Mediacom Communications Corp. (MCCC) - LONG THESIS

Thesis

Mediacom Communications is a highly-levered, cheap and underfollowed rural cable company that offers a very compelling risk/reward at current levels - especially in light of the takeout bid withdrawal by the Chairman/CEO. From an operating perspective, MCCC faces little competition in its rural footprint and is at a FCF inflection point with declining capital intensity.

• June 1^st, 2010. Mediacom Chairman/CEO Rocco Commisso offered minority shareholders $6/sh to take the company private. Any bid must get approval from the independent board, while a special committee was formed to provide a fairness opinion. To note, MCCC was above $7/sh prior to the bid - as recently as Apr '10
• August 31^st, 2010. Mediacom Chairman/CEO Rocco Commisso withdrew his bid to take MCCC private after the Board rejected a sweetened offer - rumored to be ~$7.55/sh, or ~26% higher than his previous offer. He stated:

"I am very disappointed with the highly unusual process and ground rules established by the special committee and its financial and legal advisors to evaluate my proposal. I firmly believe that the special committee's decision is not in the best interests of Mediacom's shareholders."

• MCCC trades at ~3.8x '10E FCF and ~3.3x '11E FCF vs. ~5x for peers (CVC, CMCSA, TWC). Many media investors look at valuing MCCC on EV/EBITDA, but this substantially undervalues the company given its significant NOLs (~$2.4B) and low, fixed-rate cost-of-capital (sub-6%)
• While the CEO's management-led buyout is off the table - at ~6x leverage, even modest EBITDA growth results in significant value-creation for shareholders as the debt gets paid down
• Given the impending dividend tax increase next year, I believe Commisso may return to the market with a higher bid and/or have MCCC issue a 'special dividend' by year-end - levering up 0.5x is ~$4/sh special dividend
• I believe MCCC will trade ~$6/sh level absent a new bid, while a 'bump' over the medium-term would provide upside to $8-10/sh. Ultimately, I believe MCCC has 'multi-bagger' potential over the next few years should a deal not be consummated. At a modest 2% EBITDA growth over the next 10 years, MCCC would return ~19% per annum

Description

• Mediacom Communications is an incumbent rural cable multi-system operator (8^th largest MSO) serving more than ~1.3mm basic cable subs in Midwest and Southeast, with significant customer concentration in Iowa, Illinois, Missouri, Minnesota, Florida, Alabama, and Georgia
  • MCCC is the largest and second largest cable company in Iowa and Illinois, respectively
  • ~69% of basic subs are in the top 100 DMAs, with >55% in DMAs that fall between 60-100^th largest
• Mediacom additionally serves ~705k digital video subs, ~814k high-speed data subs (HSD) and ~317k phone customers - for an aggregate of ~3.1mm revenue-generating units (RGUs)
  • ~52% of customers subscribe to two or more services ('double-play')
  • ~18% of customers are 'triple-play' subscribers
• Mediacom was founded in July 1995 by Chairman/CEO Rocco Commisso to acquire and develop cable systems principally serving rural markets in the US
• Commisso owns ~27.2mm shares, or ~38% of shares outstanding with ~86% voting interest. Public shareholders own ~43.9mm, or ~62% of shares outstanding

History

• 2007: Mediacom's markets were aggressively targeted by the satellite players looking to exploit Mediacom's programming battles with Sinclair Broadcasting and the Big Ten Network
  • Both Sinclair and Big Ten are now behind them
  • DISH has ceased its aggressive marketing push
  • MCCC not exposed to VZ/AT&T market buildouts
• 2008: MCCC's best operating year ever with +10% EBITDA growth and triple-play penetration hitting the teens (13% by Q2) - as 3-play penetration moves up in the teens, operating performance drastically improves - while churn decreases and margins improve. However, market weakness kept a lid on the stock. Despite weaker demographics, MCCC grew faster than cable industry peers
  • Capex spend was mostly 'one-time' in nature: plant upgrades, increased HD capacity and preparation for '09 digital transition
  • Q2 '08: Added basic subs for the 1^st time since Q1 2005
  • Greater video penetration expected in '09, but not in their markets
  • Operating momentum continuing into '09 with FCF guidance of $1/sh (~$65mm FCF) and lower '09 capex guidance

Competition

Historically, Mediacom was penalized due to its unfavorable demographics and from increasing competition from satellite players - however, all of the DBS market launches have already made their mark. DISH/DTV remains their most significant video competitor - but now competing mostly on price, as their video offerings are essentially similar. Like the rest of the cable industry, Mediacom has been effectively competing with the satellite players by offering 'triple-play' bundles, higher broadband speeds and other advanced services unavailable to satellite customers.

Mediacom's perceived disadvantages have turned out to be beneficial in the current environment:

1)      Telcos have been 'cherry-picking' markets with favorable demographics to deploy video, high-speed data and voice;

2)      Mediacom has been a technology laggard relative to its peers, but is now seeing acceleration in triple-play, voice and data penetration - off a far smaller base; and

3)      MCCC's rural markets have largely avoided the housing crisis.

Relative to other cable peers, Mediacom has lower voice and data penetration, and less overall competition given its rural focus. In general, rural markets tend to be technology laggards, but eventually catch up to the industry. Similar to its peers, Mediacom is now proceeding to take telephony in-house by deploying VoIP - cutting direct voice costs by ~50% on a per RGU basis.

• Mediacom has only ~12% voice penetration and ~29% data penetration, while Comcast/Time Warner Cable have ~15-16% voice penetration and 32-35% data penetration
• Mediacom's video ARPU is also ~$7 less than Comcast's and almost $10 below TWC, as a result of its lower HD/DVR/Digital/VOD penetration
• Mediacom has little cable 'overbuilder' exposure, though they compete with Qwest in Iowa and Minnesota (Qwest has no TV product). In the rest of their markets, MCCC competes with AT&T UVerse product. To note, AT&T's UVerse is based on FTTN/twisted copper-pair to the home - technically inferior to cable's hybrid fiber-coax technology
• Similar to its cable peers, MCCC is in the midst of spending capex to take voice in-house - it should be completed by mid-2011. Both CMCSA and CVC have already completed this - vastly improving phone business profitability; TWC is also in process (see Case Study below)
• Bottom Line: Since cable is a fixed-cost business - as more subs join and existing subs take on additional products/services, your costs and capex are spread over a wider base - once you reach breakeven, each incremental sub or product turns in pure profit/FCF

Declining Capital Intensity

The cable industry as a whole is facing declining capital intensity with FCF set to rise - primarily as a result of digital saturation and less of a need for add'l set-top boxes and installation labor/truck-rolls. Cablevision leads the industry as it penetration rates are significantly higher and most of their network capex is behind them. Over the last 2 years, both CMCSA and TWC have seen capital spending decline steadily as EBITDA has grown ~4-6%, on average. Most of this growth is coming from growth in data and voice products - which also happen to carry the highest gross margins. In other words, as triple-play penetration increases - both margins and FCF should continue to rise. This bodes well for Mediacom who significantly lags the industry in both data and phone penetration rates, and is still spending capex to upgrade its network (50% DOCSIS 3.0 coverage by YE10) and in-source its phone switch (expected H1 11 completion).

Product Gross Margins

• Both Comcast and TWC disclose direct product gross margins, while - unfortunately, Mediacom does not. High speed data carries direct gross margins >90% for both Comcast and TWC, with voice being the next highest at ~81% for CMCSA (see chart below)
• Interestingly, Comcast's voice gross margins are ~1500bps higher (~81.5% vs. ~66.4% in Q1) than TWC as a result of TWC's voice outsourcing contract with Sprint. Mediacom has a similar arrangement with Sprint, and both TWC and MCCC are in the processing of taking voice in-house (Comcast handles transport/interconnection in-house as a result of the AT&T Broadband acquisition in 2002)
• Similar to TWC, it initially made sense for Mediacom to outsource when VoIP was first introduced. MCCC originally entered into the agreement as a shortcut to secure interconnection in TelCo wire centers across the country. The Sprint deal allows Mediacom to handoff its phone traffic to single provider (Sprint) - who then deals with the other carriers under their existing interconnection agreements - providing MCCC a significant time-to-market advantage
• Mediacom expects to complete its phone capex by mid-2011. I would expect Mediacom voice margins to increase and penetration levels to approach industry levels (~11% today to low/mid teens)
• Assuming voice grows to ~10% of '12E revenues (~$160mm) from ~8% today, and Mediacom gains 1000bps of margins from in-sourcing, Mediacom's 'digital phone opportunity' would yield in excess of $35mm in overall margin gains, or ~$0.50/sh. On a 5x multiple, that alone is $2.50/sh!

Deal Dynamics

• At $6/sh - MCCC is valued at ~$3.7B Enterprise Value, or ~6.6x '10E EBITDA and ~6.5x '11E EBITDA. On a FCF basis, MCCC is far cheaper at ~3.2x '10E and ~2.9x '11E FCF multiples
• MCCC is currently trading roughly 15% higher than Rocco's bid price at ~$7.01/sh
• Given the CEO's near-40% equity stake and ~86% voting interest, it's unlikely another buyer emerges. However, I do believe the CEO will have to increase the bid in order to gain a majority of the minority shareholder vote - or risk facing significant shareholder lawsuits
• Any transaction also requires approval from the independent Board of Directors (see below). To note, one of the Special Committee Directors is Thomas Reifenheiser, an ex-JP Morgan banker, who was part of the Cablevision Special Committee that ultimately pushed the Dolan's original CVC offer from $27.00/sh to $36.26/sh

From the most recent proxy:

"Pursuant to a Significant Stockholder Agreement, dated September 7, 2008, Mr. Commisso has agreed not to consummate prior to September 7, 2010, an extraordinary transaction involving our company without the recommendation of a majority of either (i) the disinterested directors that are members of our Board of Directors or (ii) the members of a special committee of our Board consisting of disinterested directors. An extraordinary transaction means any transaction in which Mr. Commisso (in his capacity as a stockholder), directly or indirectly, seeks to effect (A) any acquisition of material assets of our company, (B) any buyout transaction, or (C) any recapitalization, restructuring, liquidation, dissolution or other extraordinary transaction with respect to our company."

Deal History

• Mediacom's Board formed a special committee comprised of current independent directors Thomas V. Reifenheiser and Natale S. Ricciardi to evaluate the bid. Advisors were hired, and ultimately the special committee rejected Commisso's initial bid
• MCCC closed at $6.27/sh on the first day after the announcement (June 1^st) of the bid (vs. $5.33/sh previous day's close), and regularly closed above $7/sh in the subsequent months
• On August 31^st, 2010, Commisso announced he had withdrawn the $6/sh bid and was disappointed the Special Committee had rejected "a meaningful increase" in his initial $6 bid, despite his agreement that acceptance of the bid would be subject to the approval of a majority of the minority shareholders
• MCCC promptly fell to an intraday low of $5.50 - down ~20% from the previous day's close, although it has since recovered - closing at $6.70/sh on 9/29/10

Dividend Tax Increase/Special Dividend

As a result of the Jobs and Growth Tax Relief Reconciliation Act of 2003 ("Bush Tax Cuts"), qualified dividends have been taxed at long-term capital gains tax rates: 15%.

• The dividend tax rate is scheduled to revert to an individual's ordinary income tax rate on January 1^st, 2011, unless extended by Congress
• The highest marginal rate on dividends will rise from 15% to 39.6% - or more than 2.5x the tax bill for high-income earners - a major near-term incentive to either go-private or issue a special dividend
• Bottom Line: With the going-private transaction off the table, I believe there is a decent probability Commisso capitalizes on today's relatively low tax rates by paying a special dividend by the end of the year. Alternatively, Commisso may return to the market and publicly offer a 'meaningful increase' to his $6/sh bid

Comparable Transactions

In the past few years, there have been several cable acquisitions - including three management-led buyouts. All of the transactions were ultimately consummated ~9x forward EV/EBITDA - the notable exception is Cablevision (CVC), but not without the Dolan's best efforts. At 8x EV/EBITDA, MCCC is a ~$14/sh on '10E numbers and ~$18/sh on '11E numbers - each turn of EBITDA is ~$8/sh.

• CVC/Bresnan: In June '10, Cablevision announced it was acquiring Bresnan at an 8.3x '09A EV/EBITDA.
• CVC MBO: In Oct '06, Cablevision's controlling Dolan family offered $27/sh to take all of Cablevision private - implying a ~10x current and ~8.5x forward EV/EBITDA multiple for the cable-only piece
  • In Jan '07, the Dolans increased their takeout offer to $30/sh, but was again rebuffed by the board and the offer was rejected by a special committee as 'inadequate'
  • In May '07, the Dolans again increased their takeout offer for all of CVC to $36.36/sh - this time the board accepted the offer, but it was voted down by a majority of the public shareholders
• Insight MBO: In Mar '05, Carlyle Partners and Insight's management offered public shareholders $10.70/sh to take Insight Communications private, implying ~9.7x current and ~8.7x forward EV/EBITDA multiples
  • In Jul '05, Carlyle and Insight took Insight Communications private at $11.75/sh, or ~10x current and ~8.9x forward EBITDA multiples
• Cox MBO: In Aug '04, Cox's controlling family offered public shareholders $32/sh to take Cox Communications private, implying a ~9.6c current and ~8.9x forward EV/EBITDA multiples.
  • In Oct '05, the Cox family took Cox Communications private at $34.75/sh, or ~10.5x current and ~9.5x forward EV/EBITDA multiples

Leverage

MCCC is levered at ~6x EBITDA with only ~5% of its $3.36B in debt due before '15, with a 5.7% total cost of capital and ~70% at a fixed interest rate thru '12 (50% thru '15). MCCC also has $2.4B of NOLs - no cash taxes for decades.

Risks

• Weakening Macro. A worsening economy may lead to accelerated subscriber erosion and/or pricing pressures across its products/services - though the subscriber base has shown resiliency throughout the downturn
• Disruptive Technologies. Similar to other content distributors, MCCC may face competition from "over-the-top" video offerings such as Netflix and Hulu. However, such offering require high-speed broadband connections - any loss in video revenues likely would be offset by higher-margin, higher-priced high-speed data offerings
• Increased Competition
• Minority Shareholders. Chairman/CEO Commisso owns a ~86% voting interest in MCCC. While it's clear the independent board must approve any bid on MCCC, it's unclear whether winning a 'majority of the minority' vote is necessary to go private. Shareholder lawsuits would undoubtedly follow
• Regulatory risk. Net Neutrality initiatives and the FCC's proposal to reclassify broadband access as a Title II telecommunications service could significantly impact the competitive landscape and MCCC's operations

Valuation

Most media investors look to value companies on EV/EBITDA - using EBITDA as a proxy for FCF. On that basis, MCCC is trading at a premium to its cable peers at ~6.6x '11E EV/EBITDA vs. peers ~5.5-6.8x (TWC, CMCSA, CVC).

• However, this is misleading and I believe the correct way to view MCCC is on a FCF basis, given its ~$2.4B in NOLs, substantial leverage and low fixed-rate cost of capital
• On FCF basis, MCCC is trading at ~3.3x '11E FCF vs. ~5x for peers
• At 5x '11 FCF, Mediacom would trade in excess of $10/sh - or ~50% upside from current levels

Conclusion

• Chairman/CEO Commisso was trying to 'steal' Mediacom at $6/sh knowing full well that FCF generation is at an inflection point and ramping, capital intensity is declining and significant de-levering is about to take place over the next several years
• Though the Board rejected a sweetened offer and the bid was withdrawn, I believe the real opportunity exists at current levels, notwithstanding a higher bid in the medium-term (similar to CVC)
• For shareholders, the best outcome is for MCCC to remain public company and participate in the impending FCF ramp and debt paydown , thereby capturing the transfer of value accreting to the equity. Near-term, downside is some limited at ~$6/sh with the potential for a 'bump' in the offer price in the medium-term

On MCCC's Q3 '09 investor call last August, Chairman/CEO Commisso shared his views of Mediacom's intrinsic value. At the time, MCCC was trading at ~$5.75/sh, and he highlighted that paying down 0.5x of leverage creates ~$4/sh in value, or ~9.75/sh - all else equal and without any increase in the multiple.

"When the S&P 500, made of up companies that don't have anywhere near our results in terms of growth, and some of them are trading at 15 times earnings. So maybe you should ask that question. Maybe you could give us some flavor on why we're trading less than five times, and everybody else - including the phone companies, right - as you look at Verizon, Time Warner - and AT&T, they are losing revenues and cash flow, and they are trading at 11, 12 times free cash flow?

Once you've developed free cash flow, even with a 5% growth, you know - 5% growth in revenues, right? We could deleverage at a 10% clip. You know, 5% because you are reducing your debt, and 5% because you are increasing your cash flow. What that means, then, is that that reduction in leverage all essentially flows to the stockholders. So with a 50 basis point reduction in leverage, everything else remaining the same - you know, we think we're undervalued here along with the rest of the industry, 50% reduction in leverage - a 50 basis point reduction in leverage converts for our Company, with a cash flow of $550 million, to $275 million, and now I'll do the numbers for you, just standing still, $275 million divided by 67 million shares, you know, that's $4 a share, which is almost double what our stock is trading, just by standing still and converting that free cash flow into repaying debt."

• Deleveraging: At 6x leverage - any deleveraging would accrete value to the equity
• Special Dividend: Dividend tax increase by year-end could spur a special dividend out to shareholders, of which CEO is the largest
• Go Private: CEO may offer minority shareholders a higher bid for the company
• Steady Operational Progress