Description

Arch Wireless is largest paging company in the U.S., with approximately 35% of the market (measured by units in service). A previous write-up on Arch, which recommends the bonds, provides good detail on the history of the company, the events leading up to the Chapter 11 filing and subsequent emergence from bankruptcy with a much more sensible, delevered capital structure. With the company well on its way to becoming debt free, the equity value has increased significantly, with the stock rising from around $2.00 at the beginning of the year to the current $20.00. Even with this type of appreciation, I believe there is further upside, well into the high 20s or low 30s. I recommend buying the stock at current levels.

Arch emerged from bankruptcy in May 2002 with $300 million in debt. At the end of this year, this balance will be down to $60 million. Management’s strategy of cutting costs (particularly heacount) has resulted in much lower operating expenses. This, combined with a subscriber decline that has slowed signficantly and a reduced capex spending program, has resulted in better than expected free cashflow generation.

In order to gain more comfort with the equity, we need to examine two issues in greater detail: topline erosion and the potential for futher cost reductions.

TOPLINE EROSION
There is no doubt that the rate of subscriber decline has slowed. Both Arch and Metrocall (the other major paging company, with a 30% market share) have demonstrated this on a quarter-to-quarter basis. The following table shows the number of direct units in service and ARPU at the end of each period:

# of Direct Units(000) Chg ARPU
Q1 2002 5,517 (399) $9.34
Q2 2002 5,152 (365) $9.40
Q3 2002 4,806 (346) $9.58
Q4 2002 4,312 (494)
Q1 2003 4,031 (281) $9.89
Q2 2003 3,787 (244) $9.92
Q3 2003 3,600 (187) $9.96


But the slowing rate of subscriber decline is only half the story, since most of the attrition has come from the reseller accounts, which had much lower ARPUs. As a result, overall ARPU increased, further mitigating the subscriber loss impact on net sales. In addition, the overall credit quality of the consumer went up, as evidenced by a drop in bad debt expense. So basically, not only is Arch retaining higher paying customers, but better quality ones as well.

POTENTIAL COST SAVINGS
Arch has made great strides in cutting operating expenses. G&A, which represents the bulk of the operating expenses has come down every quarter since Q4 2002:

% of Sales
Q4 2002 32.0%
Q1 2003 29.8%
Q2 2003 28.5%
Q3 2003 27.5%

While significant progress has already been made, Arch has much more room to cut, especially in the headcount area. I believe that the slowing subscriber growth and an increased focus on cutting more headcount will lead to a stabilization of cashflow in the next couple of quarters. This has already occurred at Metrocall, where EBITDA has actually increased every quarter this year.

ARCH/METROCALL MERGER
I believe that a merger of the two companies is not a question of “if,” but “when.” Economically, both parties have to realize that a merger makes all the sense in the world. The networks are completely compatible, so there will be minimal disruption, if at all, to the consumer. There is also a lot of redundancy in the regional sales coverage, so personnel could be reduced, along with numerous corporate functions and offices. Network capacity could be more efficiently utilized, since both companies operate on the identical Reflex technology. Capex could also be cut down signficantly. Both companies would benefit from Arch’s $175-$200 million in unrestricted NOLs. All this translates into increased free cashflow, which has a direct impact on equity. I’ll put some approximate numbers on this.

Q3 2003 RESULTS ($MM)

Arch Metrocall Combined
Net Sales 143.6 78.4 222.0
Operating Expenses 99.0 52.0 151.0
EBITDA 44.6 26.4 71.0
Capex 8.7 2.7 11.4
EBITDA-Capex 35.9 23.6 59.5

Given the redundancies in the operating expense structure of both companies, I estimate an annual savings of close to $100 million on a pro forma basis (which they can achieve relatively quickly due to the overwhelming similarities in the business), and a capex savings of $5-$7 million. This is how it lays out on an annualized pro forma basis:

Combined Numbers ($MM)

Annualized Q4 2003 Net Sales 850.0
Annualized Q4 Op. Expenses 570.0
Combined EBITDA 280.0
Potential Savings (90.0)
Pro Forma EBITDA 370.0
Combined Capex 10.0
Pro Forma EBITDA-Capex 360.0

Even if we were to put a conservative 3x multiple on a pro forma combined EBITDA-Capex number of $360 million, I get an equity valuation of $1,028 (taking into account debt, preferred and excess cash). If both companies share this value equally, it would imply close to a 40% upside from current levels (one could argue that Arch may be entitled to more of this value, since it contributes more in cashflow and the large NOL).

With both Arch and Metrocall, the visibility of free cashflow is improving as the months go by. Both companies seem to have a firm grasp on the cost side, and every month the subscriber decline is getting more under control and more predictable. Even if the there was a sharp drop in the overall health of the U.S. economy, both companies have already lost the marginal customers and pager usage is not sensitive to economic cycles. The bulk of the current customers are here to stay. With the relatively cheap monthly charge for a pager, price will not be a determining factor for healthcare, corporate and government institutions that are relying on the most efficient, narrowband communication device out in the marketplace.

Catalyst

- Inevitable merger of Arch and Metrocall.
- Continued improvement and gradual uptick in cashflow as a result of lower expenses and slowing attrition rates.