Description

Broadwing was formed in 1999 through the merger of Cincinnati Bell, an ILEC, with IXC Communications, a long-distance network provider. The current Broadwing is composed of these two segments and 80% ownership of a wireless division – an extension of the Cincinnati Bell wireline segment (AT&T Wireless owns the other 20%). The company currently has $2.6 bil in debt, a $150 mil preferred issue at the parent company level, and a $350 mil preferred issue at the broadband (the old IXC) level. BRW’s investment thesis is based on: 1) the ‘un-merging’ of the 1999 merger that created Broadwing, 2) the successful restructuring of the company’s bank debt, and 3) the free cash flow characteristics of Broadwing without its broadband subsidiary.

Broadband
BRW’s broadband unit is a national network that can handle voice and data traffic. The segment is similar to Level 3, WilTel (formally Williams Communications, another write-up of mine) and Qwest’s broadband unit, among others. That is, it is an ‘independent’ telecommunications network company that provides services to both other carriers as well as business customers. As has been well documented, the industry has struggled due to overcapacity, and there have been numerous bankruptcies. The company’s broadband unit has not been immune to this, and it has yet to generate positive ‘cash’ EBITDA, let alone positive FCF. With revenue growth nowhere in sight, BRW has decided to cut its losses and sell the business.

So, let’s see. We have a business that loses money at the EBITDA level, is not growing, and requires moderately expensive ongoing cap ex – there must be all sorts of companies interested in buying that! Well, actually there is. Due to the economics of the industry, BRW’s broadband revenues should generate tremendous cash flow on other networks (combined with the revenues already on those networks). This is the main reason behind Level 3’s acquisition of Genuity (another money losing competitor), and why Level 3 is currently attempting to roll-up the industry. Other than Level 3, recently emerged companies including 360 Networks and WilTel are also rumored to be looking to make acquisitions (360 actually already has, albeit fairly small). RBOCs may also be interested in the subsidiary, but their interest is probably minimal due to regulatory issues among other things. However, there are numerous industry participants that should be interested in acquiring the business, and BRW should be able to sell the subsidiary. (BRW has delayed reporting 4th quarter earnings until after the sale of the business. So, it appears a sale is close at hand.) What BRW can get for the subsidiary is an unknown, but a somewhat educated guess would put it between $250 and $350 mil.

BRW without Broadband
Assuming the company can find a buyer for the broadband segment, where does that leave BRW? Well, it basically turns it back into Cincinnati Bell, although with a lot more debt than it previously had on its balance sheet. That is, it reverts back to a stable ILEC business as well as a profitable and growing wireless business that dominates its local market. A business composed of those two units should generate tremendous amounts of operating cash flow, and BRW without broadband does. The numbers:

Over the last 12 months ending September 2002, BRW’s businesses excluding broadband generated $266 mil in CFFO and spent $140 mil in cap ex, thereby generating $126 mil in FCF. Subtracting $40 mil in preferred dividends and minority interest leaves $86 mil in cash flow to the common shares, or a 9.25% FCF yield at the current market price. Going forward, the company will be focused on FCF generation and de-levering the balance sheet. Hence, while interest expense will go up due to the financial restructuring required (mostly due to the Goldman Sachs financing – see below), cap ex should decrease materially (toward maintenance cap ex levels).

My pro forma ‘no growth’ numbers:

Revenue 1,100
Op. Income 370
Interest 190
EBT 180
Taxes (at 40%) 72
Net Income 108
Minority and Pref 40
To Common 68

Based on 240 mil diluted shares, the 68 mil in net income comes to $0.28 per share. Not too interesting. However, depreciation and amortization should be substantially above the company’s cap ex requirements. FCF to common shareholders looks something like this:

Net to Common 68
D and A 160
Cap Ex (90)
FCF to Common 138, or a FCF yield of 15.1%

Oh, did I forget the broadband segment has roughly $830 mil in NOLs that management has stated would remain with BRW after any sale of the subsidiary? So, the taxes I have forecasted for the company going forward would be a non-cash expense. That drives FCF up to $210 mil or a FCF yield of 23.0%. 15.1% is nice, but 23.0% is pretty outstanding. And, the FCF will be used to de-lever the balance sheet of the company, thereby reducing future refinancing issues for the company, and driving value to the common shareholders. That is, assuming the company is not acquired for its substantial FCF generation capacity.

Bank Debt Restructuring
Why would a company with the above characteristics need to restructure its debt? Well, due to expenditures at the company’s broadband unit, BRW has placed a substantial amount of debt on its balance sheet with most of it coming from bank lines of credit. Unfortunately, the sale of the broadband unit, if one occurs, will not come remotely close to covering the debt invested in the subsidiary. And, while the cash flow of the other businesses should more than cover financial and operating expenses going forward (see above), it will not be able to generate enough cash to pay down the roughly $1 bil of debt that comes due in 2004. While rolling over this debt would be almost automatic without the broadband unit, the potential of future cash losses from the unit has put BRW’s ability to refinance in question.

To remedy the situation, BRW has received a financial commitment from Goldman Sachs for $350 mil at 16% interest (12% cash, 4% PIK). As part of the deal, Goldman also receives 17.5 mil warrants struck at a yet-to-be-determined price. The financing is contingent upon BRW restructuring its bank debt (i.e. pushing out its maturity schedule), and will be junior to all other company debt. The financial commitment obviously came at a very high price, but the company believes the commitment (potentially combined with the sale of the broadband unit) should allow it to successfully renegotiate its bank debt maturities.

Conclusion
BRW is an extremely interesting situation. At its core, the company generates a tremendous amount of cash flow that has been hidden over the last few years by it money losing broadband unit. With the sale of the broadband unit, the cash flow characteristics of the other businesses should become apparent, and the company should be able to renegotiate its debt obligations in the short term, and pay down its debt in the long term (if it is not acquired). Based on the cash yield of the core business, I think the company’s stock is extremely undervalued. Ignoring broadband, the stock is currently yielding over 20% on a FCF basis; a 10% yield would equate to an $8.75 stock price. Of course, the stock could yield even less (should yield even less in my opinion), and the proceeds from the broadband sale could provide another $1.00 per share or so of value. So, $8.75 may prove too low. Also, the company would be an attractive acquisition candidate for both industry (notably SBC) and financial companies.

Risks
BRW cannot sell the broadband unit.
If BRW fails to sell its broadband unit, the company is stuck with a cash burning subsidiary. It could potentially shut down the unit completely, but that would burn even more precious cash as it is forced to cancel numerous access and co-location contracts. Some estimate this cost to be roughly $300 mil. Fortunately, I believe this risk is minimal, as there are numerous interested parties in the network and its client base (as discussed above).

Failure to push out bank debt maturities.
Without the broadband unit, BRW suddenly becomes a tremendous cash flow machine. However, it will not be able to generate enough cash to pay down its bank debt that matures in 2004 (as discussed above), and the company must find a way to extend the maturity of that debt one way or another. This risk is severely muted, in my opinion, due to the cash flow nature of the company, as the company should be able to find sufficient financing if it cannot successfully renegotiate its current facility.

Catalyst

Sale of the broadband unit.
Renegotiation of the bank debt maturity schedule.
Generation of significant free cash flow.
Deleveraging of the balance sheet or acquisition.