Description

Arch Wireless (AWIN) is a wireless paging company that grew, mostly through acquisitions, into the number one company in the industry. Unfortunately for Arch, those acquisitions left it far too levered. Laden with debt, it filed for chapter 11 bankruptcy protection in 2001. It emerged in 2002 with much of its debt erased, but faced - and faces life as a leader in a declining industry. Subscribers have declined precipitously in the face of competition from cellphones, blackberries, etc. However, Arch’s management has moved aggressively to cut costs and, as such, has managed to keep its cash flow reasonably stable, growing free cash flow from 2002-2003 even as revenues declined 23%. That said, the rate of subscriber shrinkage has been declining, as the business trends towards supporting a core group of customers in certain fields (medicine, construction, trucking, etc) that will continue to find pagers a favorable low-cost alternative to cell phones and email devices. (This is not intended to paint a rosy picture of the customer situation: it is highly likely that the paging industry will continue to decline for some time before eventually reaching its core, at which point the question will be whether or not paging companies can keep costs low enough to support such a small group of subs).

At the end of March, Arch announced a merger with Metrocall Holdings, Inc. (MTOH), the number two player in the industry. MTOH has a profile similar to AWIN: entered bankruptcy with too much debt, re-emerged delevered, cut costs in the face of declining subs, etc. Under the terms of the merger, AWIN shareholders will receive one share of newco stock for each share of AWIN that they own. MTOH shareholders will receive $75 in cash (up to $150mm in aggregate) or 1.876 shares of newco for each share of MTOH (Newco will have 27.495mm shares outstanding). AWIN shareholders had to retain a high percentage of the combined newco so as to not have a change of control and thus preserve AWIN’s substantial (>$250mm) NOLs for future use.

In addition to cutting costs, both AWIN and MTOH have been using cash flow to redeem debt. MTOH is now debt/preferred free (as of 5/17) and AWIN redeemed the $20mm of 12% notes that remained on its balance sheet on May 28th. Newco will incur some debt as a part of the transaction (for the cash payment to MTOH shareholders). I anticipate that this will be in the neighborhood of $90MM, since part of the cash payment will be made with (1) cash currently on the balance sheet and (2) cash generated between today and the transaction’s close (projected to be 4Q 04).

When the companies are combined, you are looking at a company that will throw off roughly $220mm of free cash flow per year before any synergies are realized. The companies forecast cost savings of roughly $58mm for the year ended 12/31/05. Newco will have a roughly $795mm market cap, using AWIN’s stock price as a proxy. Add 90mm of debt and you have a $885mm EV. Compare that to the $280mm of free cash flow generated, and you have a pretty good deal. AWIN at 28.87 is 3.16x free cash flow, or, if you prefer, a 31%+ free cash flow yield. Not a deal you find every day. All of the debt will be paid off after the first year, at which point the company will return cash to shareholders through dividends and buybacks.

Risks to the deal are as follows:

1) Department of Justice/FCC issues: Newco will have 67% of the wireless paging market. 70% is apparently the definition of a monopoly according to the DoJ. In a move that was not a surprise (according to AWIN management), the DoJ has given the companies a 2nd request for information regarding the merger. AWIN believes that the DoJ will ultimately treat this as they did AWIN’s purchase of PageNet a few years ago, whereby the market was defined broadly as wireless communications rather than narrowly as wireless paging. After all, AWIN and MTOH are losing subs to wireless phone companies, not to paging companies. Moreover, the companies will assert that, if the merger does not go through, they will have to scrap service in certain rural areas due to cost issues. In other words, if the deal were scuttled it would hurt some of the very people that the scuttling was designed to protect. My feeling from having spoken to DoJ officials is that this is probably the case. Furthermore, according to FCC officials, the FCC had planned to use “streamlining” treatment to review the merger (that is, the merger would be approved on a 45 day cycle if no opposition was received). The DoJ’s issuing of a 2nd request has resulted in the FCC using the standard 180 day review process. It would seem that the FCC’s original plans to streamline the review process indicated that it views the merger favorably. To some extent, I would guess that the DoJ would hesitate somewhat before attacking a transaction that the FCC considers benign.

2) Metrocall shareholder disapproval: MTOH shares reacted very negatively to the deal, and two large shareholders (PPM and Scion, 3% and 8% holders, respectively) have come out against the deal. True, but they’ve a long way to go. According to management, other large shareholders “easily totaling 50%” have voiced approval for the deal. “Shareholder approval won’t be an issue”.

3) Management may decide to become a trading card company: Or whatever. My point is that they may decide that, since they have this declining cash generating business, they will use it to turn newco into some kind of “growth” company. See Octel (OTL) management’s decision to take cash generated by its declining TEL business and acquire lower-multiple, risky specialty chemicals assets rather than giving money to shareholders for an example of this. I have spoken to management at length and they have assured me that this in not even on their radar screen. Moreover, the company is effectively run by the old distressed bondholders who took it through the bankruptcy process and ended up owning the company. You can bet that they wouldn’t let this risk come to fruition.

4) Liquidity is low; it’s hard to build a big position and the name bounces around as a result. True, but when the companies are combined the size will allow for far more liquidity and will hopefully mitigate some of this problem. I am also not convinced that this is enough of a reason not to own.

5) No real hedge: I don’t have a good answer for this one, other than that you’re getting a company really cheaply and, if it trades down, you may want to use that as an opportunity simply to buy more. If the deal breaks, AWIN will get hit, but you will still be getting a darn good FCF yield.

As an aside, AWIN will be added to the Russell 2000 index on June 25th, with roughly 1.1mm shares to buy. I am fairly skeptical of index trades, but there will be some amount of demand from index funds later this month.

Catalyst

Resolution of DoJ issues
Completion of merger
Cash flow