeyond’s financial reports obscure just how poorly it is doing in its new markets — profits from the 3 or 4 top markets subsidize the unfolding disappointments in the newer markets. 

If you compare all the newer cities on a timeline from startup in the market, you see an undeniable negative pattern:  The EBITDA in each newer market is worse than the original cities.  And the newer the market, the worse the comparison becomes. 

CBEY Market Compare (PDF)

2)  Competitive forces have been mounting steadily and now present a totally different landscape than when Cbeyond established its presence in its lead cities a decade ago. 

Here is one piece of reading that spells the obvious
http://blog.telephonyonline.com/unfiltered/2009/06/11/cbeyond-smbs-turning-up-pricing-pressure/

More importantly, as mentioned in a Merrill Lynch research report from June 29, it is not only pricing with their current competition that CBEY has to worry about but it is the inevitable push of cable operators threatening their mainline business – the cable companies are simply better configured to go cheaper and wireless.
http://www.cable360.net/ct/news/thewire/Comcast-Launches-Wireless_36376.html

3)  Increasing churn rates.  Probably the single most toxic statistic to Cbeyond is “churn rate” – the rate at which it loses existing customers.  Cbeyond quotes its churn as a monthly figure, so some investors may not understand the true significance of a rise from a historically “below 1%” to current 1.5% — which is a rise from single digits to 18% per year. 

Cbeyond’s churn rate is a measure of the installed base that the company loses as customers.  Presumably it is comprised of:

  • Customer companies that go out of business or severely downsize
  • Customer companies that move out of Cbeyond’s service areas
  • Customer companies that leave Cbeyond due to service dissatisfaction
  • Customer companies that leave Cbeyond due to price competition

Cbeyond’s historically reported “churn rate” was below 1%   Now it has risen precipitously.  The company purports the churn has now “stabilized” at 1.5%.  This represents a loss of 18% of the customer base each year.  If you think that’s a small increase to a small number, look deeper!  Especially note the impact this rate has on those “sweet spot customers”:

Churn Rate Annualized Years to churn through customer base “Sweet spot: revenue duration beyond commissionable original contract
1.00%  (historical for 2003 – 2006) 12.0% 8 years 4 months 5 years 4 months
1.50%  (current rate) 18.0% 5 years 7 months 2 years 7 months
2.00% (possible ?) 24.0% 4 years 2 months 1 year 2 months

The churn rate increase from 1.00% to 1.5% already lopped nearly 3 years from average customer retention.  This increase effectively reduces by half the “sweet spot” revenue from customers retained after their customer acquisition costs (eg sales commissions) have been amortized. 

If the churn rate increases towards 2.0%, note how the retention rate dips perilously close to the 3 year contract term over which the company has paid a huge incentive commission.   But a lot of damage to the “sweet spot customers” has already been done.

Looking at the churn rate this way puts in a new light why the company seems so quick to pronounce the economic downturn already over.  They almost have to believe this if they are to defend their growth model.  A high churn rate is simply toxic to its “over-the-rainbow”: financial projections.  The truth is the current economic downturn is hitting their customers – small to midsize US based companies, the hardest.

Interestingly enough there is a current shareholder class action lawsuit against CBEY and its management for specifically making misstatements designed to hide the fact that CBEY was recording a higher churn rate than they were reporting while directors sold close to $40 million in stock.

4)  Houston, we have a problem!  CBEY is being sued by the City of Houston alleging that Cbeyond has been underpaying right-of-way fees to the city since 2004.  The City of Houston is seeking unspecified damages arising from the alleged underpayment.   If this hold suit holds any merit and the City of Dallas follows, than Cbeyond could lose all of their available cash and jeopardize their business model in one of their core markets.  Citron will follow up this story at a later date with appropriate court documents,

Conclusion

Citron has more to say about this company.   We believe customer satisfaction and looming legal issues warrant further coverage.  But the points raised here should be sufficient to raise critical questions about a company with a trailing-twelve-month PE of 150, which runs a narrow business model facing increasingly commoditization with competition from the big boys of telecomm and cable.  CBEY has more than its work cut out for itself. 

Citron believes CBEY’s best days are behind them.  Investors who “follow the money” see beyond – a company whose insiders have sold stock in larger amounts than the company’s remaining cash

Cautious investing to all.