Description

HCOM: $26, $290M mkt cap

Summary

Hawaiian Telcom Holdco (HCOM: $26) is available at what should eventually turn out to be a attractive price due to a frustratingly slow and capital intensive transition in the revenue and ebitda mix from declining legacy voice access businesses to faster growing digital video and broadband related businesses. As this transition continues the company should emerge with substantial free cash flow and a more defendable profit model.  Also the company is a small cap, post bankruptcy entity with limited float and controlled by 4 large shareholders, further limiting its investor appeal.

To cut to the chase, i think the transition will stabilize and then grow EBITDA and substantially improve free cash flow and that HCOM is a year or so away from significantly accelerating shareholder friendly capital actions. HCOM could eventually generate a Free Cash Flow yield of >10% on today’s price, most of which could be paid out as a dividend.  Book value, at yearend 2014 is $28.50 ($27 using f.d. shares). Revenue and adjusted EBITDA for 2014 were $391M and $118M respectively. While I don’t expect much growth in the next year or two given the mix shift described above, a valuation of 5.5X 2016 EBITDA of $125M less $250M of net debt and $50M of pension, on 11.5M f.d. shares suggests a value of $34, nearly 30% above the current quote.  FCF of $30M could support a combination of dividends and debt paydown or buybacks also supporting a valuation in the low to mid $30’s.

Note: As FCF comes into view, we expect an interesting debate to develop on dividends versus buybacks given the discounted valuation versus the view that peers trade on dividend yield and the limited float.  Management continues to point to 2017 as the year of “significant free cash flow”. 2016 should show positive free cash flow  from core operations although the final year of Oahu build-out and the final payment for the Trans-Pacific Cable $25M in ’15-‘16) will depress reported FCF results.

Also, please note that jdr907 posted an excellent (and well timed @ $16) write-up of HCOM in March 2012. Another VIC member also wrote the company not long after the Oct 2010 emergence from BK. I will not attempt to outdo those write-ups but perhaps to update the current situation and highlight recent developments and potential catalysts.

Caveats:

Legacy Business: HCOM’s legacy voice access line business is in long term structural decline.  I do not expect this to reverse (for HCOM or other ILECs) , but rather management’s realistic take on this business is likely to lead to further cost reduction programs.

Competition: Hawaii is a relatively protected market with generally only 2 pipes to the home as satellite has significant logistical and economic hurdles. HCOM’s primary competitor, Time Warner Oceanic gained significant share before, during and shortly after HCOM’s bankruptcy process and clearly has superior financial resources.  HCOM appears to have a better video product and a better price point for broadband, but it will take time to gain back share.  I am assuming that, not withstanding the occasional skirmish, both HCOM and TWO will behave rationally in recognition of the duopoly nature of the market.

Cord Cutting:  This is happening to some degree in Hawaii though less than it is on the mainland but HCOM’s fiber build-out is also positioning the company to provide the pipes over which the cordcutters get their internet service. 

Capital Intensity: HCOM is now in year 4 of a 5 year program to build out Oahu and recently tightened its 2016 goal to 220k from 240k. Currently 160K. Thus the capital intensive part of this initiative should be peaking while the increased penetration efforts should show improved metrics for many years to come as the company gains scale in marketing and service costs.  Total Capex was $97 in 2014 and should be flat in 2015 but then begin drop meaningfully in 2016 and 2017 as the Oahu buildout winds down and the Trans Pacific Cable payments conclude.  Management claims maintenance capex is less than $20M though we estimate additionally defined “program” capex of $35-40M is required to keep EBITDA at least flat.  This implies normalized Capex of more like $50-60M.

Control Shareholders: The top 4 shareholders control 55% of HCOM. I view this a big positive for holders with a reasonable investment timeframe.  Based on communications from one of those holders in their partnership letters, they have a 12-18 month timeframe for a public market or strategic exit.  Twin Haven, the #2 holder at 16%, has been buying stock in the open market with 80K purchased in the last 2 weeks.

Management:  Management owns about 3.6% of the stock and appears to have reasonable but not heroic incentive based comp.  In a twist, the revenue, ebitda and cash flow targets and the historical performance against targets are actually laid out clearly in the proxy.

Thesis

 The wind down of the Oahu fiber network buildout program, the step down in pension costs and the one-time nature of the undersea cable initiative will allow for significant free cash flow to develop which in turn will allow for meaningful dividends and/or a share buyback program.  Management is quite open with their intentions in this regard.  Investors may simply have grown tired of waiting as previous timeframes have proven to be premature.  In addition, the ownership block held by the top shareholders is likely to hold management’s feet the fire and eventually trigger monetization of that stake.  I have been unable to confirm the realizable value of the $100M each of Federal and State NOLs as per the 2014 10K but will update that value as I learn more.

Business Summary

HCOM is the incumbent telephone carrier (ILEC) in the Hawaiian Islands. Originally the Hawaiian assets of Verizon, HCOM was purchased by Carlyle in 2005 for $1.6B (which was a wrong number?). After a BK in 2008 over $800M of debt was exchanged/extinguished and HCOM emerged in October 2010.  The company lost significant share due to underinvestment during its ownership by Carlyle and the subsequent bankruptcy but those market share trends appear to be reversing under the current management. 

Hawaii is generally an attractive market with geographic protection from satellite, low unemployment and relatively steady, albeit tourism dependent growth.

Business lines

Consumer- consists of voice access, digital video (28.1k subs, 17.6% penetration of enabled HHs, $87 ARPU) and broadband.  Voice access declining, digital video and broadband growing nicely as fiber buildout continues/concludes.

Business- consists of enterprise IP, data center and Cloud services. Also includes Fiber to the Tower buildouts (411 at yearend 2014, $6M annualized revenue, 73 additional sites under contract to build). Equipment sales, T-1s down, data center, cloud, FTTT, security services growing.

Business Strategy:

 (1) Build out fiber network to Oahu homes for its digital video offering.  (think Fios or U-verse, but much nicer weather).  Drive uptake rates through continued (and potentially more cost effective) marketing programs).  Current penetration rate of 17.6% of enabled homes implies considerable upside.

(2) Drive subscriber growth in broadband service.

(3) Capture Near term and long term revenue and Ebitda opportunity in Fiber to the tower (FTTT).  Long term, growth in wireless data traffic should make this capacity quite valuable.

(4) Make small, but strategic acquisitions which enhance the company’s long term public market and strategic value.  Bought SystemMetrics (security products and solutions) in 2013.

(5) Capitalize on the potential of the Trans-Pacific Cable project currently underway. HCOM will spend $25M between 2015-2016.

Catalyst

Wind-down of fiber buildout, reduced pension expense and adjustmment for 1-time trans pacific cable project will reveal free cash flow inflection.

Improved business mix as faster growth intiatives offset declines in legacy voice will improve and highlight strategic value.

Top shareholders likely to push for strategic monetization if public market fails to respond as the above catalysts play out.