Wisdom from the Street — High Margin is Bad

September 11, 2008

One of my readers, Mark Miller of Miller Capital Partners, wrote asking about my thoughts on an announcement by TWTC:

Any thoughts on the announcement today from TWTC (a big fiber owner), recent issues with CCOI [Cogent], while LVLT [Level 3] and GLBC [Global Crossing] say no slowdown in sight?  Is it that TWTC have so much voice and CCOI sells basics, whereas LVLT and GLBC have a different revenue base?  I guess we’ll see what LVLT and TWTC have to say later today.

First of all, thanks for writing, Mark.  I really enjoy hearing from other professionals about telecom topics such as this.

For those not following the story, TWTC filed something with the SEC yesterday and said that they are experiencing churn from their very small customers who are not paying their bills.  Well, as soon as the Chicken Littles got this news, the knee jerk reaction is to downgrade.  I say upgrade TWTC; this is good news.

The Street reaction to the tw telecom filings, per usual, just demonstrates to me, again, a major disconnect between Wall Street and reality.  Once again, Wall Street does the “the sky is falling” routine.

Want a stock tip: buy TWTC courtesy of Wall Street Analysts that are short sighted.  Clue: You can’t find an analyst on Wall Street that has run a telecom firm that can distinguish between staying power and last night’s date.

Wall Street has some kind of Oedipus complex with top line revenues.  Any disruption to revenue growth, well, that is not acceptable. When will Wall Street start realizing this game is about predictable margin and profitability growth?

If “small customers” (a/k/a Type 2 **) are churning out of TWTC, this is good.  These marginal, no growth, financially strapped customers are leaving for another carrier.  I say lets get a cake and have a party.  TWTC margins will improve!  Low end, low margins v. high end, high margin customers … what’s the problem?  Rejoice!

I would be more concerned if TWTC were having a run on the on-net customers since these are high margin, high revenue customers.  But they are not and will not because TWTC owns local fiber optic infrastructure.  Metropolitan fiber allows you to play at the 70% – 85% gross margin level with on-net customers; it’s the type 2 customer that drags down margins.  Type 2 customers – good riddance — have a piece of cake on the way out.  Go back to Ma Bell where you belong.

So, in my simple way of thinking, since tw telecom does not make sub-prime mortgage loans, manufacture automobiles or build houses, I think they are a buy.  Funny thing – the credibility of Wall Street firms – they create the bubbles and somehow want to be seen as credible.  To Citicorp that provided a downgrade take note: people who live in glass houses should not be throwing any stones.

Do your homework, and jump on buying opportunities like this when the uninspired, inexperienced Wall Street spreadsheet jockeys hand you a gift like today’s.

** Type 2 describes when a provider like TWTC buys a circuit wholesale from the phone company (because they don’t have a particular building On-net), and they then resell this circuit to an end-user.  AFS does Type 2 circuits less than 5% of the time. Paetec is 100% type 2.

Shoot me an email or add a comment below.

Written by Dave Rusin - Telecom Executive
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