3 Reasons Why Mitel Is a Value Play

Mitel Networks Corp. (NASDAQ: MITL) is a unified communication company involved in the provision of voice and video services. The company’s primary expertise includes IP-based telephony along with cloud collaboration services. Other key players in the industry include Cisco Systems Inc. (NASDAQ: CSCO), Microsoft Corp. (NASDAQ: MSFT), Avaya and ShorTel Inc. (NASDAQ: SHOR).

Mitel generates most of its revenue from on-premise communication and collaboration services for enterprise clients. It recently divested its mobile segment to focus on cloud transition. This development coupled with fear-induced discounted price makes Mitel a decent buy. Let’s dive into details.

Mobile business divestiture

Toward the end of 2016, Mitel decided to divest its mobile business for $350 million in cash alongside $35 million noninterest-bearing note and equity interest in Sierra Private Investments LP. The divestiture is important from an operation perspective as this allows Mitel to focus on the growing unified collaboration and communication (UCC) market. But how does this add value?

• First, leverage of the company is reduced as a result of the deal. Gross leverage has decreased from 3.3x to 1.8x. This reduction in financial risk naturally decreases the risk and required rate of return for investors leading to a higher value.
• Second, mobile business was a loss-making business as net loss for the year ended December 2016 amounted to $252.3 million compared to a net income of $35 million from continuing operations during the same period.

One of the primary reasons for Mitel’s low valuation was its loss-making business. As the company sold its loss-making operations, a higher valuation is warranted. Moreover, it’s not just numbers. The divestiture allows the company to focus on the growing unified communication market, which is a higher growth market as compared to the mobile business sold by Mitel.

UCC growth and cloud transition

As mentioned above the company is now focused on unified collaboration especially cloud collaboration. The UCC market is set to witness double-digit growth going forward. Industry observers are projecting health growth prospects. See the table below:

Note that IP PBX is among the primary markets for Mitel. Despite strong growth forecasts, though, Mitel is priced at ~10 times 2017 earnings. This is cheap given the fact that 13% p.a. growth will lead to a PEG of 0.80 indicating value growth. Growth forecasts are complemented by Mitel’s cloud growth as the cloud segment witnessed 90% growth during the first quarter. Why is the market not pricing Mitel accordingly?

As Mitel generates most of its revenue from on-premise cloud, the market fears that Mitel might not be able to transition successfully toward cloud. Note that Mitel generated 60% of its revenue from on-premise customers during the year ended 2016.

This fear is what creates the value opportunity. Mitel already has a strong on-premise customer base that will prefer Mitel’s services when moving to cloud. Why?

Changing suppliers is not without costs, and trusting new suppliers’ product is barrier to change. More importantly, due to the modular nature of Mitel’s products, the company is able to offer cloud migration cost effectively. All in all, it’s highly likely that on-premise customers will transition to Mitel’s cloud platform. Therefore, discounting Mitel because of a high on-premise presence doesn’t seem like a good idea.

Moreover, industry watchers put Mitel’s products in a high league. According to Gartner, Mitel is a visionary in the unified cloud-as-a-service (UCaaS) market. It’s also named a leader by Gartner in three Magic Quadrants, including unified communications, unified communications for mid-sized enterprises and magic quadrant for corporate telephony. Frost & Sullivan believes that Mitel is one of the thriving providers of UCaaS and hosted IP services in the U.S.

Overall, the argument of failed transition and halting growth isn’t backed by detail. Mitel’s performance, industry growth forecast and expert opinions conforms to that. Once the market appreciates the fault in these arguments, the stock will probably move toward its fair value.

Valuation

Mitel is priced cheaply given the fact it’s trading around a forward price-earnings (P/E) of 10. Despite market fears, earnings are expected to witness growth during the next couple of years. Positive earnings, thanks to its Mobile divestiture, also paint a favorable picture for Mitel as far as valuation is concerned. Analysts are expecting an EPS of 81 cents for the year ended 2018, translating into a 16% p.a. growth since 2016. This growth conforms to the industry forecasts of double-digit growth. The point is, double-digit earnings growth backed by a strong industry outlook warrants a higher P/E than 10. Moreover, GuruFocus' fair value calculator reveals significant upside.

Source: GuruFocus

The valuation sheet reveals a price of $9.46, translating into an upside of around 26% with a 21% margin of safety. This valuation is also supported by P/E-based valuation. See the chart below:

Based on earnings growth, price is expected to touch $11 going forward.

Final thoughts

Divestment of the mobile business allowed Mitel to reposition itself as a unified communications pure play, resulting in an improved bottom line. Cloud transition for clients is supported by high quality industry-backed products and cost incentives. Successful transition toward cloud will further improve the bottom line. As Mitel is trading at a lower multiple, earnings growth will result in fair value increase going forward. Fair value and P/E-based valuations complement the analysis.

Mitel is a reasonably priced stock in the unified communication industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.