Description

HickoryTech: Valuable Fiber Assets Hidden in Plain Sight

We've had pretty good success lately with these "re-rating" telecom ideas -- including Lumos (LMOS) which we wrote up a few months ago. Just yesterday, I noticed that NTS, a company in a very similar situation to HTCO and LMOS, was acquired for a nice valuation. In past years, we also were involved in a similar situation with SureWest (SURW), which was eventually acquired by Consolidated (CNSL). HickoryTech is one of the last remaining stories of its kind in the public markets today -- a boring, under followed telco going through a dramatic portfolio transformation that is likely to re-rate once the story becomes clearer.

HickoryTech has slowly but dramatically transformed itself since 2005, turning a challenging long-term outlook into a highly attractive one. Historically a run-of-the-mill purveyor of dial tone, its fast-growing regional fiber network is just now becoming HickoryTech's largest business. Investors have yet to catch the drift: The stock still trades at the low valuation that is routinely assigned to industry peers dealing with secular decline. But in this relentlessly consolidating industry, the growing value of HickoryTech probably won't remain hidden for long. On a sum-of-the-parts basis we estimate the stock's value at $18-$22 a share, 58%-93% higher than the Oct. 21 closing price of $11.42.

Key Points

• HickoryTech's Fiber & Data segment will overtake its traditional Telecom segment in total revenues this year, followed by a leading share of EBITDA in 2014. In 2005, Fiber & Data represented only 19% of telecom service revenues. Following years of internal growth and a pair of bolt-on acquisitions, we estimate the segment's contribution this year at 52%. This inflection point, reflected in the recent announcement that HickoryTech will soon adopt the trade name of its fiber network (Enventis) for the company as a whole, should give telecom and micro-cap investors a fresh reason to review the story.
  
  
• Within HickoryTech, Fiber & Data is at an inflection point of its own. Since 2005 HickoryTech has focused most of its resources on extending the geographic reach of its network--not unlike building a tollway without enough on- and off-ramps. Capital spending will fall in 2013 and again in 2014, but the mix of capital will shift to connecting new business and enterprise customers directly. This suggests improving margins for a heretofore under-utilized network as well as the potential for accelerating revenue growth. At the same time, our valuation is supported by current performance.
  
  
• Fundamental downside is limited. A strong balance sheet (net debt/EBITDA of 2.8), improving free cash flow (estimate $1.30/share in 2014), a handsome dividend (now yielding 5.3% including the 3.4% increase announced on Oct. 3), the economically defensive nature of telecom service revenues, and a history of disciplined capital allocation create a conservative risk profile.
  
  
• Estimate value at $18-$22 a share. 6.0x EBITDA is a fair multiple for the Telecom and Equipment segments, with the latter being only 7% of 2013E EBITDA. However, private-market transactions and public-company comparables suggest the Fiber & Data segment is worth 10x EBITDA or more, leading to a blended multiple around 8.0x. We believe the stock will achieve a wider audience as industry consolidation continues, and the recent story of Lumos Networks (LMOS) shows how quickly even a wireline telecom can be re-rated after the growth businesses become larger than the declining ones.

Profile and History

Founded in 1898 and headquartered in its hometown of Mankato, Minnesota (about an hour southwest of Minneapolis), HickoryTech operates in three segments. Each accounts for roughly one-third of revenues, but each has a distinct growth and margin profile.

• Telecom (32% of 2013E revenues, 49% of EBITDA) provides traditional voice, high-speed Internet and digital TV service to residential and business customers in and around Mankato and in several communities in northwest Iowa. Competition in HickoryTech's RLEC (rural local exchange carrier) service territory is limited: In addition to wireless providers, HickoryTech typically faces only one wireline competitor (Charter CHTR in Mankato and Mediacom in outlying areas). Wireless substitution, reform of regulatory support mechanisms, and cannibalization of business customers by the Fiber & Data segment will

• Equipment (32%/7%) is a value-added reseller of Cisco network gear and related services in Minnesota. This business was added in late 2005 through the acquisition of Enventis from Allete (ALE), an electric utility in northern Minnesota. Revenues are cyclical, lumpy, and generate EBITDA margins far lower than the Telecom or Fiber & Data segments. But it also generates around $2.5 million of pretax cash flow annually with only $10-$12 million of net assets. Managed as a separate subsidiary, it could also be sold without altering HickoryTech's other operations.

• Fiber & Data (36%/44%) also joined HickoryTech as part of the Enventis acquisition. It now operates a 4,500 route mile fiber optic network that touches all of the important population centers in the state of Minnesota as well as Fargo, Sioux City, Des Moines, La Crosse and Eau Claire in adjacent states. At the time of the acquisition, this was HickoryTech's smallest segment in terms of revenues. In 2013, Fiber & Data will become the largest segment for the first time on an annual basis.

Fiber & Data: Driving Growth and Unrecognized Value

Since acquiring Enventis in 2005, HickoryTech has invested over $40 million to broaden the reach of its network through construction projects and a pair of bolt-on acquisitions (CP Telecom in 2009, IdeaOne in 2012). The acquisitions, as well as a one-off construction project for a third-party in 2010, have messed with the yearly rate of revenue growth, but our analysis indicates consistent internal revenue growth topping 9% annually.

As the Fiber & Data segment has grown, the revenue and EBITDA profile of the company has changed considerably. Excluding the Equipment segment, Fiber & Data was just 19% of telecom service revenue in 2006, rising to 48% in 2012, an estimated 52% in 2013, and probably 60% by 2015/2016. For reasons we'll touch on in a moment, Fiber & Data EBITDA margins have lagged those of the legacy Telecom segment thus far, but Fiber & Data should contribute a majority of telecom service EBITDA in 2014.

Given the expansion in high-speed data traffic across the country, we expect good revenue growth to continue. However, we think there are good reasons to expect upside going forward--not just in margins, but also for revenue growth. The Enventis network got its start as a wholesale backhaul provider to other RLECs in Minnesota--a lower-margin source of revenue than direct customer connections. To date, HickoryTech has spent a disproportionate amount of attention and resources expanding the geographic reach of its network rather than on penetration: not unlike building a tollway before adding the on- and off-ramps. That focus is shifting right now. The Greater Minnesota Broadband Project (70% funded with federal stimulus dollars; completed on time and under budget) appears to be HickoryTech's last major network extension. Capital spending will decline from $30 million in 2012 to $24-$28 million in 2013 and should decline again in 2014. At the same time, the locus of capital spending will shift strongly toward customer acquisition.

We like management's strategic approach. Instead of building yet another metro fiber ring in downtown Minneapolis, HickoryTech is using a rifle-shot approach to target small areas that rivals have ignored both in the Twin Cities area and outstate Minnesota--areas that, once HickoryTech has laid its cable, might never face another fiber-based rival. This objective will be advanced by sophisticated mapping tools to optimize its customer acquisition and construction efforts. Wireless backhaul also remains a good opportunity that hasn't yet been realized in full, as states in the upper Midwest are often the last to receive major wireless network upgrades. Combined, these factors suggest continued annual internal revenue growth in the 10% range, with a likely bias toward the upside over the next year or two.

If anything, we suspect HickoryTech isn't deploying capital as quickly as the company's finances would allow. Between 2006 and 2012, the segment actually generated $5 million more in cumulative EBITDA than it spent on capital expenditures; in the first half of 2013, it generated over $10 million of EBITDA and spent less than $6 million in capex. But we find this approach to be prudent: It's not just how many dollars are spent, but how effectively they're spent, and management has prudently respected the segment's organizational constraints rather than simply throwing money at the wall.

Fiber & Data EBITDA should grow even faster. Considering the extensions in recent years, the network is currently underutilized, which permits the bulk of future revenue gains to drop to the bottom line. Compared to fiber peers, HickoryTech also has a relatively high proportion of customers that require leased last-mile connections through third parties. A focus on acquiring on-net revenue will benefit margins. Lately the company has also added additional marketing, engineering and support staff to make the transition toward more direct customer connections. This investment has weighed on margins in recent quarters, but can reasonably be expected to pay off. In the longer run, both the Telecom and Fiber & Data segments will benefit from sharing resources: Unlike RLEC-only peers, HickoryTech can easily reallocate staff between the two. In all, we believe EBITDA margins will soon trend toward 40%.

Telecom and Equipment: Generating Cash, Doing No Harm

The Telecom segment provides voice, high-speed Internet and digital TV service in and around Mankato, and voice and DSL service to several communities in northwest Iowa. Like most RLECs, Telecom has experienced considerable runoff in access lines, traditional voice service, and regulatory support revenues in recent years. Following reforms to interstate access charges and the Universal Service Fund (replaced by the Connect America Fund), 2012 was a particularly tough year for this segment with a 9% drop in revenues. The segment's performance stabilized in Q2/2013, though management expects a long-term revenue decline rate in the low single digits, partly due to cannibalization of business customers by the Fiber & Data segment.

HickoryTech has done a good job rolling out high-speed DSL and television service in the Mankato area, which has historically limited the rate of decline for total revenue. Competition is relatively limited as well: In addition to ubiquitous wireless substitution for voice service, the Telecom territory generally faces only one other wireline competitor (Charter CHTR in Mankato itself, Mediacom in rural areas, both of which rolled out triple-play packages several years ago). Telecom also continues to generate significant free cash flow, with maintenance capital spending of $10 million or less compared to $16 million in annual depreciation and $24 million in estimated 2013 EBITDA.

In the Equipment segment, quarterly revenues are unpredictable and EBITDA margins are low. This may strike dissonant notes for investors expecting steady, high-margin revenues from telecom firms. That said, the Equipment segment is generating about $2.5 million of pretax free cash flow before fluctuations in working capital. Moreover, working capital accounts for virtually all of the (limited) amount of capital employed in this segment, and 40%-60% of segment assets are financed at no cost to HickoryTech through a credit line provided by GE Capital. (This is the "extended term payable" on HickoryTech's balance sheet, which we characterize as a form of accounts payable and exclude from net debt.) Though this unit provides some cross-selling opportunities for the Fiber & Data segment, it is run as a standalone subsidiary. It is not a primary emphasis for future growth, and we do not believe management is opposed to selling the unit if the right opportunity arises. DataLink (DTLK), based in Eden Prairie, Minnesota, is a possible acquirer.

Valuing HickoryTech's Parts

At a closing price of $11.42 a share on Oct. 21, HickoryTech is valued at 5.8x EBITDA using the midpoint of management's EBITDA forecast for 2013 and our estimate of net debt at year end. This multiple has barely changed over the years and is reasonably consistent with the multiples accorded to larger RLEC peers like Windstream WIN and Frontier Communications FTR whose internal revenue and EBITDA growth are still staring up at 0%. Though we believe the limited competition, high triple-play penetration, and potential synergies for a strategic acquirer could earn HickoryTech's Telecom segment a higher multiple (we note Consolidated Communications CNSL with a profile similar to HickoryTech's Telecom segment trades closer to 7x), we use a 6x multiple for this segment in our analysis. Averaging our 2013 and 2014 forecasts, each 1x of Telecom segment EBITDA is worth about $1.70 a share.

A multiple of 6x is justified for the Equipment segment as well, though for different reasons. In a conversation with HickoryTech management, they suggested a private-market value of 25%-40% of revenues for comparable businesses--price/sales being the typical valuation metric. Though regional competitor DataLink (DTLK) trades at 45% of sales and near 10x trailing EBITDA, a price/sales ratio of 32.5% corresponds to 6 times EBITDA and an 1.6 times estimated net assets. This makes intuitive sense given the segment's minimal capital requirements, but the context is this: At 6x EBITDA, the Equipment segment accounts for only 5% of our enterprise value estimate.

However, a 6x multiple for the Fiber & Data segment looks absurdly low. Many peers such as Zayo and Integra are privately held, but Zayo's 2011 acquisition of AboveNet at 10x EBITDA provided a benchmark for the sector. On Oct. 21, NTS, Inc.--a broadband provider in Texas--was sold for 10x adjusted EBITDA based on annualizing the most recent quarter's results. Meanwhile, TW Telecom (TWTC) trades at 11x, Level 3 (LVLT) at 10x, and Cogent Communications (CCOI) at over 17x trailing EBITDA. Using an EBITDA multiple of 10x--just for the Fiber & Data segment--reveals significant upside potential for HickoryTech shares. On our 2013 estimates, we derive a value of $18.59 a share. On our 2014 estimates (6.5% consolidated growth in EBITDA, $9 million decline in net debt as free cash flow exceeds dividend payments), the value rises to $21.85 with the same segment multiples. Averaging our 2013 and 2014 forecasts, each 1x of Fiber & Data EBITDA is worth about $1.75 a share.

Additionally, our free cash flow estimates validate our sum-of-the-parts analysis on a standalone basis (that is, without assuming any takeout premium or synergies). Excluding year-to-year fluctuations in working capital--which historically have netted out to zero--we estimate free cash flow at $1.03 a share in 2013. This rises to $1.30 a share in 2014 on higher net income and lower capital spending. Given a 10% cost of equity and a long-term growth rate of 3.5% (which strikes us as low), HickoryTech should trade at 15 times free cash flow (a free cash flow yield of 6.5%) rather than less than 10 times 2014 free cash flow.

Limited Fundamental Downside

With the stock already trading as a secular-decline story (which it clearly isn't), we believe the potential downside is low. Telecom services are economically defensive and HickoryTech has a well-diversified customer base. Net debt, currently 2.8x EBITDA, should reach 2.6x at year-end 2013 and 2.3x by the end of 2014, assuming no acquisitions or share repurchases. The company does offer certain post-retirement benefits that are accounted for on the balance sheet, but it does not have a defined-benefit pension plan. The dividend, currently yielding 5.3%, lends strength as well. The current rate of $0.60 annually should consume less than half of free cash flow in 2014 and has been raised modestly (with no reductions since at least 1995) in each of the last four years.

We are also comfortable with management's approach to capital allocation. The company has not overextended itself in pursuit of growth through acquisition, keeping net debt close to or below 3x EBITDA since the Enventis purchase. Management has expressed no interest in adding to its RLEC footprint, but would consider additional deals similar to last year's purchase of Fargo-based IdeaOne that add fiber connections direct to customers.

Realizing the Value

HickoryTech. Sounds like the name of a community college, doesn't it? Enough of a reason for investors to ignore the stock? If that isn't the reason, it could be the total lack of sell-side coverage, the 75% retail ownership, relatively low volume (20,000 shares a day), the distracting elements of the Equipment segment (which creates volatility in total revenue and depresses total-company margins), or the easily-dismissed prospects of HickoryTech's peer group.

We believe this situation will change. Higher free cash flow in 2014 and margin expansion in the Fiber & Data segment are likely drivers of value, and if HickoryTech does not make another bolt-on acquisition, higher share repurchases are probable as well. Management could also sell the Equipment segment, using the proceeds to retire shares, as a way of highlighting the company's value. However, it's the story of Lumos Networks over the past year that really lights the way.

Lumos is the most comparable publicly-traded peer for HickoryTech; the key differences are HickoryTech's Equipment segment and Lumos' higher margins--Lumos appears to be a year or two ahead of HickoryTech in terms of customer penetration. A year ago, Lumos traded at more-or-less the same EBITDA multiple that HickoryTech did. But when Lumos hit its inflection point, with strategic data revenues overtaking legacy voice and access revenues in Q3/2012, the stock built momentum quickly. Setting aside Lumos' adjustments to EBITDA in order to arrive at an apples-to-apples comparison, Lumos shares are up 136% year-to-date and now trade at 9.2x management's EBITDA estimate.

Along the way, Lumos has benefited from sell-side initiations (all buys) and especially from the perception that the company is up for sale. Having 26% of the shares and 3 board seats held by private equity fund Quadrangle Partners certainly helps in that regard. For its part, HickoryTech has outlasted virtually all of its regional peers as an independent, publicly-held entity, and it has a staggered board and a poison pill. However, after meeting with management, we don't believe they are determined to maintain the company's independence at any cost. Instead, having the benefit of growth opportunities other RLECs lack, we think they've simply waited in order to optimize the value of the business.

Ironically, HickoryTech has already passed Lumos on several key metrics--leaving it up to investors to do just a bit of math. At the beginning of 2013, Lumos redefined its revenue and profitability classifications to shift all of its growth businesses into its Strategic Data segment, which accounted for 57% of revenues in Q2/2013. Using the same classification technique to shift the broadband (Internet and Digital TV) revenues from HickoryTech's Telecom segment to Fiber & Data, 68% of HickoryTech's Q2/2013 telecom service revenue came from businesses with stable or growing long-term trajectories, with the other 32% from access, voice service and other (principally billing services and directories).

We also note that Archer Capital Management, a small but highly-regarded hedge fund, showed up as a first-time buyer of HickoryTech shares in its second-quarter 13F. In 2012 and 2013, Archer built a stake in Lumos exceeding 10% outstanding shares at a very low average cost. This firm certainly identified the value in Lumos; we think they've correctly identified the value in HickoryTech as well.

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