Description

Disclaimer: NTS is an illiquid nano-market cap company.  Its core business is in secular decline.  I own shares in NTS and am inherently biased.  Do not buy NTS without doing your own in-depth research.  If you purchase or sell NTS, trade it carefully as it can move 5% in a day on trading flows alone.  I make many assumptions in the following write-up, which I believe are reasonable but which, by definition, are subjective and are likely to be wrong in many regards.  The write-up is filled with my opinions which similarly are likely to be wrong in many regards. I may buy or sell NTS shares at any time and do not intend to disclose those actions to you.  Do not taunt happy fun ball.  Do your own research and don’t rely on my efforts.

NTS, Inc. - Ticker: NTS

I believe shares in NTS, Inc., a nano-cap telecom company operating primarily in the south, offer an attractive entry into an increasingly valuable franchise.  I expect over the next two years, the clarity of the business model, a simplification of the capital structure, and strong cash generation will all become apparent to the casual observer.  The company is trading at 2 - 4x my estimate of 2014 net cash flow to shareholders. 

NTS is in the midst of transforming into a growing, high margin, recurring revenue triple-play fiber business, funded by an incredibly attractive Federal program which has already approved the next three years of growth CapEx.  NTS’s rural market focus and technological advantage will help insulate it from future local competitive threats.  From my vantage, this attractive economic profile has been masked by a much larger, slowly shrinking legacy copper data and voice business and arguably poor capital raising and allocation decisions, precipitating a significant mispricing in its shares.

I believe we have passed an inflection whereby the growth in high margin fiber will overwhelm the attrition from lower margin copper, leading to meaningful consolidated top line growth and attractive bottom line results. 

In combination with cash already on the balance sheet, I believe this cash generation will allow NTS to clean-up and simplify its balance sheet, leaving behind a deeply moated, recurring revenue business with attractive economics and an easy to understand story trading at a low valuation.

NTS, formerly known as XFone, is a major beneficiary of the American Recovery and Reinvestment Act of 2009 (ARRA, aka “the Obama stimulus plan”) and prior stimulus legislation.  It is building out FIOS to rural customers (“Fiber-to-the-Premises” or “FTTP”), financed primarily by outright Federal grants and low-cost long-term loans from the Federal government.  NTS appears to be quite cheap, selling at a few times 2014 earnings while investing heavily in a competitively advantaged growth opportunity funded on the taxpayers’ dime.  The rapid growth in this FTTP business is masked by customer attrition in its legacy copper business.

NTS provides integrated voice, data and video (aka Triple Play) in rural West Texas via its FTTP business (with Southern Louisiana on the pipeline).  It has an established but shrinking copper voice and data business.  NTS continues to grow, primarily with financing from Uncle Sam via the Department of Agriculture’s Rural Utility Service (RUS) under the Broadband Initiative Program for a fiber-to-the-premises build-out.  NTS refers to the bulk of this network build-out as its “PRIDE Network.” 

Target FTTP markets are perceived to be hugely underserved relative to urban environments, leading to the U.S. government’s decision to provide subsidies via Federal stimulus money to help level the technological playing field for those rural geographies.  The resultant rollout of affordable, high quality FTTP to potential customers that previously were stuck in the late 1990s means that the subscriber uptake on NTS’s fiber build-out “passes” is quite high.

On June 2, 2011, the company connected its first PRIDE Network customer.  Prior to that, NTS developed its FTTP business using a near-identical stimulus loan source from the RUS, primarily in Lubbock and Levelland, Texas.  The rollout of FTTP over the past 11 quarters can be seen in the table below.  I believe this pace of FTTP subscriber additions can persist for several more years without further geographic expansion beyond that already announced (management has alluded to an FTTP rollout into Mississippi at some point, where it currently has a legacy copper business). 

NTS has received committed Federal financing to support passing 50,000 customers with fiber (it had passed 21,000 at calendar year end 2011, so an incremental 30,000 or so).  It expects to complete that rollout in 2014.  Through Dec. 31, 2011, NTS has signed up 7,300 customers, or over 1/3 of all passes, despite many of them having just recently been passed.  If we assume the hit rate on those 50,000 customer passes is ultimately 50%, NTS will more than triple its existing FTTP customer base.  For conservatism, I assume a 40% uptake.  NTS believes north of 50% is achievable. 

The value proposition to a rural subscriber is remarkable – the preponderance of target residential customers have an internet connection with stated transmission speeds of <1Mbps.  In its newest geographies, the baseline stated residential internet transmission speed NTS offers is 20 Mbps downstream and 5 Mbps upstream (“20 x 5”), which is ridiculously fast for a home, and is life changing for someone basically used to dial-up.  This is in addition to a more interactive, higher quality cable package and VOIP services.  For the typical residence or business, NTS’s FTTP offering provides enormous value.

To see the value proposition, let’s take a look at NTS’s Burkburnett, TX triple play package.  For the NTS’s Platinum Bundle – which is 220+ channels (many of which are HD), two set-top DVR boxes (including one with a HD DVR), 20 x 5 internet transmission speeds and VoIP phone (loaded with lots of services and 5c/minute national long-distance) – the residential customer pays $99/month.  For comparison, previously a customer could create an a la carte package that looked something like the following:

• Phone: CenturyLink traditional copper costs $35/month + 5c/minute long-distance.  For a la carte fiber VoIP from Verizon, a customer would pay $44/month.
• Video: Dish’s “Top 200”package, which is 220+ channels - the introductory price is $35/month for 12 months before jumping to $60/month.  Let’s split the difference and call it $47/month.
• Data: Internet via AT&T.  First off, neither AT&T nor any other local provider offers transmission speeds remotely approaching NTS in Burkburnett.  AT&T’s fastest offering is 6 Mbps downstream.  They don’t list the upstream speed, but there’s no chance it is close.  AT&T’s fastest service costs $20/month for a few months then jumps to $43/month.  Its 1.5 Mbps service is $33/month stabilized, so I’m using that price.

In total, a typical potential customer with a copper line, DISH’s Top 200 and AT&T internet is paying:  $35 + $47 + $33 = $115/month.

That $115 purchases an inferior, unbundled service.  As a result, NTS’s customer uptake on potential customer “passes” has been over 33% and they expect it to reach 70% in some of the locations they lay fiber.  Many of the NTS’s FTTP passes were laid in the last year – in more seasoned geographies, the uptake has been over 50%.

Once laid, NTS’s fiber business has a much lower operating expense associated with it than its traditional voice and data business as NTS historically has had to lease line capacity for much of the traffic time its customers have used.  Further, the fiber business requires less maintenance and has lower electric utility requirements than traditional cable.  NTS estimates fiber is 75% cheaper to operate, once laid, than traditional cable.  These factors can be observed in the decline in operating expenses NTS is experiencing.

For example: in Q3 2010 SG&A and Cost of Service combined were $13.0 million vs. Q3 2011 $12.2 million.  There is a lot of noise in that number as NTS closed the last of its foreign operations, the legacy business continues to suffer attrition, and the FTTP business continues to grow.  It is not clear what the incremental cost of adding FTTP customers is, however current capacity easily handles the increment and NTS expects operating expenses will continue to decline in coming quarters. I assume that declining operating expenses is temporary and ultimately largely reverses.

As noted previously, core to this thesis is the uptake on converting customer passes into paying subscribers.  In a press release from October 2010, NTS stated that it believed the RUS financed growth plan would add $20 million of annual consolidated EBITDAS by the end of 2014 (the “S” in EBITDAS being stock-based compensation – not something I personally would pull out, but which is not particularly significant today).  That EBITDAS number did not include their Federal grant to rollout to Louisiana.  I tend to be somewhat suspect of pronouncements like that, but it’s worth mentioning given the entire market cap of NTS is ~$25 million.

More tangibly, we can look at Q3 2011 FTTP revenue of $3.4 million on average FTTP subs of ~6,350.  NTS disclosed that average ARPU of residential customers was $95/month and business customers was $392/month.  In Q4, we know FTTP revenue was $3.6 million on average FTTP subs of ~6,943.  The blended ARPU in Q3 was ~$180/month and in Q4 ~$174.  Incremental to this is the opportunity for NTS’s FTTP to be used as a high-speed back haul for local wireless tower installations as well.

As noted, year-over-year operating expenses of the entire business of NTS have declined.  In a May 2011 press release, NTS disclosed that RUS funded projects may have EBITDAS margins in the neighborhood of 40-50%.  Throughout this write-up, I assume margins significantly below those levels.  

Shovel Ready:

In some sense, NTS is a pure-play opportunity to capitalize on tax payer largesse. 

NTS expects to have laid fiber past 50,000+ customers by sometime in 2014, funded with extensive Federal stimulus money.  NTS has successfully applied for Federal subsidies via the US Department of Agriculture’s Rural Utility Service several times over the last several years, receiving a mix of loans and grants to install fiber-to-the-premises.  The last two awards, issued under the Broadband Initiatives Program (BIP) expire on 9/30/2015 – they are, in essence, use ‘em or lose ‘em.  NTS plans to be done in 2014.  NTS’s RUS history is as follows:

• Oct. 11, 2007: $11.8 million in long term loans from RUS (pre-ARRA via the Broadband Access Loan Program).  17 year term, fully amortizing (after an initial 12 month IO period).  Largely drawn and build-out complete.
• March 4, 2010: combined $63.6 million in grants and long term loans ($35.5mm in grants and $28.2mm in loans).  Partially drawn for West Texas build-out.
• Sept. 13, 2010: combined $36.1 million in grants and long term loans ($17.7mm in grants and $18.4mm in loans).  Undrawn.  To be used for Southern Louisiana.

The first loan of $11.8 million was structured as a facility to be advanced as construction progresses.  Each advance has a 17 year term with interest rate fixed at the prevailing US Treasury rate with similar term.  Principal is paid monthly.  At year end 2010, the average interest rate on that loan was 3.8% and was 3.75% by Q3 2011.  It is non-recourse to NTS and is secured by certain legacy assets.  NTS funded a $2.5 million equity contribution to complete the build-out associated with this loan.

The subsequent two loans, which total $42.6 million, are 19 and 20 year loans.  It has a similar set of terms and is secured by the PRIDE Network assets it is financing.  The interest rate is ~4% as of Q3 2011.

In combination with the grants from the government, I believe this incredible financing source alone is worth more than the market cap, much less the productive assets it is used to fund.

The basic terms of the loan/grant deal, as best I can assess, are as follows:

• Must serve areas that are at least 75% rural;
• Advances for grants and loans have to be held in a separate bank account and can only be used for authorized purposes (basically FTTP construction);
• Restrictions on dividends: can’t pay one until 75% of loan funds have been expended and it can’t be bigger than 25% of the prior year’s net income;
• Can’t issue preferred stock that is really debt;
• Proceeds from asset sales have to be used to replace those assets or pay down RUS notes;
• RUS can stop funding if an event occurs that’s deemed to have a Material Adverse Effect on the borrower;
• Secured by assets of the borrower, which in NTS’s case is the NTS subsidiary;
• On loan portion, interest is paid at US Treasury bonds’ prevailing rate for similar maturities.

 As a tax paying citizen, one of the things I found amazing is how unencumbered the grants and loans are. There is no requirement that the borrower use its own capital to fund any portion of the projects - government financing appears to generally be designed to cover the entire cost.  As such, the $53 million in grants are effectively asset gifts to NTS as is the discount it receives on the loan subsidy, which is enormous.  The loans amortize monthly, but are covenant light (to say the least).

Over the past five years, NTS has completed several capital raisings via a combination of rights offerings, private placements and private borrowings to fund operating expenses, acquisitions, eligibility for the stimulus, etc.  Shareholders, as measured by the stock price of NTS, have groaned repeatedly at these capital raises.  NTS also has a history of paying its executives with meaningful stock option injections.  Much of the option plan was struck at prices 2x and 3x higher than today’s $0.61 share price.  Some of the most important recent financings are below:

• Rights offering 11/2/2011: 20 million shares at 30c for $6 million of equity.  This offering was poorly received and helped tank the stock, contributing to today’s opportunity.
• ICON Secured Loan: $7.5 million at 12.75%. 12 month IO (until Oct. 2012) then 48 months amortizing.  This was just raised in order to help improve working capital position, given other debt maturities.
• Burlingame Equity Promissory Note: $3.5 million, 10% interest paid quarterly. Matures March 2013 (3/22/13).
• Series A Bonds: $15.1 million payable in four installments on Dec. 1 through 2015 (assumes $4.2 million payment on 12/1/11).  Benchmarked to Israeli CPI.
• RUS Funding as of Q3 2010:
• $10.5 million at 3.75% on first stimulus loan. Repaid monthly through 2024 (Levelland project).
• $10.5 million at 4.02% on PRIDE Network stimulus loan. Repaid monthly through 2029.  Approximately $45 million undrawn.
• $7.3 million in grants for PRIDE Network.  $38.6 million remaining to be granted.

Total Debt Profile:

• $26 million in non-Federal debt (excluding credit facility which I net from cash)
• $21 million in Federal debt (going to ~$65 million)

My take on the net net of the above is that the company has ample liquidity to continue its FTTP build-out, which is funded by the US government.  The company has ~$11 million of cash as of Q3 2011, after adjusting for Q4 financings and the Q4 $4.2 million Series A Bond payment.  I believe NTS is now structurally EBITDAS positive.  If you net the outstanding $2 million credit facility, adjusted cash was $9 million before Q4 operations.

In the next five years, the company will need to repay or roll approximately $22 million of debt.  Given a $9 million cash starting point and $10 million run-rate EBITDAS (Q3 2011 annualized), growing generously over the coming years, I believe this is quite manageable.

My basic assumptions:

• 50,000 customer passings by 2014
• 40% hook-up rate (vs. >50% experienced to date in seasoned markets)
• $150 ARPU/month (below ~$175 experienced to date):

+ $36,000,000 of FTTP revenue (50,000 x 40% x $150 x 12)

+$35,000,000 Projected 2014 non-FTTP revenue (assumes 8% annualized revenue decline)

In 2014, I believe we will own a company that has generated $25 million of EBITDAS over the prior two years which is poised to generate at least $16 million in 2014.  The $25 million of 2012 and 2013 EBITDAS combined with the $9 million of cash on the balance sheet should cover the $26 million of non-Federal debt and associated interest.  At that point, NTS will have no net non-Federal debt and approximately $55 million of very long term, amortizing below-market debt from the Federal government.  This Federal debt will require approximately $2.3 million of amortization per year plus interest of perhaps another $3 million (assuming an increase in the overall interest rate to ~5%).  This combined $5.3 million cash-need will leave over $10 million of cash flow before taxes.  Even if we assume a 35% tax rate, which I view as punitive, I believe we are purchasing the company at less than 4x 2014 net-of-everything cash flow.

Given the business is still on the come, so to speak, I tried to layer in conservatism in each operating assumption.  In contrast, NTS disclosed it believes 2014 EBITDAS will exceed $20 million from the FTTP business alone.  If we used a $20 million total EBITDAS number, it would provide another $2.5 million of net-of-everything cash flow and imply the company is trading for <3x.

It is not hard to imagine an even cheaper valuation.  If NTS achieves a 50% hook-up rate with $175 ARPU, even assuming a further 20% increase in operating costs, EBITDAS would be $21.5 million.  After financing, $16 million of 2014 cash flow before taxes or $10.5 million of net-of-everything cash flow, implying 2.4x multiple.

Other than generic economic risks, the primary risks are:

1. Poor operating execution, leading to cost over-runs and delays.  To date, NTS has stated construction costs have come in below budget and ahead of schedule.
2. Dilutive capital raises.  NTS management has left something to be desired on the capital raise front over time, though the Q4 rights offering was a step in the right direction.  Further, they have been serial issuers of options and warrants to senior employees and debt providers, gobbling up more of the economic pie.  Fortunately, the preponderance of options and warrants are deeply out of the money and generally don’t become pertinent until over $1.10 / share (vs. today’s $0.60 trading price).
3. Massive cuts to government spending that impact the subsidies that NTS benefits from.  This is hard to handicap, but – barring a US sovereign debt crisis – I put the odds at negligible.  There will not be any meaningful cuts between now and at least Spring 2013 when a potential new president could begin to have an impact.  At that point, I believe the thesis will have largely played out from a fundamental standpoint.

Catalyst

• Top line growth.  The growth of the fiber business overtakes the attrition suffered in the legacy business by a wide enough margin that consensus sees the reversal of negative top line trends.  I believe this inflection happened in Q3 2011 and Q4 will establish NTS as a top line grower.  Earnings are likely to be announced in the next two to three weeks.
• Profitability.  Similar to the top line growth, I believe we are about to experience an inflection in bottom line results, which should add more credibility to the story management has been promoting over the past several years.
• Capital Structure Clarity.  As NTS generates excess cash, I expect it will pay down much of its outstanding non-Federal debt maturities, leaving behind a simple, termed out, low cost capital structure in combination with an attractive and understandable operating business.