A Little Journal of a Shameless Investor

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$WCG.AX – Net Cash = Market Cap Set Up

 

Hi again, I have not posted for so long and need to update for new changes in the last two months. While I was away from posting my peculiar investing ideas, one special situation popped up in my hometown – Australia.

In late October 2023 (hard to believe it’s been two months), Webcentral Ltd, a small-cap IT service company in Australia, announced the sale of its IT domain business for AUD 165M.

The transaction yielded AUD 115M in net cash proceeds, with expectations of completion by late November—just a month after the public announcement.

So the company will end up with $115M in cash after transaction costs.

At the time of the announcement, the company was trading at $0.11 (AUD per share) which equates to a market cap of ~ AUD 37M.

Can you estimate the opening price of this stock after the announcement?

It opened at $0.24 – which is around 80M in Market Cap.

 

 

This has intrigued me for two reasons:

  1. Transparency in Deal Communication:

    The company accompanied the announcement with an investor presentation, meticulously outlining the allocation of the cash proceeds post-transaction. Such clarity is often a rarity in such corporate maneuvers.

  2. Moderate Market Response:

    Despite the significant deal value, the stock merely doubled, reaching three times its pre-announcement market cap. This modest response, compared to the deal’s actual magnitude, piqued my curiosity.

What led to my investment in this company was more based on the details & information that they provided.

Usually, when companies make this sort of deal, you’re not exactly sure where the capital is going to be allocated. Investors will trust the assumptions & analyze the company’s history to go and make an informed decision that is protected by probability & margin of safety. Company disclosure really helped me in making this decision.

To explain this investment, I will need to answer the three questions points in detail:

  • What is the actual value of the transaction?
  • What does the business look like after the transaction?
  • What is the business going to do with the proceeds?

 

What is the Tangible Value of the Transaction?

 

Going back to the reasons why this investment intrigues me, it comes down to how the company is not holding back to show the tangible value of the transaction.

On the announcement of the sale, they posted a worded notice & investment presentation which illustrates the balance sheet position.

  • Webcentral Sale of Retail Domains and Hosting Business – Link
  • Webcentral Investor Presentation – Sale of Domain Business – Link

The overview of this transaction is below:

They are selling the Domain name registry, consumer hosting, and email hosting business for 165M, however, this is a “total transaction value”. As explained in the total value breakdown, this includes the $20M valuation on retained equity stake (33.3%) & $30M deferred revenue.

Let’s look into this in more detail:

Cash Proceeds – $115M

 

Not much to explain here, Webcentral is receiving $115M of cash for the sale of the business to Oakley Capital. What matters is what Webcentral will do with these massive cash reserves.

For the investors, the company provides the use of the cash proceeds on one of the slides:

The company will first use the $115M for debt repayment & transaction prices. This is pretty standard practice for any M&A transaction being a “Cash-free Debt-free Deal”. Meaning that the acquirer will not keep any excess cash on the company’s balance sheet nor the debt.

What determines the company’s future value is the use of Growth Capital, which capital allocation skill will be essential for the company to maximize shareholder value

 

$30M Deferred Revenue

 

As per the agreement, Oakley Capital will take over the $30M deferred revenue currently held by the business.

This situation demands close attention.

While Webcentral retains $115M in cash, Oakley Capital must fulfill future obligations to provide services promised by Webcentral to its customers. The breakdown of this deferred revenue isn’t clearly illustrated in the transaction; however, the $30M value is considered the “fair value” and is likely to be written off.

The fair value of the deferred revenue represents the actual cost that Oakley Capital will incur to fulfill the obligations Webcentral made. Given that Webcentral operates a domain hosting business that generally requires only minor maintenance fees (additional costs incurred before securing a contract, e.g., developer costs, etc.), this value is crucial.

 

1/3 Equity Stake of the Domain Business – $20M

 

The company plans to retain a third of the equity stake in the email hosting service business, valued at 20M.

One might question why 2/3 of the domain business was sold at 165M when the retained 1/3 equity stake is valued at 20M.

The company addresses this query in the investor presentation, explaining that the $165M total value represents 9x EBITDA of the business. Assuming the book value of 66.6% of the domain business is $60M, this indicates that Oakley Capital paid 2.75 times its book value.

 

What Does the Business Look like Post-transaction?

 

Before delving into the specifics of the $165M sale of the domain business, it’s crucial to understand the dynamics between Webcentral Ltd and 5G Network, as they collectively constitute the entirety of the present business.

On July 16, 2021, Webcentral and 5G Networks jointly announced their entry into a merger agreement, envisioning a synergy that would capitalize on their respective strengths, including a combined online portal to cross-sell their products.

However, a clearer perspective emerges when we dissect the $165M sale of the domain business and treat these two entities separately.

Webcentral:

 

 

Webcentral operates domain brands such as Melbourne IT, Netregistry, and WME, essentially providing hosting services for other businesses. For those unfamiliar with the workings of domain businesses, here’s a brief overview of their economics:

Imagine running a gym business. To advertise, register, and accept payments through an all-in-one platform, a website is essential. Domain names are integral to the internet structure, allowing users to access websites. Without a domain name, customers would need to memorize lengthy IP addresses. Webcentral owns multiple domain registries, and website owners pay them for domain name issuance, renewal, transfers, and assistance with web hosting issues.

 

5G Networks:

 

5G Networks owns a portfolio of data centers equipped with supercomputers that offer a spectrum of digital services to businesses. Again, using the analogy of a gym owner:

As a gym owner, I secure customer information using 5G Network’s data centers, known for their top-notch cybersecurity and secure cloud storage. The IT infrastructure by 5G Networks ensures quick data access for customer information retrieval. For IT support, the gym owner can rely on 5G Network.

While the gym owner example may seem unrealistic, it emphasizes that 5G Network primarily serves large enterprises and government clients, including top 50 ASX companies. In contrast, Webcentral focuses on small and medium enterprise customers.

Now, with a clear understanding of these two businesses, let’s delve into the intricacies of the $165M domain business sale.

 

Post-Transaction Summary

 

Summarizing this $165M transaction in one line will be this – “The business is selling 66.6% of the Webcentral and keeping the 33.3% & 100% of 5G Network”.

I hope Webcentral changing its name to 5G network post-transaction now kind of makes sense.

The visual representation of the post-transaction structure is below:

In terms of the “type” of service for post-transaction:

 

Segmented Analysis – Webcentral vs 5G Network

 

Segmentation of the business service is as follows:

  • Data Centres, Network & Cloud – We will treat this as a 5G network
  • Managed Services – This includes onsite and remote IT support, provision of voice services, and hardware and software procurement. As this relates to the IT infrastructure support, we will treat this as a 100% 5G network.
  • Webcentral – This is the webcentral part of the business including webcentral domains, email, webhosting, and digital marketing business.

Based on the segmented income statements from the 2023 Annual Report, I’ve compared the business quality of the two businesses.

The margins of the two businesses are below:

 

We can clearly see the difference in the business quality across the two businesses. Webcentral was a wonderful business, producing a staggering 32% margin in pre-tax profit. No wonder why Oakley Capital paid a sizable amount for just two-thirds of the business.

The 5G Networks is clearly a money-losing business. The wages are higher while the revenue is dropping and the business is more skewed towards the hardware side than the Webcentral, which depresses their margin quite a bit.

A closer look through segmentation analysis reveals that Webcentral strategically divested its stake in the lucrative venture, now retaining only one-third of a prosperous business. Unfortunately, the remaining 100% ownership of 5G Networks appears to be a less favorable investment, characterized by financial difficulties.

 

$5M NPAT??

 

Adding a layer of skepticism is the peculiar announcement that the remaining business is projected to generate $5 million in NPAT while aiming for a revenue of $45 million in the 2024 fiscal year. This assertion, when juxtaposed with the recent financial history of the 5G Networks segment, raises considerable doubt. Having incurred a substantial pre-tax profit loss of $45 million over the past two years, the sudden optimism about a $5 million net profit in the upcoming year is just hardly imaginable. I’m curious to see how the company is backing this claim.

 

12 Million Dollars Transitional Service Agreement between Oakley & Webcentral

 

The transitional agreement for the domain business is a crucial aspect that cannot be overlooked. Transactional service agreements, particularly in the IT sector like Webcentral, are common due to the intricate nature of separating complex systems or processes, which often doesn’t align with the timeline of M&A transactions involving separation.

I hate valuing these agreements, given that transitional arrangements may not align perfectly with the strategies of either the seller or the buyer. This can result in a distortion of the EBITDA of both parties, rendering the total deal value of $165M a somewhat ambiguous figure. The Transitional Service Agreement (TSA) itself is only minimally explained in the investor presentation.

 

 

According to the agreement, Webcentral will continue to source cloud services and managed support services for the next five years. The agreement is valued at AUD 12M, with a minimum of $4M in the first year. In essence, Oakley is committing to pay $12M over five years to Webcentral for operating all agreed-upon IT services, and Webcentral is obligated to provide the agreed level of service.

It’s evident that this arrangement will impact the company’s future profits, and it should be duly taken into account when evaluating the overall value of this transaction.

 

What are the Pros and Cons of this Deal?

 

We’re in an intriguing situation with opposing forces shaping the company’s valuation.

Upside Force

On the upside, Webcentral is in a robust financial position after strategically divesting from a lucrative venture. Holding $79 million in cash, clearing all debts, and with a valuation between $80 million and $90 million, Webcentral has various options for capital deployment—dividends, share buybacks, or strategic acquisitions to enhance overall value.

Downside Force

Looking at the downside, a nuanced view reveals a different narrative. The structural realignment left the company with a business that, at face value, seems potentially resource-draining. The majority sale of the more prosperous segment puts Webcentral in a position where the remaining venture could erode its cash reserves over time.

 

 

What is the Business going to do with the Proceeds?

 

Company Announced Share Buybacks

 

 

As of the writing of this post, Webcentral has already announced an on-market share buyback program using the proceeds. Proposing to buy back 33.4 million shares.

Compared to the total shares outstanding of 334 million shares, this represents a 10% buyback of the shares outstanding. It’s hard to estimate how much cash they will spend in this buyback program ending on 20/12/2024. If we assume that they will buy back shares within the share price of around $0.33 (I’m just picking an average between $0.26-$0.40), this will cost the company around $11 million dollars.

This didn’t really surprise me as the company has already bought back 5.2 million shares between August to November 2022, spending around $1M from their cash reserves – Link to the announcement

The current buyback initiative, targeting 10% of shares outstanding, coupled with the efficient utilization of approximately 14% (1/7) of the remaining cash reserve, presents an enticing proposition. If the company can acquire shares within the $0.25-$0.26 range, this could further amplify the positive impact on shareholder value.

 

Targeted Acquisition

 

In the investor presentation, the company aims to acquire complementary web hosting/cloud and managed services at less than x5 EBITDA.

Reflecting on Webcentral’s acquisition in November 2020, the management team’s $100M profit this year showcases an impressive M&A track record.

Despite recent milestones—completion of the domain business sale and the buyback program initiation—the share price has surprisingly stayed relatively static. Despite my short-term investment horizon, the imminent acquisition will likely steer the share price trajectory in the immediate future.

 

What is the Value of 5G Networks Post-Transaction?

 

As we are valuing a money-losing business, I will need to make the following assumption when conservatively valuing this company:

  • I don’t think the business will make $5 million in NPAT in 2024FY as they say in the investor presentation. I will expect them to burn cash in the next two years.
  • The 1/3 equity stake of Webcentral will continue to grow at the current growth rate under the watch of Oakley Capital
  • We will assume that the TSA costs are not underestimated ($12M over 5 years)
  • The targeted acquisition using the cash reserve is taken out when valuing the company as the company has not made it clear.
  • Assuming the share buyback program will be completed as the company says

 

Valuation Summary

 

Based on the assumptions above, my valuation looks like this:

 

1/3 Equity Stake of Webcentral

 

I thought about valuing this by just using the implied book value of $20M, however, this part of the business is valued way higher considering the margin & quality of the business as explained earlier.

I’ve assumed the following in this valuation:

Accelerated revenue growth in the first 5 years managed under Oakley Capital

Oakley has recently been investing in the web hosting space, including Intergenia, HEG, WebProas, and Contabo. As a PE firm, I believe they have the leverage to grow their business through the networks they have.

They’ve recently acquired Contabo – a regional web hosting platform for SME businesses (same target market as Webcentral), transforming an unknown German business to generate an EBITDA growth of 63% CAGR in the last three years –  Link to the Oakley Capital Story @Contabo

These guys are specialists in the field, and I believe my growth estimate is rather conservative for Webcentral.

 

 

The main assumptions for this valuation are below:

  • The operating margin will gradually fall to 25% in the next few years
  • Accelerated revenue growth, topping at 12% in the fourth year once the business was up and collaborated with Oakley’s network.
  • The reinvestment rate (currently 29%) will drop to 20% to support the terminal growth rate of 1%
  • The discount rate used is 11.51%, I’ve used the same discount rate that was used in the annual report which the company used to account for the value of the intangible assets.
  • The tax rate is fixed at 30% (corporate tax rate in Australia), and the carried forward tax losses over the years are taken outside of consideration.

This leaves the value at $62M for the 1/3 of the equity stake, a lot higher than the $20M implied book value that was in the deal.

 

5G Networks – Liquidation Value

 

As 5G Networks is a money-losing company for several years, I really want to value this company conservatively. I believe that the operating performance will not turn around and structural problems will arise in the business. As they hold a lot of tangible assets (data centers & computers etc.), I’ve valued this part of the business based on the liquidation value.

The post-transaction balance sheet is used as an estimate of the asset value and assuming a sale situation, they will sell its asset for 80% book value and liquidation cost will be 5% of the proceeds.

If they make $5M in NPAT next year as the company says, this valuation is totally wrong. But I rather be conservative and value this as a negative earning company with no debt ($27M as a result).

 

Transitional Service Agreement

As explained previously, I’ve valued this based on the expected pre-tax margin of the business with a discount rate of Webcentral.

This leaves a value of $2.13M for the current business.

 

Cash

 

As per the completion notice announced on 21 December 2023, the total cash proceeds were $107.4M

This amount falls short of the expected proceeds outlined in the investor presentation. We must work with the most up-to-date information regarding valuation.

The net cash position incorporates the anticipated spending in the share buyback, depicted as follows:

 

Even after adjusting for cash proceeds and share buybacks, the company maintains a robust cash position of approximately AUD $65 million.

Intrinsic Value Per Share

 

Putting together the puzzle pieces of what comprises the remaining business (whether we refer to it as Webcentral or 5G Networks, given the yet-to-be-changed name), my bottom line evaluation pegs this company at a valuation of AUD 156.13 million.

Interestingly, this stands significantly higher than the current market cap, currently trading around $80-90 million. If the shares were to realign with this intrinsic value, we could be looking at a substantial x2 return.

In my perspective, retaining a 1/3 equity stake in the business holds more value than meets the eye. Conversely, I’m less optimistic about the residual 5G Network business, doubting its potential for generating future cash flow for the firm.

Considering the reduced share count post-buyback, my calculations suggest that the shares should ideally be trading at approximately $0.52 per share.

 

Summary

 

Now, I’ll be the first to admit that my valuation has its flaws. As explained in this post, valuations are never perfect.

But I think represents the best effort within the confines of my limited brain capacity. I extend my appreciation to those who shared their insights on Twitter as soon as the transaction surfaced. The speed and adeptness with which others quickly assessed and valued this company were nothing short of astonishing.

It’s worth noting that my valuation overlooks the interest income the business will earn before tapping into the cash reserve and the potential for future acquisitions on the horizon. This missing piece of information is crucial, but unfortunately, we’re working with what’s available.

I’ve been buying this in the past couple of months, my average price is around $0.26~27.

Rest assured, I’ll be keeping a close eye on developments and promptly updating if anything new emerges.

 

Cheers,
Ritzty

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