Description

Hawaii Telecom is a post bankruptcy turnaround story that is trading at a distressed multiple, despite having a stable and potentially growing business and a clean balance sheet.  Carlyle acquired the assets of Verizon Hawaii in 2005, ran the business into the ground and then the company filed for Chapter 11 in December 2008, and emerged from bankruptcy in October 2010.  The company relisted on the Nasdaq in July, 2011, and has since seen its shares slide from a high of $30 to a low of $13.50.  The business was written up a little over a year ago, when it was trading north of $25 (ticker was HWLT), and the prospects have only improved since then, yet the stock is trading almost 40% lower. 

HCOM trades at 3.5x & 3.4x 2012 & 2013 EBITDA, and an 8% and 21% FCF yield for 2012 and 2013.  Rural competitors trade at multiples averaging 5.5x.  Granted most of these companies have dividend yields to support the stock, but given the recent refinancing of the company, they will be in a position to start a dividend in the next year. 

Overview

The Hawaiian economy has been fairly resilient given some of the shocks it has taken in the past few years.  Aside from the 2008/9 recession, the tourism industry which is the primary economic driver in Hawaii was hit hard from the earthquake/tsunami in Japan.  Late 2011 and early 2012 arrivals have rebounded to levels slightly below the record 2007 year, however expenditures continued to lag.  Unemployment is far lower than the mainland, sitting at 6.6%, down from 6.8% in August, 2011.  The public sector, including the federal government are the largest employers in Hawaii, and 95% of private businesses employ under 50 people. 

Residential Market

About 40% of the HCOM’s revenue comes from the residential market. Over the past few years, the company has been investing to reverse the trajectory of the consumer business, which has been plagued by access line erosion, broadband share loss as well as declining long distance revenue, as consumers shift their LD minutes to mobile or VoIP platforms.  The only competitor in the Hawaiian residential market is Oceanic Cable, owned by Time Warner Cable.  As HCOM was unable to invest in the network until the past few years, TWC has taken significant broadband market share away from HCOM – and now has about 65% share.  HCOM is in the process of investing in upgrading its network and increasing HSI speeds through a Fiber to the Node (FTTN) strategy, akin to AT&T’s Uverse product.  The company’s goal is to cover approximately 80% of Oahu’s 300,000 homes in the next 4-5 years.  They are projected to end 2011 with about 37,000 homes passed and build to about 50,000 homes per year.  Over the past few quarters, the company has begun to take market share back, and now is offering high speed broadband products with competitive speeds to cable. 

In June 2011, HCOM received approval to offer video services to the island of Oahu, which holds roughly 70% of the Hawaiian population.  The company is rolling out its IPTV product to the homes passed by the FTTN network, and began selling services in Q3 and Q4 of 2011. The company discussed during the Q3 call that early results were positive, reaching approximately 10% sales penetration of marketable homes.  The company is targeting both the single family home and MDU market, as 43% of the households in Oahu live in MDUs.  Here, they discussed their strategy of locking up bulk MDU contracts, where they will sign a 5 year exclusive contract with the building offering a standard video package, and then the ability to upsell broadband, premium channels and other services.  During Q3, they signed 4 such deals, with 1,400 subscribers.  The company expects that over the next 4-5 years, their business plan is anticipating garnering roughly 30% of homes passed in Oahu.

The competitive video landscape is pretty attractive in Hawaii, and has been essentially a monopoly.  Oceanic Time Warner has a 95% share of video in Oahu, with satellite having only 5%.  Neither DISH nor DTV have satellites that can reach the Hawaiian market with a satisfactory service, and the service is not marketed.  There are no other video competitors in the market, making it ripe for HCOM to take market share.  In addition, ARPUs are extremely high relative to the mainland, with HCOM commenting that they believe TWC video ARPU (exclusive of VoIP and Broadband) was north of $90.  The company has set lower expectations, and is anticipating a blended ARPU of $65, with EBITDA margins near 30% - essentially at the company average. 

This investment strategy will keep capex elevated for the next few years, but should begin to show some meaningful benefits in the next few years.  In addition to the obvious incremental revenue opportunity, the ability to sell the triple play package should reduce company churn, decelerate access line losses and pull through additional product sales like broadband and VoIP.   Currently, total penetration of broadband at HCOM is only 40% of primary access lines, while 74% of those subs are in a bundled package, which is up from 71% a year ago.  The potential of taking broadband market share from TWC presents upside to my model, where I have the company getting to 25% market share for IPTV of homes passed by 2014.  The IPTV revenue quickly ramps, and is almost 10% of revenue exiting 2014. 

Recent Results

The company has seen a moderately declining top line, while a cost cutting program generating over $10 mm of runrate savings has led to EBITDA margins expanding to around 31%.  There a few moving parts which will impact growth over the next few years.  I am modeling residential access lines to continue to decline, at slightly decelerating rates – roughly 7% per year.  Offsetting the declines in the consumer market, is growth in High Speed Internet of about 3.5% y/y.  This should accelerate as FTTN is rolled out to 200k homes in Oahu, and bundled with IPTV, however I have conservatively modeled in relatively stable HSI growth.  Additionally, IPTV will grow from less than 1% of revenue in 2011 to almost 10% exiting 2014.  Margins should remain relatively stable, with some additional margin gains possible through additional cost cutting.

On the business side, traditional access lines have been falling as businesses move over to IP enabled bundled solutions, which has been offsetting the declines.  HCOM lost a significant portion of its enterprise business, while it was being run by Carlyle and subsequently in bankruptcy.  CLECs including TW Telecom, as well as Time Warner Cable are tough competitors in this part of the market. 

Wholesale revenue will begin to benefit in 2012 and 2013 from the investment the company has been making with its Fiber to the Tower initiative.  The company has signed contracts with AT&T and Verizon to build out fiber to approximately 250 towers in Hawaii.  It has 62 sites left to build in 2012, so the capex should begin to decline in the 2H of 2012.  While this will provide potential upside in the next few quarters, in the near term, the wireless carriers are turning down their T1 lines at a faster rate than anticipated, and the revenue from the fiber is not offsetting it.  However, the company expects in the next few quarters, they should begin to see a growing wholesale business, stemming partly from FTTT.  None of the large tower operators own towers in Hawaii, the towers are generally owned by the carriers, and some by HCOM, which presents more tower opportunities than otherwise might exist.  Additional upside remains from T-Mobile and Sprint, which have not rolled out fiber to their tower sites in Hawaii yet, but may contract with HCOM in the future. 

 Union Agreement

About half of the company’s employees are unionized and are currently not operating under an agreed upon collective bargaining agreement.  In November, after negotiations broke down, the union held a strike for 2 days, before returning to work.  Negotiations resumed later in the year, and HCOM management presented its ‘last, best and final offer’ to the union.  When it went to a vote, about 1/3 of union members voted for it, 1/3 against it and 1/3 abstained.  The company declared an impass and implemented its offer.  As of now, employees are working, and the union has filed charges with the National Labor Relations Board, which does not have any enforcement ability.  The key disputed items in the agreement are closing the defined benefit pension plan and beginning a company sponsored and matching 401K plan.  Other items that were up for discussion were reducing the amount of paid sick days from 6 months to 8 weeks.  The company implemented these changes, despite not having them ratified by the Union, and the 401K plan began on March 1.  Management is still in negotiations with the Union leadership and believes it will come to an amicable resolution; however they are holding firm on the pension issue.  This is a key risk to the story, and if the company went on an extended strike, would severely harm the company.  A few mitigating factors include that employees would be covered by unemployment insurance, however they would only have access to healthcare through COBRA.  Additionally, the Union has no reserves to pay members while they are striking. 

The company has a pension that is underfunded by roughly $30 million (waiting for 10-K for exact #).  They contributed about $17 million in 2011 to the pension, and because of the falling discount rate will contribute roughly the same amount this year.  If the Union ratifies the Collective Bargaining Agreement, and the 401K plan is approved (despite it being implemented already), there would be a rebate of roughly $3 million in 2012, and a significant drop off in contributions in 2013 and beyond.  I have accounted for the entire $30 million as debt on the balance sheet. 

Balance Sheet

On February 29^th, the company refinanced its balance sheet with a $300 mm senior secured credit facility.  They were previously paying 11% on their term loan, and now will be paying L + 575, with a LIBOR floor of 1.25%.  The notes were sold at $98.5.  The notes are significantly less restrictive than the prior $300 mm term loan.  The company paid a 2% call premium on their term loan to take it out early.  After the company meets a leverage test of 1.75x, 50% of excess FCF will go towards mandatory amortization, while the other 50% can be used for dividends or stock buybacks.   The company’s leverage is currently about 1.85x.  Additionally, the prior term loan restricted certain capex, speciffcally around parts of the IPTV rollout. 

The company will not be in a position to pay a dividend, after spending $16 mm on its refinancing, and another $14-$17 mm in pension expense in 2012.  However, in 2013 they would be in a position to start a dividend of roughly $0.50 / share, which could more than double in 2014 as the benefit from the IPTV rollout shows up in the numbers. 

As mentioned earlier, the stock trades at a significant discount to all its peers.  While all Verizon spinoffs should probably be trading a discount (Fairpoint, Idearc, Frontier), HCOM has already gone through the pain of bankruptcy, and come out with $2 billion less of debt.  Fairpoint exited bankruptcy with over 4 turns of leverage, while Hawaii exited bankruptcy with under 2 turns.  Additionally, the company has been investing over the past few years in growth, which should begin to turn into margin in the next few years.  The company has a significant amount of NOLs, and will not pay cash taxes until after 2016.  I did not include the NOL into the valuation, because I won’t have the correct amount until the 10K is filed.

Assuming a 20% haircut to the valuation of peers, or a 4.5x 2012 EBITDA multiple, the stock would be trading at $27, or 73% higher than current levels.  Several catalysts could help move the stock higher over the next year.

1)    IPTV rollout begins to generate revenue, and grow the consumer business.  Broadband net adds should follow, as over 70% of consumers taking the IPTV product are also taking high speed internet.  The top line has not grown in this business in years, and would be a sign that they are moving in the right direction

2)    Fiber to the Tower provides a growth engine for the wholesale business, at a higher margin then the HCOM average

3)    Union comes to an agreement with the company, and the company begins to contribute less to the Pension plan

4)    Potential for initiation of a dividend in 2013

5)    Consolidation in the industry has been very active.  Most recently Consolidated Communication agreed to buy Surewest for 6.3x EBITDA.  While you could argue around the synergies attainable from acquiring an asset in Hawaii, Surewest and Consolidated operate in disparate parts of the mainland.  This is not a core part of thesis, but potential upside.

There are several risks that could significantly impact the investment thesis. 

1)    Most notably is the risk  that the Union does not come to an agreement with management, and they decide to have a prolonged strike. 

2)    Additional impacts of this outcome, may be that the Pension obligation continues, and the annual mandatory contributions continue at similar levels as current.  I have conservatively assumed the $30 mm of underfunded pension debt, and have not modeled in significant step downs in pension contributions. 

3)    The IPTV rollout may not gain traction, and the investment could have a subpar return on capital

4)    Line losses could accelerate, especially if Time Warner Cable decided to get aggressive on the pricing and promotion front.

5)    The economy of Hawaii could turn down severely.  It is highly correlated with tourism, which has so far recovered nicely from the 2008/2009 levels. However, other indicators of economic strength, including new business formation have not rebounded at similar rates.  

Catalyst