A couple of months ago the Capital H Inception Fund acquired a stake in IAB after they disclosed the possibility of 'material transactions.' It seemed fairly clear that the Indirect business was worth a lot more in the hands of an acquirer than what the public market was willing to pay for it.

I then proceeded to draft a note written from the perspective of a letter to Rene Sugo of MNF, the acquirer who made the most logical sense, outlining why MNF should buy IAB's Indirect business and taking a guess at what they should pay for it. It was never sent nor published.

This morning it was announced that MNF has agreed to buy IAB's Indirect business, subject to shareholder approval. IAB shareholders have been told they can expect to receive cash proceeds "potentially in excess of 80c" if the deal goes ahead as planned.

And so rather than resign the letter to a folder in a Desktop for the rest of enternity, I share it below without changes (you'll note some errors e.g in the earnings estimates for IAB Indirect, although the end outcome is proven right).

The value for IAB shareholders is now minimal given this research is shared in hindsight, but it might be valuable for MNF shareholders to understand the type of value they are getting - I think Rene got a bargain here. Well played.

Letter:

Dear Rene,

We’ve chatted in the past and I’ve previously been a shareholder in your company. Since our initial chat when MNF was a tiny micro cap you’ve proven yourself to be one of the best telco execs in the industry. The market agrees with that statement, reflected in the premium that MNF’s stock trades on.

Acquisitions are a key part of your strategy. I have an opportunity that fits all your criteria, will generate excellent returns on capital and an immediate increase in shareholder value.

This is why you should acquire In-A-Box (ASX:IAB).

A Hidden Gem & Why There Is An Opportunity

IAB has been listed for a number of years and has been a perennial under performer. The founding business is called Telco-In-A-Box and pioneered the wholesale telco aggregation model allowing smaller companies and larger brands to start and grow a telco business. It competes with your domestic wholesale business, specifically iBoss.

I’ll refer to the business as ‘IAB Indirect’.

After listing they acquired a number of businesses that diversified away from their core. These were classified these as the ‘Direct’ business. After a string of poor acquisitions they’ve now been sold leaving just the IAB Indirect and Enablement businesses.

It is this business that has been a consistent performer despite management’s distraction. It is a bit of a hidden gem. It has a market leading position with 450 customers (out of approx. 1200 addressable market) and >80% recurring revenues with customers signing 36 month contracts.

The business is now on a nice growth path. After a couple of years of uncertainty for smaller RSPs and resellers of the NBN things seem to have settled down. There will be natural growth as NBN adoption increases and IAB’s customers themselves grow their revenue. 

They have the opportunity to expand with the bigger end of town too. The recent contract to provide white label enablement services for Telstra Wholesale is material and indicative of IAB Indirect’s market position as they beat a number of domestic and international competitors to win the contract.

Then there is the opportunity that comes with big consumer brands (grocery chains as an example) looking to offer telco services to their customers. As the leading provider of wholesale aggregation IAB Indirect is well placed to grow off the back of this and management seem to be indicating that they expect to announce new customer wins soon.

IAB Indirect now does “over $50m in revenues” and “around a 12% EBITDA margin”. The stock IPO’d at $1.20 but today trades at 60c with an enterprise value of just $24m. They’ve sold their Direct business and now just focus on Indirect. But the public market doesn’t want to price it appropriately because of years of underperformance and a lack of faith that existing management can deliver.

That is why there is an opportunity for MNF.

What Should You Pay?

I’ve gone through your acquisition history and there are two things I’d note.

1. Your team has proven its ability to acquire well and are typically looking for businesses you can integrate into the Symbio network and then cross-sell higher margin software services to the acquired customer base.

2. You don’t overpay. On average, you’ve paid 5.5x EBITDA pre synergies for your acquired businesses.

So I’ll use that 5.5x EBITDA pre-synergies as the benchmark.

On that basis you should bid $1.10 for the IAB parent company.

The Metrics

At $1.10 and 23.8m shares on issue the equity is valued at $26m. IAB have ~$10m of net debt and you would acquire $3m of franking credits for an EV of $33m.

Here is what you would get for that $33m.

You’d get the IAB Indirect business generating $6m of EBITDA for 5.5x pre synergies. That would be in line with the typical transaction multiples you’ve been known to pay.

But the real value is strategic and comes from what you could do with the business under your ownership.

IAB Indirect have 450 RSP customers and $44m of annual revenue. Your domestic wholesale business has approximately 280 customers and about $32m of revenue.

Acquiring IAB Indirect would more than double your domestic wholesale revenue and take your total customer base to just under 800 - the clear market leader in the wholesale telco aggregation market.

It would be a significant boost to your iBoss business, which competes directly with IAB Indirect and has been an excellent performer since you acquired it in 2014.

A quick look at the numbers suggests you and your team have been far better at maximising the value generated from the RSP customer base in the domestic wholesale business compared to what IAB Indirect have been able to achieve.

Rough numbers -  IAB Indirect has 450 customers and $44m of revenue for an average revenue per customer of about $98,000. MNF’s wholesale domestic business generates $32m of revenue from 280 customers, or $114,000 of revenue per customer. 16% more revenue per customer.

The Real Opportunity

The real opportunity in MNF acquiring IAB is to plug the Indirect business into MNF’s network and have VoIP services run over the Symbio wholesale network. That would provide cost reductions for the IAB Indirect business and its customers, but more importantly it would give MNF 450 captive customers to sell OTT, high margin services to - the core of the MNF business model.

The revenue and earnings uplift would be significant. There would be a 16% uplift in revenue if you can increase sales per customer in line with the existing MNF domestic wholesale business. That is another $7m of revenue over the medium term.

And the RSPs would love it as the additional services generate revenue and earnings growth for them too, as well an ability to differentiate in a highly competitive market.

Cost Synergies

As always with these types of acquisitions there will be plenty of cost-out opportunities and synergies in the development teams.

When 5GN acquired the IAB Direct business there was $1m of executive staff costs to strip out on Day 1. The Indirect business is of similar size and is probably carrying a similar level of executive costs that can be removed immediately.

IAB had been investing ~$2m of CAPEX into this business annually. MNF have an existing and larger development team in place already. What would the benefit be in having the MNF development team cover the requirements for IAB Indirect too? No doubt material.

When you plug the IAB Indirect business into the Symbio network the RSPs will have the option to provide services over your own VoIP network, as outlined above.

What sort of benefits would there be when purchasing capacity off the big 3 telco wholesalers in Telstra, Optus and Vocus when your domestic wholesale business moves from 280 customers to 730 customers?

MNF is 5x the size of IAB by revenue. There is no doubt you would be able to negotiate better supplier terms across a host of items. While I don’t have the expertise to quantify that, I am sure it is material.

Under IAB’s ownership the IAB Indirect business is apparently generating $6m of EBITDA.

I would hazard a guess that under your ownership there would be $1-$2m of costs to strip out within a reasonably short time frame.

At $1.10 you might be acquiring IAB for <4x EBITDA before we factor in revenue growth.

Shareholder Value Creation

One of MNF’s strengths is its proven track record over a long period which has manifested itself in a premium multiple and consequent low cost of equity.

MNF trades on 15x EBITDA. Acquire IAB on 5.5x of EBITDA and, all else equal, you’ll create $57m of additional shareholder value.

EBITDA would grow by 22% pre-synergies above your current FY18 guidance. Closer to 30% after all the above synergies are factored in.

You could structure it in a number of ways and it would still be accretive to MNF shareholders. You might even be able to pull off an all scrip deal with equity issued to IAB shareholders at a premium to the current MNF share price.

The strategy makes a lot of sense. It is an opportunity to significantly increase the scale of your domestic wholesale business and take a dominant position in the wholesale aggregation market.

The cost synergies are significant both at the gross margin level and in the reduction in operating costs.

The cross selling opportunity to a customer base >50% bigger than your current domestic wholesale business is enormous and central to the MNF business model. This business is worth a lot more under the ownership of MNF Group than it is under IAB’s current ownership.

My guess is the market will back you to run the business far better than IAB have. That’s the benefit of a proven track record. And, most importantly, your shareholders should like it.

I can only hazard a guess that others, perhaps those over at SuperLoop, are taking a close look at it too.

In the interest of full disclosure, the Capital H Inception Fund is a shareholder in IAB.

All the best,

Harley

Disclaimer: The author holds shares in IAB through Capital H but does not hold shares in MNF at the time of publication.