Description

Summary
Dobson was introduced last November by rpu848, but since then, the company has reduced guidance twice, and the stock has been decimated, falling 80% from $6.00/share to $1.40. While I would not argue that Dobson has one of the stronger management teams I have ever seen, the company has a strong niche in the rural wireless industry and is not going bankrupt anytime soon. At this price, you are buying an option that has the potential to appreciate significantly, while recognizing that the stock is likely to be volatile over the coming months. I believe that DCEL could hit $2.00 by Q1 2005 as the local subscriber business should improve and pessimistic market concerns over the roaming business are overblown. In addition, the company has $100MM cash and has the opportunity to monetize its 550 tower assets (~$75-$100MM) and/or stop paying cash dividends on their preferred stock (about $35MM/yr), which should provide adequate liquidity and reduce the likelihood of bankruptcy. DCEL currently has an equity market cap of $187MM and TEV of $2.8B. Based on the midpoint of the company¡¦s 2004 EBITDA guidance of $340MM, the company trades at 8.3x EBITDA.

Business Overview

DCEL is one of the largest rural wireless carriers with 11.4MM POPs and 1.6MM subscribers. The company generates revenues from two distinct segments ¡V local subscriber (~80% of revenues) and roaming (~20% of revenues). DCEL¡¦s primary roaming partners are Cingular and AWE ¡V I will discuss the effects of the merger shortly.

DCEL is competitively positioned in the local subscriber segment, which generally has less penetration and less competition than the more urban markets. Penetration is estimated at 35-40% for the rural markets compared to 55-60% for the urban markets. In addition, DCEL faces an average of only 3-4 competitors in their markets. These two drivers should fuel subscriber growth over the next 12-18 months, although the company is coming off a few quarters of miniscule growth. However, the company recently finished rolling out its upgraded GSM network in April for the continental US and June for its Alaskan markets. Without GSM and the associated product offerings (picture phones, data, longer battery life, etc), DCEL struggled to gain new customers in the first half of the year. The company started gaining some momentum in June and July, in which they saw an average of 30-35k gross adds/month compared to 20-25k/month in April and May. I expect that gross adds will pick up in the 2nd half of the year and DCEL should see strong growth in 2005.

The company¡¦s cost structure was also inflated driven by the cost of maintaining 2 networks (TDMA & GSM), advertising costs associated with the launch of GSM, and the equipment subsidies associated with both new customers as well as existing customers transitioning from TDMA to GSM. The company provides about $85-90/gross add in equipment subsidies for customers that sign a 2-yr contract. Since GSM generally provides a $6-$8 higher ARPU than TDMA, this is a good long-term investment. However, these costs hurt the company¡¦s profitability in the short-run, as the subsidy is immediately expensed. In addition, DCEL was previously offering a $100 GSM credit over four months and free data for 2 months. These promotions have ended, and the management is focused on reducing marketing costs while implementing several initiatives to improve ARPU through the rest of the year and into 2005.

ARPU initiatives
Dobson has one of the lowest ARPU¡¦s in the industry (about $40 compared to $50 industry average), which is a function of fewer Minutes of Use (MOU) and a higher proportion of local/regional plans. The company has implemented several initiatives to improve ARPU, which basically drops right to the bottom line.
„« Increase regulatory fee charges by $0.65: DCEL is increasing the charges on their customers bills to recover costs associated with federal mandates such as E911 and other regulations; The new fees will be in line with industry averages
„« Discontinue all post-paid plans under $40/month: By marketing plans with higher price points, DCEL is hoping to improve ARPU without significantly increasing churn
„« Reduction in rebates and credits ¡V should come down significantly from $1/sub/month
„« Increased data revenues ¡V will likely impact 2005 more than 2H 2004
„« USF funding starting in Q3 ¡V the company expects to receive $450k/month and expects USF funding to be $12-15MM/yr in 2005

Roaming Business
Dobson generates a significant portion of its EBITDA from its roaming partners. With little incremental costs associated with roaming, EBITDA margins are estimated to be 80%+ on roaming revenues. For those investors that are new to the industry, here is a brief overview of the roaming market.

„« General strategy of the major wireless carriers is to focus on the higher density urban and suburban markets
„« There is a niche in the market for rural carriers to provide for local service in rural areas and also capture roaming business from the national carriers
„« It is not economically wise/feasible for the national carriers to build out the entire country so they use affiliates/partners to achieve a wider network
„« Rural carriers generally use 800MHz cellular spectrum, which have lower frequency radio waves that generally travel longer distances. This is preferable in rural areas where towers can be placed 20-30 miles apart vs PCS (which operates at 1900MHz) that has higher frequency, enabling good coverage in dense areas, but would be much more expensive to build out in rural areas
„« When the national carriers rolled out 1-rate national plans (AWE starting 1998) with no roaming charges, it provided a boost to the roaming partners such as DCEL
„« While the contracts generally provided at least some protection from overbuilding, the national carriers negotiated hard to lower roaming yields as it became a large part of their cost structure. Where the carriers identified areas of significant usage, they attempted to overbuild or swap property with the wireless affiliates. In addition, roaming rates, which reached $0.75-$1.00/minute in the late 90¡¦s have declined significantly to the low-mid teens.
„« Dobson has contracts with AWE through 2008 (rates fixed through July 2006) and Cingular through 2011 (rates fixed through 2008). The company claims that the contracts succeed the merger, and provide certain exclusivity and overbuild protection (for details of the contracts, see Dobson¡¦s investor presentation from Feb 2004). The highlights from reviewing the contracts are that the roaming rates should stabilize starting in Q1 2004 (the only decline comes from the TDMA/GSM mix) and that Cingular¡¦s contract doesn¡¦t provide overbuild protection. While this may seem alarming, Cingular has publicly stated that they are reluctant to overbuild with 1900 MHz spectrum and my opinion is that roaming rates are so low, it would not be economical for Cingular to invest in their rural network.
„« One of the big risks/overhangs on the stock is that DCEL and the new Cingular will likely renegotiate a master contract. Timing is uncertain, but Cingular has been aggressive in negotiating deals with other carriers, and most often, Cingular comes out a winner (e.g. Triton PCS). Although DCEL should have more negotiating leverage, there is a risk that the new contract will provide for lower roaming yields ¡V however, DCEL will likely get a long term contract with at least some exclusivity and overbuild protection in return. DCEL has been proactive in readjusting their coverage through swaps, acquisitions and divestitures to avoid major overlap with AWE/Cingular and I believe any new contract will not be devastating for DCEL.

Dobson Roaming Minute Summary
2002PF 2003PF 2004 2005

Roaming Minutes (000s) 1,213,000 1,478,000 1,435,229 1,541,680
Growth in Roaming MOUs 21.8% -2.9% 7.4%
Roaming Yield / Minute $0.268 $0.201 $0.139 $0.130
Sequential Growth in Yield -25% -31% -7%
Roaming Revenues $325.0 $297.0 $199.5 $199.8
Growth (yoy) -8.6% -32.8% 0.1%

„« As shown above, DCEL will likely report negative to flat YOY growth in roaming minutes for 2004. I believe this is a temporary blip ¡V for much of the first half of 2004, DCEL did not have its GSM network complete, and thus they lost out on the roaming minutes for Cingular and AWE¡¦s customers who were on GSM plans. I expect roaming MOU¡¦s to rebound in 2005 ¡V driven by subscriber growth at Cingular and higher MOU.


Projections
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My projections are summarized below. I assume that the company is able to improve their local subscriber business and that the roaming business stabilizes (more MOU / lower yield). I expect EBITDA to come in at $340-$345 for 2004 and improve to about $370MM in 2005. The improvement is driven by higher ARPU, lower customer acquisition costs, and USF funding of $8MM. Cash flow should also improve as DCEL has completed its GSM overlay and capex should only be approximately $90-$100MM. in 2005-6. The company is extremely leveraged, so the stock price is very sensitive to fluctuations in EBITDA and multiples. However, if the company is generating positive FCF, and the roaming business doesn¡¦t get crushed, there is tremendous upside in the equity.



2003 2004 2005 2006

Beg Subs 1,357 1,552 1,638 1,687
Net Adds 64 33 49 54
Acquisitions 131 54 - -
Ending Subs 1,552 1,638 1,687 1,741
Ave Subs 1,455 1,595 1,663 1,714

ARPU $40.20 $40.15 $40.74 $41.22

Local Rev 702 769 813 848
Roaming Rev 284 200 200 196
Equipment Rev 42 58 62 65
Total Rev 1,027 1,027 1,074 1,108

EBITDA 447 343 369 381
Capex (197) (139) (95) (95)
FCF 250 204 274 286

Less: Interest (203) (207) (208) (208)
Less:Pref Div (20) (23) (38) (38)
FCF to Equity 27 (26) 28 40

Net Debt & Preferred 2,631 2,613 2,582
TEV @8x EBITDA 2,741 2,952 3,048

Implied Equity Value $110 $339 $466
Shares 134 134 134
Stock Price $0.82 $2.54 $3.48<-------------

Roaming EBITDA 241 170 170 167 (Est)
Roam Margin 85% 85% 85% 85% (Est)

Local EBITDA 206 173 199 214 (Est)
Service Margin 28% 21% 23% 23% (Est)

Total EBITDA 447 343 369 381
EBITDA Margin 44% 33% 34% 34%

My 9-12 month target price is $2.50, which represents 8x 2005 EBITDA of $370MM.

Capital Structure Comments
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DCEL is a highly leveraged company and is subject to various covenants of their bank agreement (at Dobson Opco) and bond indentures (at Dobson Holdco). In addition, American Cellular has a $900MM bond issue that is non-recourse to the parent company. There are two items I would highlight over the next 6 months - DCEL will be very tight on its total debt/EBITDA covenant in Q4 and may need to amend its covenants. I don't think this will be an issue as bank debt/Dobson EBITDA is only 2.5x. The other important note is that DCEL can't pay cash dividends on the preferred equity unless total leverage is <6.75x. The company is currently straddling the line and may not pay cash dividends in October. While the non-cash dividends are dilutive to equity holders, I think this would provide additional liquidity and the company¡¦s cost of capital is certainly more than 13% right now.

Risks
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Master contract renegotiation with Cingular is more unfavorable than expected
DCEL is unable to maintain adequate liquidity or negotiate with banks
DCEL is unable to win new customers or lower cost per gross add (CPGA)

Catalyst

DCEL meets/beats revised 2004 EBITDA guidance
Company monetizes tower assets and/or amends bank covenants
Company improves ARPU and lowers CGPA