Description

NTELOS is an interesting defensive investment that has been beaten up recently on competition concerns regarding one of its three segments. It's a high free cash flow company, with a disciplined management team that pays out a healthy and likely growing dividend. There is 30%+ upside to a conservative estimate of fair value, plus the potential catalyst for further value realization in May 2010.  In the meantime you get paid well to wait, with a dividend of over 6% and growing.

NTLS is a provider of wireless and wireline communications services to consumers and businesses in Virginia and West Virginia. The wireless operations are composed of an NTELOS branded retail business and a wholesale business that is operated under an exclusive contract with Sprint Nextel Corp.

The stock trades at a very reasonable valuation (about 5.5x 2009 EBITDA, 9x 2010 FCF (when capex normalizes) and 6.2% dividend yield) despite growing EBITDA and FCF.  The company has been showing growth, even in the downturn as it reaps the benefits of prior investments.

The company has a significant Private Equity ownership (Quadrangle), which keeps management honest regarding capital allocation, and a couple of cash cows in the RLEC/CLEC businesses and a wholesale contract with Sprint. Management are focused on capital allocation and the concept of only adding profitable subs.

Taking the 3 segments one by one:

Stable high FCF RLEC and CLEC business

Although the RLEC business is in slow decline, the FCF generated is still substantial (about $30mm EBITDA-Capex in 2008), and the CLEC is growing through investment. NLTS has been investing in data offerings (IP TV, triple play, DSL) and overall EBITDA has been growing, despite the worries of competition from cable:

Jim Quarforth - NTELOS - CEO

 Comcast, of course, brought the Adelphia property; they launched in the Waynesboro-Augusta county market last May, I guess, actually May of 2008. We saw at the very beginning fairly as aggressive approach by Comcast in that one market, which realize only represents about a third of our ILEC footprint.

 As you look at line losses and you look at the line losses from cable,  that has really diminished probably since the middle of the third quarter. For example, last summer if you looked at the second quarter, it probably ran about 17% of our line losses where it came from cable. First quarter was about 11%, so it's really a small piece of the line loss story, the bigger piece I think is wireless substitution, and secondly I think the economy obviously has had some impact where folks have just dropped lines or they've chosen to move towards wireless.

So with our introduction of IP TV, we've had tremendous success with that product as I pointed out in my talk that in those neighborhoods where we have deployed that, the propensity towards churn is one-fifth of that in the non-fiber to the home neighborhoods. So we are continuing to reposition the ILEC to a fiber-based broadband video platform and we really are having great success. If you look at some of the industry stats in neighborhoods where we've been, we've had customers or neighborhoods where we've had the availability for 18 months we have 27% penetration. If you compare that with FIA's cross it's dramatically better performance, so we are very excited about the transition we are making. We think it's the right long-term strategy and it will continue to allow the ILEC to grow. However, it will get its revenue and cash flow from different sources over time.

 ....I think the other big story, Phil , in wireline that's somewhat unique to NTELOS is a number of years ago, we really went after the competitive business and fringed out, leveraging off our long haul fiber network and as a result of that, that is generating a very meaningful amount of revenue and revenue growth, and if you go back in time, it's an accelerating margin.

So as I pointed out earlier the margin is approaching 41% in that competitive segment, again driven primarily by data. So this whole growth story on wireless and wireline is all about data, and that's where we expect to garner our growth.

 NTLS' wireline EBITDA is roughly $65mm.  At a multiple of 6x EV/EBITDA that's worth ~$400mm.

PCS Towers

NTLS owns the PCS towers in Virginia and West Virginia. Sprint needs these towers to carry its traffic, and has guaranteed (through 2015) to pay NTLS $9mm/month in wholesale revenues. NTLS is obliged to provide an EVDO compliant network in the region (should be complete this quarter). There was an issue with billing earlier this year, but it has been fixed. This revenue is very high margin (estimate over 80% EBITDA margins). Sprint could overbuild the area, but it's probably not economically viable to do so, and S would probably be better served to just buy NTLS, particularly with the debt maturities they face in 2010-2012.

Taking that EBITDA at 6x (108*85%*6) = $550mm.

NTELOS brand wireless business.

NTLS operates its own postpaid and prepaid (Frawg brand) wireless service. Build-out of the EVDO network allows NTLS to offer better data services to its own wireless customers, which has increased ARPU through the improved data offerings and smart phone sales. The recent concerns about the stock have focused on this segment.

• LEAP wireless is moving towards rollout in Richmond and Norfolk, which would affect around half of NTLS POPs. 29% of NTLS subs are prepay, so arguably ~15% are at risk.

• Sprint has an IDEN network in NTLS's area which has a lot of capacity, so Sprint may try to fill its IDEN network with Boost prepay subs concurrently with LEAP, which could put more of the prepay at risk.

The concerns are valid, but I believe they are overplayed, and there are several offsets

• Smart Phones and Data Cards were 27% of Q1 postpay sales, and data ARPU increased $0.89 to $9.37. Penetration of Smart Phones and Data Cards, is about 10% vs the industry at over 30%, which gives management comfort that there is further upside. The increase in data offsets pressure on voice ARPU primarily in the prepay segment which is both more economically sensitive and vulnerable to competition.

• NTLS has pre-empted LEAP's Cricket offering to some degree with its own prepay Frawg offerings at similar price points ($30-$50). This reduces any economic incentive to switch to Boost or LEAP.

• NTLS network coverage in the area is superior to that of LEAP and offers better data than Boost.

• A LEAP launch is still a year or two away, and NTLS is continuing to promote its Frawg brand, and lock in customers. LEAP will take some subs, but its questionable how many of them will be profitable NTLS customers.

On balance, I believe that NTLS will continue to grow its EBITDA here despite the pressures.  

Competition will come in a year or two and from there we expect growth to slow, as the upside of a data profile more in line with peers offsets the pressure on the ~15% overlap.

We estimate the EBITDA for this segment of wireless is about $82mm for 2009, rising to $92mm in 2010 as we annualize the benefits of the data plans.

At a low/no-growth multiple of 5.5x 2010 EBITDA, that gives a value of ~$500mm

Valuation:

Total Sum of the parts

RLEC/CLEC:                                     $400M

PCS Towers:                                     $550M

Wireless:                                            $500M

Total EV                                            $1,450M

Net Debt =  $550 =>  Equity Value of $900

Shares outstanding =                       42.3

Equity Value =                                 $21.30/share

Upside = 30%

Dividend = 6.0%

Return     = 36.0%

There is the potential for the company to be broken up and sold in 2010 (see below). If that were to happen, the sum-of-the-parts value would run significantly higher, potentially to $30.

Catalysts:

• The company is a take-out or break-up candidate as of May 2010. Due to the Quadrangle/CVC buyout, the company cannot be split or acquired until May 2010. The companies could be split, leaving the wireline business with the debt, and potentially opt to sell the wireless business (most likely to Sprint as they are PCS). It would make sense for Sprint to buy NTLS just for the PCS towers.

• Share repurchases: Management is shareholder-friendly and there is significant PE ownership through Quadrangle. Management has also indicated an interest to repurchase shares once their debt maturities in 2010 are addressed.

• Potential Dividend Increase. As the EV-DO related Capex trails off, FCF should increase, we estimate to over $80mm in 2010. That's over an 11% FCF yield and growing. The current dividend is 6.2%, and it will likely be increased in line with FCF, as has been the policy.

Risk Factors

• Comcast becomes more aggressive in NTLS markets, hurting wireline EBITDA. We have addressed this above, and it does not appear to be a major factor for the moment, particularly with NTLS having rolled out its own triple play offering.

• Sprint: 22% of the top-line (and much more of the bottom line) comes from one customer. This is locked in through 2015, but if Sprint really hits hard times, they could see some contracts renegotiated. We believe that S would be more likely to just try to buy out NTLS for access to the towers.

• National price war among majors could drive down ARPUs and/or increase churn. NTLS faces competition from Sprint, AT&T, and Verizon in nearly every market. As noted above, LEAP wireless has recently announced plans to expand into some NTLS markets. So far, NTLS has competed successfully and is only now starting to reap the benefits of its network upgrade. We see risks, but with the offset that NTLS has the significant tailwind of data penetration to offset it.

Catalyst

• The company is a take-out or break-up candidate as of May 2010. Due to the Quadrangle/CVC buyout, the company cannot be split or acquired until May 2010. The companies could be split, leaving the wireline business with the debt, and potentially opt to sell the wireless business (most likely to Sprint as they are PCS). It would make sense for Sprint to buy NTLS just for the PCS towers.

• Share repurchases: Management is shareholder-friendly and there is significant PE ownership through Quadrangle. Management has also indicated an interest to repurchase shares once their debt maturities in 2010 are addressed.

• Potential Dividend Increase. As the EV-DO related Capex trails off, FCF should increase, we estimate to over $80mm in 2010. That's over an 11% FCF yield and growing. The current dividend is 6.2%, and it will likely be increased in line with FCF, as has been the policy.