Description
Hector Communications is an undervalued situation with a compelling catalyst. Hector operates a Regional Local Exchange Carrier. The Company also has a hidden asset in the form of a minority ownership stake in a very profitable and growing wireless partnership, to which I believe the market is (errantly) not assigning much value. Management has recently hired an investment banker to “explore strategic alternatives” after being on the receiving end of significant pressure from a number of large shareholders to sell the Company. One shareholder, Opportunity Partners, stated in a 13D that it believes a sale could result in $35+ per share of proceeds to shareholders, and my work concludes that a conservative floor on a takeout price would be $28 with a high number of $38 per share. With a high probability of a deal in the next 12 months, this appears to be an attractive risk/return situation.
Business Description
Hector Communications’ primary business is to operate a Regional Local Exchange Carrier (RLEC). The Company services 29,369 access lines in 28 rural communities in Minnesota, Wisconsin and North Dakota. HCT also provides cable television and video service to 7,869 subscribers in Minnesota, Internet access to 6,679 customers and other ancillary services. The Company also owns an 8% interest in Midwest Wireless, LLC, a wireless operating partnership with 415,000 customers primarily located in fourteen rural service areas across Minnesota, Wisconsin and Iowa. The Company also has small investments in a number of ancillary businesses including a CLEC.
Activist Shareholder(s) Involvement
Activist shareholder Opportunity Partners (owner of 8.2% of the Company) in a 13D filed 4/13/05 had discussed running a proxy solicitation in opposition to the current Board of Directors, stating the following:
“As you know, at last year's annual meeting, shareholders approved a proposal requesting the board to either redeem Hector's poison pill or put it to a shareholder vote. Since we have not seen an announcement since the meeting, we must assume that the board has determined not to implement the proposal.
We believe the market price of Hector's shares is significantly less than their intrinsic value and that a merger or a sale of Hector's operating business could yield a package of cash and securities worth more than $35 per share. We request that the board consider whether it is time to pursue a transaction designed to maximize shareholder value.
We respectfully ask you to give serious consideration to this matter at your next board meeting and, if necessary, to postpone the annual meeting to allow shareholders adequate time to reflect on the board's determination. While we sincerely hope it will not be necessary, we are prepared to conduct a proxy solicitation in opposition to the board rather than allow the 2005 annual meeting to go forward without resolving this matter.”
The proposal from Opportunity has apparently been dropped as no subsequent filings have been forthcoming. The reason for the lack of follow-up from Opportunity was apparent after the Company’s 8-K was published on 5/4/05. In it the Company stated that it had hired an investment banker to consider its strategic options, code for pursuing a sale of the Company, I believe.
So it appears the Company will be for sale and considering strategic options. With Gabelli owning approximately 10% of the stock, North Atlantic Value at 10%+, and Opportunity Partners at 8%, if a value realizing transaction is not effected in the next 9-12 months, I believe a proxy fight will be forthcoming. In addition to Opportunity Partners’ 13D above, other shareholders have been vocal regarding the future of Hector. Gabelli put forth the aforementioned shareholder proposal that the Company redeem its poison pill, and North Atlantic Value filed a 13D in mid-2004 stating that they would take action if the Company did not take steps to enhance shareholder value, including a sale of the Company. The writing is now on the wall for management and they appear to be capitulating. I would note here that the CEO is 73 years old and owns 13% of the stock; it appears he may be prepared to retire and agrees with Opportunity Partners point of view.
Valuation
A sum of the parts and separate stand-alone valuation suggests that the $35 per share valuation suggested by Opportunity Partners is not out of the question.
In terms of valuing HCT, I have taken two approaches. The first is to consider a sum of the parts valuation, which I think is particularly relevant given the potential for a transaction in the near-term. The second is to check this valuation against an all-in absolute valuation.
SUM OF THE PARTS VALUATION
RLEC Valuation
RLEC’s are still afforded reasonable multiples due to their ability to generate high margins and sizable cash flows. Additionally, RLEC’s are typically in less desirable markets for direct competition as new entrants cannot justify the cost to directly compete in the local telephone business. While revenues from long distance access and other phone related services are falling gradually due to the regulatory environment, wireless substitution and voice over Internet competition, the provision of DSL and Internet-related services have helped to cushion the fall.
Given that a transaction appears to be in the offing, I believe a look at comparable company valuations is appropriate:
EV/Revenue EV/EBITDA EV/Access Line
Centurytel 3.1x 6.1x $3,325
Citizens 3.8x 7.3x $3,652
Commonwealth 3.7x 7.3x $2,519
CT Commun 1.7x 5.4x $1,946
Fairpoint 4.4x 9.1x $4,179
Iowa Telecom 5.0x 8.5x $4,009
Average 3.6x 7.3x $3,271
Source: Baird, June 2005 “Spectrum” Report
Based on these valuations, it is reasonable (and conservative), I believe to assign a range of values on a takeout of $3,000 to $3,500 per access line as a low and high bound on the valuation with the thought in the back of the mind that it could be higher. I then spot-check these numbers against an EBITDA multiple:
Total RLEC Access Lines: 29,369
Value/Line (Low) $3,000
Value/Line (High) $3,500
Total RLEC Value (Low) $88.1 Million
Total RLEC Value (High) $102.8 Million
LTM EBITDA $14.8 Million
LTM EBITDA Multiple (Low) 5.95x
LTM EBITDA Multiple (High) 6.95x
I think a 6-7x EBITDA take-out multiple is a conservative assumption and the numbers could certainly end up higher than this in the end, but I think it serves as a reasonable place to begin valuing Hector. Please note I have not attempted to value the cable subscriber and Internet customer base as they are in large part serviced through broadband equipment layered on top of the access lines. The Company also provides a number of other ancillary services, including fiber leases, directory services, billing services, commissions from sales of services, etc. that I have not attempted to value separately. These businesses are all profitable and are included in the LTM EBITDA figure above. I feel the exclusion of these businesses from my calculation leaves some margin for error and gives me more comfort in the $3K-$3.5K figure I used to value the access lines.
Midwest Wireless Investment Valuation
Midwest Wireless is owned by telecommunications companies located within the Midwest Wireless’ operating footprint in southern Minnesota, northern Iowa and west central Wisconsin. Hector is the second largest member of the LLC, with an 8% ownership stake. Hector actively participates in Midwest’s operations and has had a seat on the Board of Directors since its inception. The Company made a very nice acquisition of PCS licenses in 2001 for regions of Iowa, North Dakota and Minnesota from McleodUSA. Here is an overview of historic financials:
1998 1999 2000 2001 2002 2003 2004
Revenue $49.1 $58.0 $112.3 $140.5 $162.7 $179.6 $220.7
EBITDA $25.5 $40.1 $50.3 $59.0 $61.0 $74.7
Op. Inc $17.6 $17.5 $24.5 $28.0 $39.6 $38.2 $44.7
Net Inc $17.0 $16.0 $16.2 $16.6 $28.1 $27.5 $35.2
Net Debt$10.0 $28.4 $130.8 $159.8 $152.7 $183.7 $160.2
CapEx $11.5 $16.6 $28.0 $33.8 $31.9 $29.2 $33.8
Acq $0.0 $0.0 $96.2 $22.4 $7.4 $42.8 $0.0
Unit Red$0.1 $12.8 $0.0 $0.0 $0.5 $0.0 $0.0
MembDist$8.6 $6.8 $5.9 $8.2 $8.3 $9.5 $9.2
While Midwest has grown substantially over the past five years, it appears they are now seeing a new leg in their growth. Q1 2005 numbers were exceptionally strong. In addition to new subscribers, Midwest appears to be benefiting from new technology adopted recently. In 2003 Midwest made the decision to switch its cellular network from TDMA to CDMA. They incurred significant costs in 2003 and 2004 to make the switch and these benefits now appear to be paying off. CDMA infrastructure offers the ability to drive more data to the phone, allowing cell phone providers to offer new high margin wireless services including camera phones, digital music and text messaging (there is a good article in the 6/25 issue of Barron’s discussing the opportunities to deliver digital music via cell phone), as well as a much easier migration path to 3G technology. Midwest Wireless Q1 numbers were as follows:
Q1 2004 Q1 2005
Revenues $48.4 $58.5
Operating Income $8.4 $16.5
Net Income $8.5 $13.4
Given that Depreciation and Amortization has been running at $7-$8 million per quarter, it appears that Midwest is on a run-rate for $90-$100 million in EBITDA for 2005. They currently have 415,000 subscribers. Additionally, these subscribers are in rural markets, making these assets much more attractive versus those in urban centers. After building a cellular network in areas like North Dakota and Iowa, a rural cellular operator like MW Wireless has a much more protected franchise with a lower threat of competition, because the economies of overbuilding a rural market are less attractive.
To place a value on this investment, I have looked at multiples of comparable companies as well as recent M&A transactions.
Comparable Company
EV/’05E EBITDA EV/Sub
Alamosa 9.3x $2,278
Dobson 8.4x $1,934
Leap 6.5x $1,137
Ubiquetel 9.2x $2,503
U.S. Unwired 11.0x $2,331
Average 8.9x $2,036
Source: Baird, June 2005 “Spectrum” Report
Comparable Transactions
Date Acquirer Acquiree EV/LQA EBITDA EV/Sub
1/10/05 ALLTEL Western Wireless 8.7x $2,042
12/15/04Sprint Nextel 8.3x $3,045
12/8/04 Alamosa Airgate PCS 9.3x $1,640
2/17/04 Cingular AT&T Wireless 10.5x $2,151
3/19/02 ALLTEL CenturyTel Wireless 10.1x $2,400
Average 9.4x $2,256
Source: Baird, June 2005 “Spectrum” Report
Considering these valuation multiples and the strong recent results, I believe an 8-10x EBITDA multiple applied to Midwest is a reasonable assumption. Midwest should be generating strong cash flow at current levels of profitability, and I estimate the Company will pay down approximately $25 million of debt by the time of a sale (last balance sheet I have seen published is as of 12/31/04).
Using EBITDA Multiple
($’s in Millions)
EBITDA (Low): $90.0
EBITDA (High): $100.0
Multiple (Low): 8.0x
Multiple (High): 10.0x
EV (Low): $720.0
EV (High): $1,000.0
Net Debt: $135.0
Equity Value (Low): $585.0
Equity Value (High): $865.0
Value to HCT @ 8% Ownership (Low): $46.8
Value to HCT @ 8% Ownership (High): $69.2
Using EV/Sub
($’s in Millions)
Current Subscribers: 415,000
EV/Sub (Low): $1,800
EV/Sub (High): $2,400
EV (Low): $747.0
EV (High): $996.0
Net Debt: $135.0
Equity Value (Low): $612.0
Equity Value (High): $861.0
Value to HCT @ 8% Ownership (Low): $49.0
Value to HCT @ 8% Ownership (High): $68.9
Current Total Enterprise Value
In order to compare our sum of the parts analysis to the current valuation, it is necessary to calculate the current total enterprise value of the Company.
The Company has investments in a number of ancillary businesses that produced $482K of “Other Income” for the Company last year. Rather than assigning an EBITDA multiple to these, I have taken them out of the enterprise value at their book value of $3.3 million (Note: these investments are categorized as “Other Assets” on the Balance Sheet).
The Company also owns long-term CD’s, investments in the public stock of other telecommunications companies, Rural Telephone Bank stock and CoBank stock worth in aggregate $7.5 million which I take out of Enterprise Value. I calculate the current TEV of Hector as follows:
$’s in Millions
Cash: $21.6
Investments, Affiliates: $3.3
Other L-T Investments (CD’s, etc.) $7.6
Debt $55.0
Net Debt $22.6
Market Cap $89.7
TEV $112.3
Conclusion
The sum of the parts looks like this:
$’s in Millions
Low High
RLEC Value $88.1 $102.8
MW Wireless Value $46.8 $69.2
Total TEV $134.9 $172.0
Less Net Debt $22.6 $22.6
Projected Equity Value $112.3 $149.4
Value/Share $28.61 $38.06
% Upside 24.4% 65.5%
The book value of the MW Wireless investment is about $16 million, so there may be some tax implications if they sell the stake directly rather than spin/split it off or sell the entire business. However, with my “low” valuation I have used numbers well below the average of the comparables (which are not trading with a control premium attached), so I feel as though I’ve been sufficiently conservative.
STAND-ALONE VALUATION
My next step was to check the sum of the parts valuation against a stand alone look at the Company valuation. I tend not to use DCF’s as I think there are too many assumptions that go into triangulating around a value. I instead look at free cash flow yield and the potential for stability in cash flows. In the case of Hector, I looked at free cash flow inclusive of the free cash flow allocable to it from its ownership of MW Wireless. Based on the first quarter’s result for MW Wireless, I would expect the free cash flow allocable to Hector from the investment for 2005 to be $2.5-$3.5 million, while free cash flow from the RLEC should be around $6.5-7 million, in line with LTM numbers. With a current equity market cap of $87.5 million, this puts the current free cash flow yield at 10.5% to 12%. I consider this to be an attractive valuation of a business such as HCT given its stable free cash flows and rural market focus. While one could argue that LEC cash flows are in a secular decline, I would argue that the wireless investment cash flow growth should counterbalance this issue in the future. I would close out this line of thought by saying that I have not found many reasonable businesses in the current environment trading with a 10%+ free cash flow yield. A valuation of $35 per share would imply a free cash flow yield 6.6%-7.7%. This may be a bit high but certainly not outrageous, and certainly not outrageous in the context of a change in control where an acquirer could take out costs.
Another way to look at this is to consider the TEV/EBITDA multiple for the entire company using a “look-through” to allocate HCT’s proportionate interest in the EBITDA of Midwest Wireless. Using an EBITDA number of $95 million for Midwest Wireless, of which $7.6 million would be allocated to HCT and EBITDA of $14.8 million for the rest of the business, we have a pro forma EBITDA of $22.4 million. We then allocate an additional $10.8 million of debt to HCT (share of the MW Wireless debt), you have an all in EBITDA multiple for the business of 5.4x.
This is the same level as the lowest valued RLEC comp. Considering RLEC’s are trading at 7x+ and wireless businesses (not many growing as quickly as MW Wireless) are at 8x+, current pricing of HCT appears too cheap, particularly in the context of a “maximizing shareholder value” transaction. Investors appear to be valuing the Company solely on the value of the RLEC, as the whole enterprise trades at an approximate 7.5x Enterprise Value/LTM EBITDA of the LEC.
CONCLUSION
My conclusion is that Opportunity Partners point that a sale of the Company would generate in excess of $35 per share in cash and securities is not out of the question, and it is tough to envision something without a 3 in the front of it. Considering the timeframe to realize value given that the company is beginning a sale process, I believe this investment will generate a nice rate of return from these levels.
Catalyst
1 of the following:
Sale of the Company
Spin-off/split-off of RLEC or MW Wireless Investment
Sale of MW Wireless investment and dividend or share buyback
If none of these occur in the next 12 months, I would expect a proxy fight to be launched by either Opportunity Partners or North Atlantic Value to force one of the above.