Description

Situation overview

Consolidated Communications (‘Consolidated’ or ‘CNSL’) is a telecommunications company that provides voice, video and

data/internet services to residential and commercial customers. The company has attempted to offset declines in its legacy highmargin

voice business through growth in its commercial/carrier business and through M&A, having spent an aggregate ~$2.3bn on

acquisitions over the past 5 years (including their most recent $1.5bn acquisition of FairPoint in Q2’17). We believe these efforts will

ultimately be insufficient to stem the overall tide and that the PF business will continue to deteriorate for the following reasons: 1)

high-margin voice revenue (~30% of the business) should continue to decline as the business shifts to wireless; 2) data/broadband

(~46% of revenue) will face increased competition from cable/other CLECs and ILECs/wireless carriers (e.g. 5G/fixed wireless)/other

ISPs (e.g. Google Fiber) over time (and moreover this is margin-dilutive); and 3) network access/subsidy revenue will gradually

decline due to lower CAF subsidies and access fees. Furthermore, we believe the recently closed FairPoint acquisition creates an

interesting entry point for the short due to complexity (e.g. lack of detailed PF financials, capital structure, etc.), lack of sell-side

coverage (4 analysts) and misdirection (e.g. the co reports a PF dividend payout ratio of ~57% but this doesn’t consider working

capital requirements, lease payments, mandatory amortization or pension contributions). As results continue to deteriorate, we think

the stock will de-rate from ~6x 2018e EBITDA to the current ~4.8x trading multiples of other RLECs (i.e. FTR, WIN, and CTL).

Investment thesis and summary

We think CNSL’s business is challenged and that the stock is a short at $12.85 (2.3x / 6x 2018e revenue / EBITDA) for the following

reasons:

1. Legacy, low-return business model with minimal FCF generation that is being disrupted/pressured by wireless, cable and

OTT video (standalone CNSL ROIC has consistently declined to ~5% in 2016 and ROIC of the PF combined business is

approximately ~3% as of 3q17).

2. Roughly 30% of CNSL’s PF revenue still comes from legacy voice lines (approximately 15% residential and 15%

commercial/carrier), which is a business that is declining 8-10% y/y as everything shifts to wireless (e.g. PF voice

connections declined -7% y/y in 3q17). We expect these declines will continue/potentially worsen going forward. Moreover,

this is one of CNSL’s highest-margin segments (in addition to access/subsidy revenue), which will result in margin pressure

as the business continues to shift away from voice.

3. CNSL has tried to respond to the legacy voice declines via broadband/data growth (with a specific focus on the

commercial/carrier segment vis-à-vis enterprise services, wireless backhaul, etc.; broadband revenue in aggregate accounts

for ~46% of PF revenue), but we expect that this will be pressured over time as well due to cable competition and wireless

providers pushing back on rates on contract renewals (e.g. CNSL had previously been targeting 3% growth in its

commercial/carrier business but recently stepped back from this as PF commercial/carrier revenue declined -2.3% y/y in

3q17).

4. Network access fees will continue to decline as FCC reform systematically reduces minute-of-use-based access rates, which

carriers are supposed to (try) to make up for via subscriber charges (e.g. PF network access revenue declined -12% y/y in

3q17).

5. High-margin CAF subsidy revenue will take another step-down in 2018e as CNSL transitions entirely to CAF II funding

(specifically, total PF CAF funding will decline from $62.7m to $50.5m per year beginning in August 2018).

6. Margin dilution as the business mix shifts more towards lower-margin bandwidth/commercial/carrier revenue.

7. Continued topline declines and margin pressure are expected to drive EBITDA and FCF decreases such that the dividend

(~$110m/yr or approximately ~12% current yield) is pressured and debt covenants are eventually breached.

8. Potential de-rating from ~6x 2018e EBITDA to the ~4.8x EBITDA multiples of peers (i.e. WIN, FTR and CTL).

Net-net, we like the short here at $12.85 (2.3x / 6x 2018e revenue / EBITDA) and see 24-month upside of 70%+ to ~$4 total value

(5.3x base-case 2020e EBITDA + two years of $1.55 per share dividends) and ~35% risk to $17.50 total value (5.8x downside 2020e

EBITDA + two years of $1.55 per share dividends).

Business overview

CNSL is a telecommunications company that operates as both an Incumbent Local Exchange Carrier (‘ILEC’) and a Competitive

Local Exchange Carrier (‘CLEC’) dependent upon the territory served. The company provides several products/services to

residential, commercial and carrier customers across 24 states (PF for the FairPoint deal in 2q17), which include: local and longdistance

service, high-speed broadband Internet access, video services, Voice over Internet Protocol (‘VoIP’), custom calling features,

private line services, carrier grade access services, network capacity services over regional fiber optic networks, data center and

managed services, directory publishing and cloud data services. Approximately 42% / 39% / 6% / 12% of the PF business consists of

commercial/carrier / consumer / subsidy / network access revenue, respectively, with 684k residential customers (~28% of

homes in the co’s footprint subscribe to its data service) and ~1.9m total connections (i.e. voice, data and video across residential,

commercial and carrier).

Continued declines in the legacy/PF business

CNSL’s legacy standalone business has declined 4%+ per year as customers cut their phone lines (moving to 100% wireless) and as

competition from cable has increased (an estimated 80%+ of CNSL’s footprint overlaps with cable providers). We expect this will

continue going forward primarily as a function of increased cable competition (i.e. cable offers faster data speeds at equivalent

monthly pricing). Moreover, it is cost-prohibitive for CNSL to try to upgrade speeds via fiber (only ~40% of CNSL’s homes are

covered by fiber), which costs upwards of $1,000+ per home to roll out (this is also why the RLECs have historically generated

minimal free cash flow). And while the co states that ~28% of homes in their footprint subscribe to its data service, total residential

customers have been declining 5%+ per year (and thus legacy CNSL market share has declined from ~37% of marketable homes in its

footprint to ~33% in 2016).

Moreover, the FairPoint deal only worsens the PF trends as FairPoint underinvested in its network (e.g. FairPoint was spending capex

at 13-14% of revenue vs CNSL at 16-17% and only ~50% of homes in FairPoint’s footprint could get 15mbps+ speeds vs nearly

100% in CNSL’s footprint). Indeed, the rate of decline in total connections has worsened from -1.9% y/y for legacy CNSL to -4.3%

for the PF business and consumer ARPU has decreased from $83.90/mo to $70.44/mo. This is entirely a function of worse trends in

the legacy FairPoint business, which has seen 7-8%+ declines in total connections per year and minimal FCF. We expect this will

continue going forward.

The deterioration in the PF business can also be seen in the decline in ROIC from ~5% for legacy standalone CNSL to ~3% for the

combined business as of 3q17.

CAF funding and access fees

In addition to connection declines, we expect CNSL’s subsidy and access-fee revenue (which collectively account for 17-18% of the

PF business and declined -11% y/y in 3q17) will continue to decrease due to 1) reduced minute-of-use-based access rates as mandated

by the FCC and 2) a final step-down in CAF subsidy funding in August 2018. PF network access revenue decreased -12% y/y in 3q17

due to lower per-minute fees and we expect similar declines going forward. Moreover, a final step-down ($12.2m on an annualized

basis) in CAF subsidy revenue will occur in August 2018 as transitional CAF I funding goes away. Note also that this is very high margin

revenue and will thus be dilutive to overall margins.

Model highlights, dividend coverage and covenants

We believe the topline and margin pressures mentioned above will result in continued 3-4% revenue declines per year and a decrease

in overall EBITDA margin from 37-38% to 35% (or below) over time. More importantly, should this occur, the co will likely have to cut its

~$110m/yr dividend either because it breaks debt covenants or because it runs out of cash

(or both). The most restrictive dividend covenant is the term loan’s 5.1x net leverage ratio (the notes have a 4.75x net leverage

dividend covenant but there’s a large [~$800m] basket/carve-out in the event the co breaches 4.75x), and we believe CNSL will be at

risk of breaking this covenant sometime in 2019e or 2020e. Moreover, while the rationale of the FairPoint deal was allegedly to

improve CNSL’s dividend payout ratio from ~70% to ~57%, this does not consider changes in working capital, lease payments,

mandatory debt amortization or pension contributions. Fully burdened, CNSL’s payout ratio is likely >100% (see below) and the co

will have to start drawing down its revolver to fund dividend payments in 2019e. All of this makes an eventual dividend cut at some

point likely (current ~12% yield), which could potentially cause the stock to de-rate (similar to what happened to WIN when it cut its

dividend).

We see a 70%+ 24-month upside to the short to ~$4 (based on a de-rating to 5.3x base-case 2020e EBITDA [which would be more inline

with CNSL’s RLEC peers at ~4.8x] + two years of dividends) and a 24-month risk to the short of ~36% to $17.50 (based on 5.8x

downside-case 2020e EBITDA + two years of dividends), which equates to an attractive risk/reward of approximately 1.9x.

We see an expected value of ~$6.50 for CNSL stock or -50% vs the current $12.85 price.

Catalyst

1. Comlink RLEC/wireline data shows declined

2. Employee headcount cuts do nto keep up with topline declines

3. Price pressure in key markets