Description

Knology Inc (KNOL: $14) provides cable TV, local and long distance phone and high-speed internet access to customers in eight states, mostly in mid-sized and smaller markets. 

Knology operations are solidly profitable (34-35% ebitda margins) and the company is growing revenue (both net subscribers and pricing) in a challenging economic environment for their residential and small business customer base. We believe the company trades below fair public market value and well below strategic value due largely to a recent marketing misstep, some industry concerns about cord-cutting and other competitive challenges and a general lack of investor awareness given KNOL's relatively small market cap.

Investment Thesis

Despite a recent, and candidly acknowledged, marketing/pricing misstep, Knology continues to build a solid track record of internal growth, high return incremental capex and value accretive tuck-in acquisitions. The company also has a sizable ($200M) NOL. As the noise from the Q4 misstep fades, organic growth recovers, recent acquisitions show expected benefits and free cash flow accelerates, KNOL's reported results should improve and strategic value should continue to appreciate.  As these improvements become transparent to even the casual observer, we believe the gap between the current price and fair public market valuation (and higher strategic value) will compress, initially through market appreciation, and eventually through a sale of the company. Our sense is that management is frustrated with the current situation, but believes that sticking to the internal/acquisition growth plan for at least the short term will maximize ultimate value in the event of a sale.  Fair public market value would be at least a 20% gain, while reasonable strategic value is at least 50% above current levels.  Management concedes that only a strategic transaction is likely to truly maximize value for shareholders given the prospects for eliminating public company costs and corporate overhead.

We believe that most of the current corporate expenses (estimated at $10M) could be eliminated in the event of an industry consolidation.  The savings to an in-market purchaser could be substantially higher.

The company recently (2/18/11) refinanced its debt, increasing the combined facility by $70M, extending the Term A/B out to 2016/2017 and dropping the Term rates by 100-150 bps.  All in, the refinancing should save about $10M /year in annualized interest expense.

What Happened Recently: Our assessment of the Q4 stumble referenced above is that management overreached on a new marketing plan and did not appropriately factor in the overly aggressive effective price change to be seen by the customer.  In other markets a competitor offered an irrational promotion which the company chose not to match and which, indeed proved to be short-lived.  The combination of these two events produced net subscriber adds well below expectations and created a 20% sell-off in KNOL stock. The internal and external pricing issues appears to have been corrected and net subscriber adds appear back on track.

Valuation

At $14, with 39M f.d. shares and 700M in net debt, KNOL has a market cap and EV of $546M and $1.25B, respectively. This represents 6.6X 2011 EBITDA ($188M) and a 7% free cash flow yield, defined as (EBITDA-Capex)/EV.  On '12, the EBITDA multiple drops to 6X and the free cash flow yield jumps to 10%.  ($201M-$75M)/$$1.2B. Capex should be less than $100M in 2011 (including $25M for edge-out strategy) and decline substantially in 2012. We have not explicitly included any value for the approximately $215M NOL (probably worth $1-1.50/share), but the tax shield should produce a substantial cash flow benefit and does factor into our lower net debt assumption for YE '11 and '12.  In addition, some of the prior, and the most recent, acquisitions have been structured as asset deals and thus provide an incremental tax/cash flow benefit relative to reported results.  Beginning in 2011 and into 2012, KNOL will be producing substantial net income and free cash flow as ebitda continues to grow, capex peaks, net interest expense declines from free cash flow and the recent refinancing and the NOL is utilized.  Depending on the final depreciation, interest and tax rate, KNOL should report eps and free cash flow between $1.25 and $1.50 in 2011.

Strategic Value

We estimate that at least $10M of corporate overhead costs could be eliminated in the event of a combination with a host of industry players.   A strategic buyer could thus realize at least $210M of 2012E EBITDA and consummate a highly accretive deal at 7X ebitda or $21 per KNOL share, 50% above the current $14 stock price.  

Strategic transactions in the cable sector would support valuations in the 6.5-8X ebitda range adding up to $300M or $8/share to the 6.5X/$16.50 "public market" valuation target.  Private equity also continues to be active in the cable space, although clearly that interest and the resulting valuations are predicated on aggressive external financing terms.

Management

KNOL's management and directors own about 24% of the company and have recently expressed the view that while they stumbled in Q4, the stock has "grossly overreacted" and is currently "dramatically undervalued".

The CEO (63) and the President have each been with the company for over a decade.  The CFO recently returned to the company (and to the CFO role) after a brief stint at another company.

Business Description

Knology provides service in eight states (AL, FL, TN, SC, GA, SD and KS) and competes effectively on marketing and customer service with one or more of AT&T, Comcast, Time Warner, Charter, MediaCom, Qwest and Midcontinent in each market.

While historically categorized as an over-builder, Knology and other providers now provide similar products and services and compete effectively, and are indistinguishable in the customer's eyes, versus the incumbent cable companies, particularly in mid- and small sized markets.  As of 12/31/10, Knology passed about 1.045M marketable homes and had 766K total connection including 255k video, 268k voice and 243K data. Of the total connections 651k were residential and 116K were business.  Average monthly ARPU was $53.61 in Q4-2010 versus $51.93 in Q4-2009.  By service ARPU was $73.37 for video, $40.10 for voice and $40.86 for data.

Edge-Outs are high margin investments which expand the company's footprint in existing and contiguous franchise areas.  KNOL will spend $25M of the sub $100M '11 capex budget on what they claim are +40% ROI Edge-out projects. 2010 edge-out spending was $18M.  Edge-outs should allow KNOL to produce faster growth than the cable industry.  In total, the company has identified more than $100M of edge-out opportunities.

Acquisitions continue to be an integral part of the Knology business plan and so far appear to be value enhancing although the largest is only recently closed. In 2010 KNOL closed the acquisition of Sunflower Broadband for $165M(less than 6X after savings).  Sunflower had higher margin than Knology, offered additional edge-out opportunities and at least $5M in annual consolidation cost sayings. Management claims to measure acquisition accretion against its own stock/company value and thus the recent stock decline has in effect raised the bar for any future acquisitions.  Ultimately we believe Knology would make an attractive acquisition candidate itself and management has acknowledged this as the likely endgame.

On Feb 21, the company signed a $30M deal to acquire former Charter cable/broadband operations in GA and AL, contiguous to existing Knology operations.  The acquisition is expected to add 21k connections, $15M in annualized revs and $5.5M ebitda, along with tax benefits from asset treatment. On its face this appears to be a very sound, value accretive acquisition for Knology.

Video - While the cable industry overall has been losing video customers, Knology has been growing video subs, in part because it is adding homes passed and in part because its video penetration (25%) is 15-20% below bigger players such as Comcast and Time Warner.  Knology's video ARPU has been growing as well, reflecting continued increases in digital penetration, which is also 15-20% below peers but rising.

Broadband - Knology provides fully competitive residential (and small business) broadband services at a variety of download speeds/prices. The network has been upgraded to DOCSIS 3.0. Once again, given the nature of its markets and the edge-out strategy, Knology's broadband penetration rate is below the peers, providing a path to more rapid growth in broadband subs and ARPU and overall margin given broadband's substantially higher margins

Voice -  Knology has higher penetration but lower ARPU in voice versus peers.  Management expects growth in voice subs to lag well behind Video and Data as the company specifically emphasizes the latter two offerings and as wireless substitution begins to impact even the mid/small markets.

Risks

Competition: As noted above, Knology competes with at least one big incumbent in almost every local market.  Given its focus on mid-and small markets and its demonstrated success in marketing and customer service we expect the company to continue to gain share over time.  However, as shown in Q4, 2010, the behavior of a temporarily irrational competitor, or Knology's own decisions can impact short term results.

Cord Cutting: Video cord cutting appears to be more of a big market trend, however big market cable players are implementing responsive (streaming) strategies and based on our discussions with Knology management, we expect them to respond when/if cord cutting registers in any meaningful ways in their markets.  Management has used this "slow follower" strategy in adapting to developments in Video-on-demand (VOD).

Acquisitions: Management may do a value destroying acquisition, but seems to have a good track record and seems focused on value creation rather than simple mathematical accretion.

Catalysts

Noise from the Q4 misstep fades, organic growth recovers, recent acquisitions show expected benefits and net income and free cash flow accelerates.

Gap between the current price and fair public market valuation (and higher strategic value) closes, initially through better operating performance driving market appreciation, and eventually through a sale of the company.

Free option on an eventual strategic process initiated by mgmt, shareholders or strategic/financial players.

Catalyst

Catalysts

Noise from the Q4 misstep fades, organic growth recovers, recent acquisitions show expected benefits and net income and free cash flow accelerates.

Gap between the current price and fair public market valuation (and higher strategic value) closes, initially through better operating performance driving market appreciation, and eventually through a sale of the company.

Free option on an eventual strategic process initiated by mgmt, shareholders or strategic/financial players.