Questions about Genuity

As Genuity launches a high-profile new product, Black Rocket services, concerns about its business model and valuation remain.

Access the numbers here.

by Manish Aurora
of rationalinvesting.com

Genuity Inc. (GENU)is a wholesale (to ISP) and retail (to business) seller of internet access. It is trying to grow its high end hosting, e-business infrastructure and digital access services under the Black Rocket brand. It plans to deploy fiber-optic networks for corporate intranets, content delivery, as well as services such as Virtual Private Networks (VPN's) and Voice-over-Internet Protocol (VoIP). The bulk of its revenue, however, still comes from access and AOL contributes almost half its revenues.

Genuity has a billion dollar revenue run rate but is losing money on a cash basis. A spin-off of GTE, it has $2 bn in cash and almost as much in hard assets with little debt. Its Market to Book Ratio is 0.4. and the book value is understated by a massive accumulated deficit i.e. it is trading for less than the cash on hand or its depreciated PP&E (property plant and equipment), much less the sum of the two. This is a low valuation, and one that seems to reflect low expected returns on assets.

One reason GENU is down is that growth in the ISP sector has vaporized, yet the firm continues to offer its services at loss-making prices. Why? If continuing costs were that much lower than initial cost of goods sold, it should have started showing up on its income statement by now. However, if (and this appears to be the case) they are selling services at a loss despite achieving scale, then there is a serious problem with their pricing and especially their negotiation with AOL, which seems to be driving much too hard a bargain. Are switching costs for AOL (to another vendor) that low?

It is not possible for AOL to get out immediately if Genuity were to price for profits (assuming someone else is willing to serve AOL at a loss perpetually.) If so, who cares? The business is not worth holding on to at these levels. This stock is cheap for a reason: the management is unable to tell the markets what it plans to do with investor assets. The firm just signed a $2 billion line of credit with Chase and other banks to back bond issues. They plan to spend $4 billion, presumably on building fiber-optic networks and data centers. For what rates of return? Will Black Rocket really offset the losses from serving AOL? Their SEC filings do not clarify this in the least. Our Free Cash Flow model describes what is possible, but not what is probable.

With no telecom convert issues remotely possible, and the high yield new issue market out of business, what are they thinking? If they believe they have a high growth plan that, oxymoronically, can get funded by investment grade debt despite negative cash flow, then they really need to tell the market what magic wand they are waving. The stock is trading below IPO price, destroying the logic of 'unlocking shareholder value' that drives spin-offs. This financial statement makes us feel that GTE abandoned a problem child, and smoothly dumped it on the public to boot (the stated reason is required divestiture due to the merger with Bell Atlantic, with certain options that would enhance their ability to regain control of the company buried in the prospectus). We are lost trying to understand this firm's strategy with publicly available information.

Related article
For a more detailed discussion of the method of www.rationalinvesting.com, see our article, "Pricing A Stock."

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