Consolidated Communications CNSL S
February 20, 2015 - 10:53am EST by
jdr907
2015 2016
Price: 23.86 EPS .56 .8
Shares Out. (in M): 50 P/E 42.5 29.9
Market Cap (in $M): 1,203 P/FCF 13.4 0
Net Debt (in $M): 1,379 EBIT 0 0
TEV ($): 2,582 TEV/EBIT 0 0
Borrow Cost: General Collateral

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  • dividend cut
  • Telecommunications
  • Regulatory Downside Risks

Description

Opportunity

 

·      Consolidated is an acquisitive high yielding rural local exchange carrier (RLEC), with consumer and enterprise operations in 6 states – most importantly Texas, Minnesota & Pennsylvania.  The company recently acquired Enventis, another RLEC in Q4 2014.

·      Consolidated is trading near the lowest dividend yield in 10 years 6.4% (although it dipped below 6% in December) – which would make sense given interest rates if the dividend was safe.  However, the market is completely missing the likelihood for a dividend cut for several reasons

o  Wireless partnership income from Verizon slowing

o  USF subsidies begin to step down in mid year 2015

o  Begin to pay cash taxes in 2014, ramping in 2015

·      Regulatory revenue currently provides 50% of discretionary FCF available for dividends, and over the next three years will step down by 50%.  This alone renders them unable to pay their dividend.

·      They touted the recent Enventis acquisition as a success b/c they anticipate that after getting full opex synergies of $14 mm in 2 years, they will have leverage that is below 4x (now at 4.25x). 

o   What is missed, is that this is a highly dilutive transaction to EPS and FCF/shr for a number of reasons:  a) very large equipment sales business at Enventis business that is declining b) lower core EBITDA margins c) higher capex intensity d) all stock transaction increases their dividend payout

·      This all adds up to actual dividend coverage ratio close to 100% - although in their press releases they ignore certain important cash flow details, getting to a payout ratio of around 70%.  

o   CNSL will have burned through all of their NOLs by YE 2014 - and will be a full tax payer, however bonus deprecation will help on the margin.

o   CNSL has an underfunded pension , requiring between $10-$15 million of contributions annually

o   Term Loan requires an additional $12 million of annual amortization paid quarterly which began in 2014.

·      The company has small ownership stakes in 5 Verizon Wireless partnerships – which generate roughly $35 million of dividends (all FCF) annually.  This had been growing at low double digit rates until Q3, where it declined for the first time. 

o   This line item should continue to be under pressure on a go forward basis given the state of the current wireless market.  As VZ guided to higher churn, declining wireless margins, flat capex and higher cash taxes, dividends at the partnership level will get hit.  The two largest DMAs are Houston and Minneapolis

o   Verizon’s shift away from handset subsidies to Equipment Installment Plans (EDGE) – has a significant working capital drain on FCF until the company reaches a run rate level of subscribers on EIP – unlikely for ~2 years - this will also hit partnership dividends

 

·      CNSL is also beginning to deemphasize the residential video business – where it had invested significantly over the past few years.  The company is struggling with cash flow in this business given a lack of scale, and ever increasing content costs.  This should add additional pressure on the revenue line, as the company shifts ad spend away from the triple play, and focuses on broadband

 

Capital Structure            
             
        Trading Information  
Current Price   $23.86   52 Wk High   $28.81
Fully Diluted Shares Outstanding        50.434   52 Wk Low   $18.42
Market Capitalization    $      1,203   Beta                0.96
Cash                  0   % Short / Float 5.8%
Total Debt           1,379   ADV           338,650
Total Enterprise Value    $      2,582   Dividend Yield 6.5%
             
Summary Financials            
             
FY Ended 12/31     2013 2014E 2015E 2016E
Revenue Estimates      $         601.6  $       637.2  $         783.3  $         772.8
% Growth     NM 5.9% 22.9% -1.3%
Adjusted EBITDA Estimates    $         287.2  $       286.1  $         327.8  $         323.1
% Margin     47.7% 44.9% 41.8% 41.8%
% Growth     NM -0.4% 14.6% -1.4%
FCF after OPEB                  54.2             74.3              89.5              83.9
% Margin     9.0% 11.7% 11.4% 10.9%
% Growth     NM 37.0% 20.5% -6.3%
FCF after OPEB, Term Loan Amort    $          45.0  $         65.1  $          80.3  $          74.7
% Margin     7.5% 10.2% 10.3% 9.7%
% Growth     NM 44.6% 23.4% -7.0%
CNSL defined FCF - Cash to Pay Dividends  $          97.0  $         89.8  $         100.7  $          97.8
% Margin     16.1% 14.1% 12.9% 12.7%
% Growth     NM -7.4% 12.2% -2.9%
FCF / Share     $2.41 $2.23 $2.00 $1.94
        -7.4% -10.4% -2.9%
FD EPS      $0.86 $0.82 $0.56 $0.80
% Growth     NM -4.5% -31.7% -2.8%
Current Multiples         EPS Dilution -31.7%
EV / EBITDA     9.0x 9.0x 7.9x 8.0x
FCF Yield - CNSL Defined   8.1% 7.5% 8.4% 8.1%
FCF Yield - Actual     4.5% 6.2% 7.4% 7.0%
CNSL Defined Payout Ratio   64.0% 65.2% 74.0% 77.7%
Actual Payout Ratio     137.9% 95.6% 97.5% 104.8%
             
Target Multiple   Dividend Yield   7.5% $16.15
Implied Target Price   New Dividend @ 65% Payout Ratio/$13 mm USF cut $1.21
% Upside from Current           -32.3%

 

Regulatory Background

 

·      A key part of the FCCs broadband plan from 2010 was to transition Universal Service Fund support for high cost rural areas to a 21st century vision of providing broadband to the most rural areas. 

o   Connect America Fund (CAF I) was started last year, and had one-time payments for discreet rural build outs.  It also froze USF funding at current levels.  CAF Phase II is slated to start in 1H 2015, after being delayed several times – and calls for completely replacing current USF funding with funds that are required to build broadband to high cost areas. 

o   Some carriers will get more support, others will get less. 

o   The problem for CNSL is that it has already built out broadband with speeds >10 mbps to 99% of its areas, minimizing the support that it will receive in a CAF II environment. 

·      Pro forma for the Enventis transaction, they will receive in 2014 $59.3 million of subsidies, $37 million of this from the federal government.  This amounts to ~5% of PF revenues, 11% of EBITDA and 39% of free cash flow (company defined; it’s actually 50% of discretionary cash flow).  This is broken down into $31.2 mm of USF and $2.9 mm of intercarrier compensation (also shrinking) and another $3 mm from Enventis that falls into different regulatory buckets.

o    Of that $31.2 mm - in a CAF II world will be reduced to $4.6 million over a 3 year period.  This is over 50% of cash available to pay dividends.

·      The FCC has implemented a step-down mechanism so the revenue will not go from $31 to $5 in a year.  In year 1 (2015), the company will recover 75% of the difference ($31.2-$4.611) x 75% + $4.611 mm - or a year 1 reduction of $6.64 million.  Then 50% in 2016, 25% in 2017 - so essentially $6.64 mm less in 2015, 13.3 mm in 2016, 19.9 mm in 2017, and 26.6 mm in 2018. 

·      This is best case scenario --> they do not have to accept all the CAF II money if it doesn't make economic sense (ie: they will have a negative NPV even with the subsidy to build out to those homes).

·      The other $25.2 million in subsidies are from Texas, which is declining $1.2 million / year through 2017 and from Pennsylvania where it is flat until the state addresses it.

·      The sellside shows subsidies flat for the next 3 years - and looking at the stock trading at all time low yield, the Buyside hasn't picked up on this either.

·      Huge discrepancy in my estimates from street

 

Catalysts

·      The FCC issued a final notice on the CAF II funding in December, and they should be distributing money around midyear.  They have already started a 120 day notice period which will finalize the USF proposals and be completed when the money is offered/allocated to the carriers. 

 

o   Once people realize that there is a massive haircut that they will need to take - the dividend will become questioned, and will become trading as distressed

 

Consolidated Communications                            
Illustrative Dividend/Stock Prices with Various Regulatory Cuts
USF   Payout Ratio   Dividend @  Dividend   New Price @ Yield   Stock Price Change @ Yield
Cut Cut   CNSL Defined   Actual   65% Payout Cut   6.5% 7.5% 8.5%   6.5% 7.5% 8.5%
 $   (6.6) 0.0%   78%   97.5%   $1.30   -16.3%   $19.95 $17.29 $15.25   -16.4% -27.5% -36.1%
 $   (13.3) -14.3%   83%   106.2%   $1.21   -21.9%   $18.63 $16.15 $14.25   -21.9% -32.3% -40.3%
 $   (19.9) -28.6%   89%   116.8%   $1.13   -27.4%   $17.32 $15.01 $13.24   -27.4% -37.1% -44.5%
 $   (26.6) -42.8%   97%   129.6%   $1.04   -32.9%   $16.00 $13.87 $12.24   -32.9% -41.9% -48.7%
 $   (33.2) -57.1%   106%   145.6%   $0.95   -38.4%   $14.69 $12.73 $11.23   -38.4% -46.6% -52.9%
                                   

 

·         Guidance – huge discrepancy between my numbers and street consensus

o   Will include Enventis – and I don’t believe the street has fully realized how dilutive to EPS and FCF the Enventis deal was. 

o   A weak print for the VZ partnerships will scare investors – as that is a key to FCF stabilization. 

o   Declining equipment revenue from Enventis will hurt top line growth and margins

o   Unionized work force contract up for renegotiation in 2015, recent ILEC union negotiations, led by Fairpoint have not gone well. There has been a strike ongoing for 3 months now. 

o   Company is continuing to ramp sales force – while at the tail end of the investment –  will continue to hit margins in 2015

 

o   This will all lead to a cut to the dividend.  

 

Estimates vs. Consensus  
       
  2014E 2015E 2016E
Revenue      
JDR907      637.2      783.3      772.8
Consensus      641.2      802.4      810.0
% Difference -0.6% -2.4% -4.6%
       
EBITDA      
JDR907      286.1      327.8      323.1
Consensus      295.5      341.3      347.0
% Difference -3.2% -3.9% -6.9%
       
       
EPS      
JDR907 $0.82 $0.56 $0.80
Consensus 0.92 0.895 1.08
% Difference -10.7% -37.3% -26.0%
       

 

Risks

 

·      Regulatory delay on the step downs of CAF II disbursements.

·      CAF II allows for other carriers to bid on locations outside their footprint, if the incumbent has not taken the subsidy.  There is a possibility that CNSL bids on additional footprint

·      Potential for refinancing term loan at 50 bps lower rate – could save 4.5 mm / yr in interest costs

·      Q3 for Enventis was only reported in an 8K from CNSL, and only has consolidated revenues.  While revenues were stronger than expected, I believe this was from the lumpy equipment business, and not a fundamental change in the growth rate.

·      Some type of sale of VZ partnerships – highly unlikely from their tone – they are more likely a buyer from other RLECs, rather than a seller.

·      Continued acquisitions to mask the FCF payout issue.

·      Upside to synergy estimates for Enventis transaction

 

·      Windstream is in the process of spinning off its fiber assets into a REIT, which will then acquire additional fiber assets. While CNSL has said they are not interested in this structure, there is now a potential acquirer in the mix for CNSL.  

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

·      CAF II funding announcement, offers and disbursement

·      Guidance for FY 2015

o   Will include Enventis   

o   A weak print for the VZ partnerships will scare investors 

 

o   Declining equipment revenue from Enventis 

o   Unionized work force contract up for renegotiation in 2015, recent ILEC union negotiations, led by Fairpoint have not gone well

o   Company is continuing to ramp sales force – while at the tail end of the investment –  will continue to hit margins in 2015

 

o   This will all lead to a cut to the dividend.  

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