General Communications GNCMA
December 21, 2007 - 9:27am EST by
logan884
2007 2008
Price: 8.62 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 457 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT

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Description

An attractive long investment opportunity exists in General Communications (“GNCMA”)—downside protection from a 17% equity FCF yield (if management maintains the business) with an option on growth (driven by an imminent wireless strategy that has potential to drive the stock by well over 100% in the next two years).
 
General Communications dominates the broadband data, cable video, and enterprise voice/data business in Alaska, a state that leads the nation in disposable household income.  With the cable companies in the lower-48 states discussing potential avenues for being wireless providers to achieve a quad play (video, data, voice, and wireless), one can look to Alaska where General Communications already offers it.  GNCMA provides downside protection from a “normalized” equity FCF yield of ~17% and more importantly significant upside from numerous likely catalysts which will drive FCF growth.  If one were to apply a 10% equity FCF yield to the current business, that’s equivalent to GNCMA being at ~$15; this assumes, however, that management simply harvests the existing business but that’s not their intention since they are well-positioned to seize further growth. 
 
One can buy GNCMA’s cable business (assuming the telecom business that serves carriers and enterprises is valued at 6x EBITDA) for an implied ‘08E EBITDA multiple of ~4x or ~$1,500 per cable subscriber.    If you prefer to value the telecom business at 5x, then you’re buying GNCMA’s cable business at ~6.5x and ~$2,375 per sub.  There are numerous catalysts, including management restoring its credibility, to drive equity appreciation.
 
GNCMA is overseen by an owner-oriented CEO who effectively allocates capital and seeks to optimize his capital structure; CEO Ron Duncan owns 3.5% of the company, excluding options.  Part of Ron Duncan’s acumen stems from being mentored by John Malone who was a Professor to Duncan at John Hopkins.  The stock has recently been bought by John Stanton, an “insider” (Stanton and Duncan have been friends for years) well-known in the wireless industry as one of the industry’s best operators/investors (note that Stanton was COO/Vice Chairman of McCaw Cellular; Founder/Chairman/CEO of Western Wireless; Chairman/CEO of T-Mobile USA and a Board member at Hutchison Telecommunications and the recently sold wireless carrier ALLTEL).  Stanton’s basis is ~$11 with purchases made at $8.69-$14.50 (the $14.50 purchase was of the super-voting stock he bought directly from Verizon); he owns over 7% of the company.  With regards to wireless at GNCMA, it’s not currently contributing much to profitability but it is among the key growth catalysts going forward.
 
In May 2005, I submitted GNCMA to VIC.  The stock was trading at $8.09 then and it peaked at $16.10 on January 3rd of this year.  If you had the crystal ball to buy when I submitted the idea and sell at the peak, then congratulations on the double (vs S&P up 19% during that period).  The stock has retreated and the risk/reward is now more favorable to own GNCMA for another and likely larger long term gain.  For those of you who are not familiar with GNCMA, I suggest you review my original submission for more details regarding some important company background/competitive positioning but let me reinforce the core tenets of the initial thesis below, highlight some reasons why I think GNCMA is now a more attractive investment than in May 2005, and contextualize the key issue that has recently transpired to propel the stock’s decline.
 
Business Mix
 
Reported Segments (2008E); EBITDA Composition

Consumer:  $54m, 22% margin
Network:   $83m, 51% margin
Commercial:   $19m, 19% margin
Managed Broadband:   $9m, 31% margin

Source of Revenue (2008E); EBITDA Composition

Voice:   $57m, 34% margin
Data:   $85m, 44% margin
Video:   $16m, 15% margin
Wireless:   $7m, 10% margin
 
Valuation Snapshot
Equity Value:                $0.5B
Enterprise Value:           $1.0 B
NOLs                           $128M
 
Based on street EBITDA estimates, GNCMA is trading at ~6.0x ‘07E, 5.7x ‘08E, and 5.1x ‘09E EBITDA.  Based on management’s guidance for 2009, GNCMA is trading at 4.6x EBITDA.   Note that one multiple point change (i.e., a change in sentiment) to EBITDA multiple is ~$3 impact to the stock price (~35% from current price).  It is of course more appropriate to focus on free cash flow. 
 
GNCMA’s downside protection is partially derived from its relatively unique set of infrastructure assets that enable data, video, voice, and wireless traffic/service for carriers (e.g, Verizon/MCI and Sprint), enterprises, schools/government, and consumers.  The company’s “normalized” equity free cash flow yield is ~17%.  I define “normalized” equity free cash flow yield as estimated EBITDA of $162m in 2008 less interest expense of $36m and $50m in maintenance capex.  I assume maintenance capex is $50m instead of the $25m that is consistently communicated by management and also which is described in their debt offering.  If one uses $25m, then the equity free cash flow yield is currently 22%.  Based on $25m of maintenance capex coupled with a 10% equity free cash flow yield, the implied stock price is ~$20.  Since depreciation is ~$80m, one might inquire how maintenance capex could be so much less.  There is a significant difference in economic and accounting life for a majority of the infrastructure-related assets (specifically 9-11 year depreciable life versus 30 year asset life).
 
Another way to assert the attractiveness of the current value is to frame valuation by contextualizing the value of GNCMA’s cable subscriber footprint (i.e., the reported consumer segment but excluding wireless) based on a sum-of-the-parts approach.  Based on the assumptions applied below, the current value per cable sub is ~$1,500and ~4x ‘08E EBITDA.  Yes, all the public cable system operators (Comcast, Time Warner, Cablevision, Charter) are down significantly and arguably some (if not all) of the larger MSOs are undervalued as well, but as noted in the original VIC submission in 2005, I believe GNCMA deserves a premium valuation to the lower-48 cable system operators because GNCMA doesn’t confront the same competitive challenges for multi-channel video from either the satellite providers (topography issues challenge satellite as an alternative) or the Bell companies (i.e., there is no FiOS-like alternative confronting GNCMA).  GNCMA is structurally advantaged to compete versus multi-channel alternatives in Alaska, one of the most attractive states from a demographic and communication usage perspective.  Regardless of whether you agree with me on that assertion, the opportunity to own cable systems at ~4x ‘08E EBITDA and ~$1,500 per sub is compelling. 
 
Assumptions to derive “pure” cable multiple:
  • Network Access / Commercial / Managed Broadband businesses is valued at 6x EBITDA (or $660m)
    • For context, Bells are valued at ~6x, RLECs at ~7x, and Alternative Carriers at ~10x
    • GNCMA’s telecom business (as described above) generates a majority of its EBITDA from data-driven traffic among carriers, enterprises, schools/government; the consumer telecom business is all cable telephony and in the consumer/cable segment
 
·         Assume the current consumer wireless business is valued at $1,025 per sub (or $68m)
    • For context, this is derived from $500 per sub ascribed to the 65% of subs currently on Dobson’s network (i.e., MVNO) and $2,000 per sub assumed for the Alaska Digitel subs (GNCMA bought 80% of Alaska Digitel in early 2007 for $30m and the minority interest is captured as part of the net debt calculation)
    • ALLTEL was recently acquired for 9x EBITDA and ~$2,200 per sub by private equity; note that “insider” Stanton was on the Board of ALLTEL, which bought Stanton’s Western Wireless for 8.5x EBITDA and ~$2,100 per sub
    • In thinking about the current and expected wireless value (explained more below), it’s important to note that a substantial part of the cost (30%) for a wireless carrier is the backhaul/telco line connection which incidentally in Alaska is enabled by GNCMA’s infrastructure; GNCMA will ultimately (when able to compete using its owned facilities) generate a higher wireless margin than ALLTEL’s 34% despite 12m subs at ALLTEL versus my estimate in 2010 of 150,000 subs at GNCMA (currently almost 70,000)
 
Among the Previous Key Reasons to Own GNCMA that still hold
  1. Management continuity and strength; CEO Ron Duncan is effective at allocating capital
    • With the exception of this year, each year’s capital spending since 2000 has led to at least 17% “return” and as much as 45% (“return” defined as incremental EBITDA two years subsequent to the non-maintenance capex being incurred)
o        For example, in 2006, the company generated $15m more EBITDA than in 2005, after spending $88m of “growth capex” in 2004 to yield a 17% “return”
o        For purposes of calculating the “normalized” equity FCF yield at 17%, I use $50m but for these purposes I use the $25m of maintenance capex communicated by management; the “return” metrics are obviously higher if one assumes maintenance capex is in fact $50m
  1. Attractive equity free cash flow, at 17%, provides downside protection; if $25m is used for maintenance capex, then the equity free cash flow yield is currently 22%
  2. Alaska is an attractive market (demographics, communications service usage); barriers to entry are high, structural competitive landscape advantages exist relative to cable/telecom competitive dynamics in lower-48 states
    • Disposable household income is ~30% greater than the U.S. average
    • Much of this difference is generated from over $1B that is distributed from the Alaska Permanent Fund annually to all residents
  3. General Communications is among the most advanced at bundling cable/telco services, thereby reducing churn
    • 20% of calls to Customer Service result in cross-sale
    • 80% of Internet customers up-sold to cable modems
    • 75% of GNCMA’s bundled customers are 75% less likely to disconnect/churn
  4. Private equity interest was expressed at a price ~ 40% to the current stock price
    • The appetite for take-private still exists (I have recently received inquiries from major private equity firms) but obviously the credit markets challenge this potential outcome in the near-term (when the company was offered $12 a couple of years ago, the CEO said he wasn’t a seller below $18 and I am relatively certain he was negotiating to split the difference)
 
What happened to propel the recent decline in the stock?
 
Weakness in Network Access was the main culprit
In the most recent quarter announced October 31st, the strength in the consumer business (revenue grew 25% and EBITDA grew 39% yoy; there was strong underlying demand across all consumer product lines but the main growth driver was wireless, including the acquisition of Alaska Digitel) was overshadowed by the company’s weakness in the Network Access segment.  In Network Access, gross margin was down over 500bps based on scheduled rate reductions and some issues impacting comparability (specifically $800,000 non-recurring fiber outage expense deemed recoverable from the shipper that anchored into the fiber, thereby causing the outage) but also because minutes grew at a slower pace relative to the typical seasonal strength. 
 
Network access minutes decreased 14% yoy; the main issue was a market share shift that the company is addressing.  In Alaska, the Network Access business has largely been a duopoly comprised by General Communications (since its founding in 1979) and AT&T.  However, Alaska Communications also competes but its infrastructure is only single-thread fiber and its ability to move traffic beyond the Seattle-Anchorage corridor is currently limited.  Nevertheless, Alaska Communications managed to compromise GNCMA’s recent performance by taking network access share.  Alaska Communications simply offered a lower price and GNCMA (appropriately so in my opinion) refused to compromise its pricing discipline.  I believe the company has a strong competitive position (with “monopoly” access to certain parts of the state; the company reaches 20% of rural communities where there is no alternative) and relationship with its carrier customers to address the recent competitive issue.
 
GNCMA management said the carrier customer who played the “game of chicken” with GNCMA suffered as well since the reduction in traffic cost between Seattle and Anchorage didn’t compensate for issues related to optimizing that traffic.  In regards to its competitive response, management will not provide details, in an effort to avoid compromising its strategy, but they communicate that actions are being taken that within the next six months will address the Alaska Communications issue to stabilize the carrier business.  There is some leap-of-faith associated with accepting management’s comment in this regard but I ascribe much weight to the CEO as being very capable and owner-oriented (he has effectively built each of his businesses to a share of 30-70%, generated attractive growth/returns, and is strategically thoughtful for how he manages the business and allocates capital).  Management doesn’t expect this business to grow and has managed expectations accordingly.  As noted above, the other issue was the non-recurring $800,000 expense that GNCMA envisions getting back in reimbursement; the company has incurred issues like this in the past and although it can be an issue of legal expense and time, I view the expense as non-recurring and another catalyst (albeit small) for investors to realize the miss was somewhat less severe than reported. 
 
Why is now an attractive reason to invest in GNCMA?
 
Putting recent tax-loss selling pressure aside, the key reason to invest in GNCMA is the downside protection based on its current “normalized” free cash flow yield (management is sitting on at least a 15% equity FCF yield and can pay a large dividend/buyback shares but someone mentored by Malone isn’t likely to pursue the high dividend yield path) and “asset value” coupled with option value from the FCF growth prospects based on attractive returns that I envision will be generated from recent and on-going investment by management. 
 
If management wanted to coast, they could retrench on trying to grow the business and pay a large dividend plus buyback more shares (note that management has repurchased 1.725m shares for ~$13 over the last 12 months).  I believe management effectively invests its capital as “returns” (defined above) have been 17-45% from 2002-2006.  The concern is that trend was not evidenced in 2007.  From an overall perspective, the attractive return profile didn’t hold in 2007 because of the unanticipated issues described in the Network Access business (which declined from $91m of EBITDA in 2006 to $83m expected for 2007).  However, the return on $56m of growth capex spent in 2005 (i.e., $81m reported capex less $25m maintenance capex) did in fact have its intended impact on the consumer business (which grew from $27m of EBITDA in 2005 to $43m expected for 2007). 
 
Much of the capital recently invested by management has been directed to the consumer segment to enable the statewide local telephony expansion (i.e., cable telephony provided on GNCMA’s own facilities including digital local phone service).  The return on this investment and other consumer investment (primarily cable modems and set-top boxes providing growth/lower churn via cross-sale) has been very attractive and it is the consumer segment (including wireless) that will be GNCMA’s primary growth driver going-forward.  Despite the well-documented issues regarding the consumer, the fact is that spending on multi-channel video, high speed data, and wireline/wireless communications is largely non-discretionary. 
 
GNCMA is already a wireless carrier (among the key areas of growth for lower-48 MSOs) with a telecom infrastructure advantage (as described above) but this part of GNCMA could provide substantial upside.  In 2007, it is estimated that only $1m of EBITDA was generated; it is captured in the consumer segment.  GNCMA’s wireless business of $1m of EBITDA compares to Dobson at ~$70m and Alaska Communications at ~$63m.
 
The wireless market in Alaska (like video and other communication services) is much less competitive than in the lower-48 states.  The landscape is essentially as follows:   
·         Dobson (acquired by AT&T for 9.6x EBITDA):  215,000 subs (plus ~35,000 are re-sale with GNCMA; MVNO for GNCMA)
·         Alaska Communication (ACS):  150,000 subs (estimated to generate $63.4m of EBITDA in ’07, or $423 of EBITDA per sub based on 47% margin)
·         General Communications:  70,000 subs (includes ~35,000 subs noted above)
 
GNCMA’s management openly coveted Dobson’s Alaskan wireless business; note that this business generated ~$70m in EBITDA, or ~$335 per sub, and this is without the benefit of owning the backhaul/interconnection telecom infrastructure.  You’ll note the more than 26% of EBITDA per sub generated at ACS on 30% lower subscriber base; this is largely because of the interconnection/backhaul costs that ACS doesn’t incur. 
 
GNCMA’s acquisition strategy was neutralized when AT&T announced its acquisition of Dobson in June.  Moreover, the alternative path GNCMA management considered taking and still intends to take (the build-approach) has been challenged from a timing perspective because the re-sale arrangement with Dobson prevents General Communications from competing as a wireless carrier with its owned facilities-based network.  However, now that AT&T will own Dobson, there is an event-driven catalyst. 
 
AT&T (like GNCMA) will benefit by eliminating ~30% of Dobson’s backhaul/interconnection costs which came at Dobson’s expense and much to GNCMA’s benefit as part of the Network Access business.  There is a win-win situation to this negotiation as AT&T wants to move all that traffic to their network and GNCMA wants to compete on its own facility, some of which still has to be built but much is already enabled by the acquisition of Alaska Digitel and spectrum GNCMA had already owned.
 
Wireless is the substantial growth catalyst.  What is the potential value of GNCMA wireless?
There are currently 435,000 subs controlled by Dobson/AT&T, ACS, and GNCMA.  Of the state’s 677,000 residents, the wireless penetration is ~64%.  It is likely that 80% penetration will ultimately be achieved, thereby representing a market of 542,000 subs (note I am making no assumption for population growth going-forward to be very conservative).  GNCMA has achieved at least 30% market share in every business in which it participates.  I assume 150,000 subs (i.e., 25-30% market share) in the calculation below (management thinks 200,000 is likely).  At either 150,000 or 200,000, this obviously implies a share shift; I am confident it can be achieved since GNCMA has a significant bundling advantage (video/data) versus both ACS and Dobson/AT&T.  As evidence of GNCMA taking share, note that in each of the major local markets the company has launched cable telephony, the company has achieved ~50% share (i.e., taking share from ACS’ wireline business). 
 
Management’s approach to building its base of ~70,000 current subs hasn’t been a focused effort (nor a significant contributor to profitability at just $1m this year) but when one considers that GNCMA already has a billing relationship with a majority of Alaskan households through cable/internet/telephony coupled with a strong retail presence/state-wide brand, it’s not too much of a leap-of-faith to embrace that this management team will increase its base from 70,000 to 150,000 wireless subscribers.  If one applies the same metrics that ACS is achieving on its 150,000 subscriber base, that’s an additional $63m to be generated in EBITDA at GNCMA (note that I am not assuming growth to ACS’ current EBITDA to be conservative and also in recognition of potential concessions GNCMA might make to consumers to drive share but this approach is indeed conservative in the context of the increasing ARPU across wireless service providers because of advanced wireless applications that consumers are embracing). 
 
GNCMA already has a substantial spectrum position—30MHz of statewide 1.9GHz spectrum directly owned and another 30MHz of spectrum owned by the company’s 80%-owned subsidiary Alaska Digitel.  In 2008, a substantial capital investment is assumed to enable the wireless strategy.  Jefferies is the most negative and so I use their estimates for capital spending at $236m.  Using the assumption above for GNCMA wireless (based on 150,000 subs) as $63m being achieved in 2010 plus using the low 2009E EBITDA at $178m (note that management is guiding ~$200m) less $17m of estimated wireless EBITDA in 2009, this implies $224m of EBITDA in 2010.
 
Targeted Upside in Two Years (assuming 150,000 wireless subs in 2010) is ~$18 (this assumes no value ascribed to NOLs nor any change to outstanding shares):  The methodology used is applying a 7x multiple in ’09 to ‘10E EBITDA of $224m, subtracting estimated debt then of $619m (note large capx plan to enable wireless will lead to negative FCF in 2008 but GNCMA’s credit facility has already been amended to address).  If management were to achieve its 200,000 subscriber objective, that equates to an additional $2.75 of targeted value in two years, thereby suggesting a value (if management achieves its ultimate wireless vision) of almost over $20.50.  This might explain why Stanton was willing to invest $20m last Spring at $14.50 and quickly bought more in the recent unexpected miss in the Network Access business.
 
Key Risks
  • Network Access business doesn’t stabilize (the key risk is how irrational ACS is willing to get)
  • Outcome of the AT&T/GNCMA negotiation to exit the re-sale arrangement (since both companies appear to derive mutual benefits, I don’t think the risk is substantial but one never knows how irrational a larger company might get)
  • Return on capital spending no longer evidences historical growth/return (the main issue was Network Access but returns are being evidenced in consumer where majority of capital has recently been directed; wireless is the key area of future capital spending and the company is strategically well-positioned to improve its share at a high margin)
 
Selected Catalysts
  1. Wireless strategy is clarified (i.e., resolution of re-sale arrangement with AT&T) is effectively executed
  2. Management restores credibility with investment community (remember that one EBITDA multiple is ~$3 of stock impact)
    1. stabilize network access business profitability
    2. demonstrate attractive returns on investment again
  3. Growth from construction of a natural gas pipeline/other natural resource developments in Alaska/increased tourism to Alaska
    1. The population would spike with natural resource project developments (pipeline highly likely)
4.       Current FCF yield provides substantial downside; management has been frustrated in the past and could retrench capx program/harvest and/or pursue going-private (note Goldman Sachs funded Western Wireless and knows Stanton very well)

Catalyst

1. Wireless strategy is clarified (i.e., resolution of re-sale arrangement with AT&T) is effectively executed
2. Management restores credibility with investment community (remember that one EBITDA multiple is ~$3 of stock impact)
1. stabilize network access business profitability
2. demonstrate attractive returns on investment again
3. Growth from construction of a natural gas pipeline/other natural resource developments in Alaska/increased tourism to Alaska
1. The population would spike with natural resource project developments (pipeline highly likely)

4. Current FCF yield provides substantial downside; management has been frustrated in the past and could retrench capx program/harvest and/or pursue going-private (note Goldman Sachs funded Western Wireless and knows Stanton very well)
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