Description

Who wants to own a debt free company with a free cash flow yield of 23% and a management team that is committed to returning that free cash flow to shareholders in the form of dividends? The stunning turnaround of Metrocall and the stabilization of the paging industry continue, and yet few notice.

When I first invested in this company in June of 2003, I thought this company was going to be run down in a slow liquidation, and that its cash flow was worth more than the stock price at the time ($21 post split). I assumed that paging was disappearing and that I would just enjoy the cash flows while they lasted. I have been very wrong.

Now, I find a company with soaring cash flows in a stabilizing industry with a decent future. Through aggressive cost cuts, rising ARPU (Average Revenue per Unit), historic lows in its churn rate, and a focus on stable business customers, MTOH has been a golden cash cow.

The numbers alone tell the story. Instead of earning $60 million in FCF for 2003 as I had originally estimated, MTOH will do more than $90 million in FCF (no taxes paid). And in 2004, MTOH will produce $120 million in FCF on a pre tax basis ($85 million in FCF fully taxed).

Despite rising over 200% since June of 2003, MTOH is still ridiculously cheap. Why does MTOH trade at 4.4 times rising FCF, when even the worst companies with plummeting cash flows and revenues such as AT&T and MCI/Worldcom trade at 7-8 times FCF? Given comparable multiples, MTOH would trade a price target of $104 to $120 a share, a 60% to 85% increase from current prices.

Metrocall and its Industry

In 1999 the paging industry had 45 million subscribers, and now there about 12 million. Due to the collapse in demand, especially from consumers, every independent player in the paging industry went into bankruptcy.

Where there used to be dozens of competitors fighting fiercely, five players now control 92% of the market. The industry now finds it has too much capacity in terms of network equipment, salesmen, call centers, etc. The industry is still restructuring and paying down debts incurred during the build-up and frenzy in the late 1990s.

At the same time, the industry is starting to stabilize around core business and government customers who find paging cost effective and reliable. Cell phones are not likely to ever go down to anywhere near the $7 to $10 a month a pager costs. And on a reliability standard, pagers rule the roost. It is well known that the only wireless technology that worked extremely well during 9/11 was pagers. This goes for hurricanes, earthquakes as well as other natural disasters.

Metrocall has a diverse customer base, with no industry group exceeding 13% (the construction industry). A good example of who uses Metrocall, is American Airlines. Is American Airlines going to change from inexpensive and reliable pagers for its employees to give them Treos or Blackberrys? I doubt they are going to mess with a system that works, is reliable and is undeniably cheap.

Think of the government workers to health care professionals, who all use pagers and are not likely to change. This is one reason why Metrocall’s churn is at the lowest rate since the company was founded. And it is also why the industry is starting to stabilize around 12 million subscribers.

An interesting data point is that tower companies are starting to see signs of stabilization in the paging industry. Paging companies are not dropping leases like they were before. This is a very positive sign for the industry.

MTOH’s numbers are starting to bear that stabilization out, as its revenue decline and subscriber losses are moderating:

Revenue Decline (millions)
Q2 2002 $ (6.4)
Q3 2002 $ (5.2)
Q4 2002 $ (5.1)
Q1 2003 $ (4.1)
Q2 2003 $ (4.6)
Q3 2003 $ (3.4)

Net Additions in Subs
Q1 2003 (119,879)
Q2 2003 (63,095)
Q3 2003 (55,778)


Metrocall’s Restructuring & Turnaround

Metrocall exited bankruptcy in October of 2002, and in February of 2003 launched an extensive cost cutting and restructuring process. This called for a 25% reduction in corporate managers, a reduction of sales field regions from 6 to 3, a consolidation of their call centers into one location from two, a consolidation of inventory fulfillment centers and the deconstruction of at least 250 transmitter sites supporting under-utilized frequencies.

Metrocall’s numbers show how well of a restructuring job, they have accomplished. MTOH’s EBITDA margins are up to 33.6% in the third quarter of 2003 versus 17.8% in the first quarter of 2002. And free cash flow has been rising every quarter this year:

FCF (millions)
Q4 2002 $ 20.73
Q1 2003 $ 22.18
Q2 2003 $ 23.10
Q3 2003 $ 23.64

Why Have Cash Flows Been Rising So Dramatically?

MTOH has been taking out costs faster than revenue has been falling. But more than that, the revenue MTOH has been losing is low margin, high churn consumer customers. So, MTOH’s ARPU is surging and churn falling. MTOH has been able to dramatically lower SG&A, and at the same time its revenue per customer is rising as unprofitable customers leave. As evidence, ARPU rose to $7.06 in the third quarter, up 13% year over year. And there is further upside to that number, as MTOH’s chief rival, Arch Wireless (NASDAQ: AWIN) has a rising ARPU of $10.

Management has indicated that the trends of rising ARPU, lower expenses and falling churn are not going to be changing soon.

Balance Sheet Should Be Debt Free By March

All of these cash flows have been paying off debt and preferred the company owed since coming out of bankruptcy. Since the beginning of 2003, MTOH has paid over $121 million in debt and preferred.

I estimate that by March 31st, MTOH will have no net debt, and will be able to pay off the $26.7 million in preferred it has left over. After all, the company is producing around $9 million a month in free cash flow.

Weblink Acquisition

Metrocall acquired Weblink Wireless in November of 2003. Weblink was the nation's fifth largest wireless messaging and paging provider. By acquiring Weblink, MTOH added 850K subscribers. Metrocall and Weblink's networks have been connected and partially integrated for some time as Metrocall offered 2-way paging services over Weblink's 2-way network and ultimately became Weblink's largest customer.

MTOH owed Weblink money before the transaction plus MTOH received a warehouse full of inventory of equipment. The end result is the acquisition cost about $6 million after all is said and done. The amazing part is Weblink should contribute at least $10 million in free cash flow in 2004. Why?

Weblink customers maintain the same account manager, account team, billing interfaces, contract terms and network interfaces. Even as a standalone company, Weblink produced $2.4 million in free cash flow in the third quarter. What will Weblink produce in cash flow fully integrated with all redundancies taken out?

Weblink is just an excellent acquisition and maybe a template for future small acquisitions.

Estimates

I estimate that Metrocall will be producing around $120 million of free cash flow before taxes as of the fourth quarter of 2003, and that MTOH will produce $85 million in free cash flow after taxes in 2004. They have about $40 million left in NOLs, which will be used up quickly, and their depreciation shield will help.

Capital expenditures are around $8 to $10 million a year, but maybe lower due to the Weblink acquisition in which they received substantial amounts of inventory and equipment.

There are approximately 5.63 million shares outstanding, so MTOH should produce $15 a share in free cash flow in 2004.

Dividends, Dividends, Dividends

I expect MTOH to announce around a $5 a share annual dividend by July, and use the rest of the cash flow to acquire smaller distressed paging companies. Without acquisitions, MTOH could pay a $15 a share dividend. But I think they may let cash build up and pay it out slowly.

Is Metrocall the Acquiree or the Acquirer?

Through economies of scale and reduction of redundancy, MTOH has a tremendous opportunity to acquire small paging companies and integrate them into MTOH’s system.

There is also a further opportunity for the big five competitors to merge. I think there is a compelling argument to make that pagers compete against all other handheld devices and that these companies must merge, thus reducing the regulatory burdens. Arch and Metrocall could merge and the end result would be cash raining from heaven.

However, there is also the opportunity that Metrocall itself may be acquired for its cash flows. Verizon is a competitor and so is SBC. Also, Metrocall partners with Nextel to sell solutions. Any of these companies and more could acquire Metrocall and use their cash flow to fund future growth opportunities. Also, Metrocall’s business customer base would prove fertile ground to sell the acquirer’s other products and services.

Summary

In summary, there is no other company that is debt free that possesses a free cash flow yield of 23%. Then even with indebted companies, there is no other company that is not subject to massive litigation risk that possesses a free cash flow yield of 23%. Simply, Metrocall is best investment idea I’ve come across in a long time. Especially, in this market environment, Metrocall sticks out with its severe undervaluation.

Catalyst

1) Complete payoff of preferred by end of March
2) Quarterly conference call in early March, first since before bankruptcy
3) Dividend policy announcement
4) Stock split announce in May, will enhance liquidity
5) Further small acquisitions, like Weblink
6) Analyst Coverage
7) Takeover from larger telecom