TCX - TGV Partners - Tucows: Investing In Fibre Optic Expansion

2023-07-31 21:50:00 ET

Summary

• Tucows is investing in the deployment of local fibre optic connections for high-speed internet in smaller US cities and towns.
• The investment requires perseverance and confidence in management, as the rollout will take over a decade and has experienced extreme fluctuations in share price.
• Tucows has secured a comprehensive financing solution for its expansion, which includes using connected households and subscribers as collateral.

The following segment was excerpted from this fund letter.

Tucows ( TCX )

I have explained the various challenges at Tucows several times in the past and also in the last letter of 2022. ³ The company has three businesses, the most important of which today is the deployment and joining of local fibre optic connections for high-speed Internet connectivity in smaller cities and towns across the United States.

I believe that investing in Tucows illustrates three different aspects of how the TGV Partners Fund differs from other traditional investment funds. I am going to show these aspects while explaining why I consider Tucows a good investment for the future:

1. It is an investment that requires a lot of perseverance. The fibre optic rollout is a project that will take over a decade from start to finish. The first shares were purchased in 2016 by the TGV Partners fund.
2. Investing in Tucows requires great confidence in the integrity and ability of management. Without getting to know and exchanging with the people involved over many years, the extreme fluctuations of the share price in the recent past would have been difficult to bear.
3. The Investmentaktiengesellschaft für langfristige Investoren TGV has been one of the larger shareholders in Tucows for several years and has a representative on the board of directors. The resulting stability gives the company the backing it urgently needs for its expansion.

In the 2022 annual report, I reported that Tucows had invested several hundred million US dollars in their “Ting fibre optic project” for several years. The financing for this project came from the cash flow of the domain business segment and was also covered by debt. By the end of 2022, around 100,000 of the 400,000 planned, self-built and owned addresses had already been developed, and Ting had just over 30,000 active customers.

I reported that Tucows missed an earlier, favourable time for comprehensive financing of the entire fibre optic project but had given itself space for further expansion through interim financing via preferred capital in late summer 2022. In perspective, this interim solution was sufficient to expand further into 2024. At the end of the year, however, there was still no final “major” and, therefore, viable solution for a full expansion of all planned networks.

In May 2023, the company hosted a “Capital Markets Day” in Toronto, where they wanted to report in detail on the plans and prospects for the next few years. Most market participants expected that the major financing solution for the expansion beyond 2024 would be announced by then.

In the weeks leading up to the Capital Markets Day, there was obviously panic in the market and enormous uncertainty about the company’s future. Generally rising interest rates, the lack of encompassing financing, and concerns about construction costs caused prices to collapse.

From the end of 2022 to April 2023, the price halved again to below USD 17 per share. And that after it was over USD 80 in 2021. This represents a -80% price drop, which is normally considered a spectre of bankruptcy. Given that Tucows has been one of the larger holdings in the TGV Partners Fund for years, this is a massive blow to the overall reported performance.

To illustrate how significant this impact on the TGV still is today: Suppose the TGV Partners Fund had exchanged its entire position in Tucows for a passive equity investment in 2018, for example an ETF on the MSCI World, the entire fund performance at price development in the first half of 2023 would have been around 25-30% (or almost + 4-5% p.a.) better than it actually was by April 2023. This is an enormous negative impact, which, on the one hand, highlights the risks of concentrated investing and, on the other hand, underscores Tucows’ extremely poor share price performance.

So was an investment at the time obviously a mistake?

Today, after a slight recovery to a price of USD 27, to me, Tucows is valued as if the fibre optics business had no value. Because for the domains business alone, I am estimating an intrinsic value of about USD 30 per share. This includes the debt that Tucows took on to expand the fibre optics division at the holding level.

At the same time, however, I do not doubt that the fibre business is of great value. Tucows has invested little more than USD 25 per share in the expansion of fibre optic connections over the past few years. To this day, I am convinced that the actual value of these investments far exceeds the associated costs. This value will continue to increase if the networks are expanded and finalized as planned.

Therefore, it was crucial that a comprehensive, structured financing solution was finally announced shortly before the Capital Markets Day in May: This financing solution means that Ting can use already connected households and subscribers as collateral at the subsidiary level. Suppose additional households are connected due to the subsequent construction progress. In that case, they can also be used as collateral, and further funds required for the construction can be accessed. With an interest rate of slightly above 8% p.a., this financing is not exactly cheap at first glance. In light of a significantly increased general interest level for longer-term corporate loans of currently more than 5% p.a. in the

USA and the extraordinary total loan amount and acceptability as collateral, which includes a significant part of the construction costs per connection, it is an excellent structure to finance further expansion.

Within the scope of the Capital Market Day, a final picture of the expansion and the final costs planned was also provided for the first time, a statement about “how it will look like when it’s finished”.

This plan envisages that Tucows’ networks will have around 400,000 to 500,000 owned addresses and just as many partner addresses over the next five to seven years. Partner addresses are owned and built by municipalities or public utilities with Ting’s help in the planning process. These networks are leased to Ting long-term and also operated by Ting. If at least half of all connected households use the offer later in time and as planned, this would mean more than 400,000 users who get their Internet connection through Ting.

According to Tucow’s CEO Elliot Noss, this project will result in a total investment volume of around USD 1.5 billion in just a few years, of which just over USD 300 million has been invested to date. A gigantic project, without question. The above-mentioned structured financing is an important component here and will account for the lion’s share of the further investments required.

A point of criticism from many observers is that the costs per connection planned by the company cannot be derived from the publicly reported figures. In fact, these total cost assumptions are difficult to verify, and it is virtually impossible to extract these numbers from public reporting because there are numerous different networks, all at different stages of construction, and each with high start-up costs. This would only be possible with comprehensive and transparent data access as part of a comprehensive due diligence process.

In this case, we are obviously and without question talking about an investment that is subject to numerous assumptions and imponderables. Without confidence that Elliot and his team are “doing the right thing” and that the projected costs are well planned, Tucows is difficult, if not impossible, to invest in. The project is too big, the path too unpredictable, and the goal too far in the future.

This leads to what I consider a significant risk, which would have become relevant for many other companies at the latest after the price fell again in March 2023: How do you ensure that you really get where you want to go without being thrown off the train on the way there? “ Knowing what it will look like when it’s done ” is good, but getting there is all that matters.

Many other companies would have called for the management team to be removed by spring at the latest. Some shareholders have certainly toyed with dismantling the company to quickly ease the share price situation. In many other situations, a lowball offer from a private equity company would certainly have meant the end of the journey to fibre optic land.

Here I draw a lot of confidence from the combination of the people involved, the value of the business model “fibre” and “domains”, and the shareholder structure. I am confident that our fibre odyssey will have a happy end. Furthermore, I have no doubt that Elliot and his team consider and treat their shareholders as partners and will find a way to close the extreme gap between the current share price and what I believe to be intrinsic value.

At the same time, the Investmentaktiengesellschaft für langfristige Investoren TGV is represented by Marlene Carl on the supervisory board. Marlene, the Chief Financial Officer of Chapters Group AG, has pursued her professional career in financing fibre optic projects and, thanks to her no-nonsense character, is undoubtedly an extraordinary asset for all long-term-oriented shareholders.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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