Description

North Pittsburgh Systems is an undervalued RLEC with hidden assets and a catalyst to realize value. NPSI has investments in very valuable wireless partnerships that in my opinion are being given no value by the market; additionally, the recent liquidation of the Rural Telephone Finance Bank (in which NPSI owns an interest) will add to the Company’s already strong balance sheet. NPSI has very little following on Wall Street and is covered by just one analyst. Recently, a couple of activist shareholders who have had success investing in the industry took a position in NPSI and there presence is likely to unlock the value inherent in the Company’s balance sheet and cash flows, to the benefit of all shareholders.

NPSI is the incumbent local exchange carrier for multiple rural areas north of Pittsburgh (285 square mile territory, including Alleghany, Armstrong, Butler and Westmoreland Counties) where it services approximately 70,000 access lines and approximately 12,000 DSL lines. Over the past decade, the ILEC territory has experienced, and continues to experience, robust population growth due to the continued expansion of new housing territories as these territories are one of the last remaining areas of rural land within driving distance (southernmost territory is 12 miles away) of Pittsburgh. The Company also operates a very successful CLEC in neighboring cities and the Pittsburgh metro area, focusing on small business customers. The CLEC now has approximately 60,000 access lines and 2,500 DSL lines. Finally, the Company owns interests in 3 wireless partnerships, stakes which date back to the early 1980’s when cellular licenses were issued. The three partnerships are 1.) the Pittsburgh metro region in which the company holds a 3.6% stake; 2.) a rural license encompassing Clarion and Lawrence counties and the northern portions of Armstrong and Butler counties in which the company holds a 14.3% stake and 3.) a rural license covering the southern portions of Armstrong and Butler counties in which the company holds a 23.7% stake. The Partnership’s are run by Verizon Wireless, which act as the General Partner.

The Company has done a good job of using its strengths to edge out into the more densely populated Pittsburgh and suburban Pittsburgh markets. The competitors in the CLEC markets, MCI, Sprint and Verizon (depending on the area) all are massive companies and do not offer the personalized service and “high touch” of the CLEC that has been taking share. Additionally, the Company recently unveiled its own VOIP solution, and the Company is likely to roll out a video product shortly as they are completing a fiber to the node project, which will allow them to compete with local cable companies (to be discussed in “risk factors”) in offering a triple play of services. It is notable that the Company has not yet rolled out a video offering, which is the industry trend. This is a result of a cozy relationship that existed for years between NPSI and the local cable company, Armstrong. Armstrong for years owned approximately 10% of the stock in NPSI and had a board seat. Armstrong’s representative was recently kicked off the board in 2005 after the cable company announced its own voice product, a trend throughout the industry. My guess is that Armstrong was feeling pressure from satellite providers and therefore felt it needed to expand into new offerings. This opens up competitive issues as well as opportunities for NPSI as they receive competition from Armstrong while eventually going after Armstrong’s (near) monopoly on video in the market. A larger acquirer with a wireless presence could purchase NPSI, add the video offering and a wireless offering and offer a quadruple play in a growth market.

The wireless assets have been well managed and operating profit in the owned service areas have more than doubled in just two years. The market seems to assign little value to these assets. In fact, the only analyst covering the stock states, “at the end of the day, while these properties benefit the Company’s cash flow position, we think they are unlikely to be accorded much value in terms of NPSI stock.” I think the market is mistaken in this assumption. The results of the wireless businesses for the past few years are as follows (all 3 markets, combined):

2003 2004 2005
Revenues 304.6 402.2 485.0
Op Income 46.2 81.7 90.5
Net Income 47.6 82.9 91.6

These partnerships carry no net debt and in fact carry a small net cash position. From publicly available documents it is difficult to determine exactly the amount of the overall pie that NPSI owns, although equity income on NPSI’s books was $3.1 million in ’03 $5.6 million in ’04 and $6.0 million in ’05, implying NPSI ownership of about 6.7% of the overall pie.

The Way the Market Looks At Valuation

The market simply looks at NPSI and sees a boring LEC trading at about 6x EBITDA with no catalyst. I think this is mistaken. Current valuation per the numbers:
Market Cap @ $23: $345 million
Net Cash: $30 Million
TEV: $315 Million
EBITDA: $50 Million (6.3x)
EBITDA-Capex: $40 Million (7.8x)

Here is how I look at it:
Market Cap @ $23: $345 million
Net Cash: $45 Million (includes RTFC cash proceeds & Q1 cash flow)
Wireless Assets: $55-$65 Million
TEV: $235-$245 Million
EBITDA: $50 Million (4.7x-4.9x)
EBITDA-Capex: $40 Million (5.9-6.1x)

Combine this with the fact that this company may receive a premium as an attractively sized buyout candidate for the CTL’s and CZN’s of the world while a group of activists might be able to force something in this regard (see below), and it makes no sense for this company to trade at a 36-37% multiple discount to the comparables (see below).

Sum of the Parts Valuation

RLEC’s are still afforded reasonable multiples due to their ability to generate high margins and sizable cash flows. Additionally, RLEC’s are typically in less desirable markets for direct competition as new entrants cannot justify the cost to directly compete in the local telephone business. While revenues from long distance access and other phone related services are falling gradually due to the regulatory environment, wireless substitution and voice over Internet competition, the provision of video, DSL and Internet-related services have helped to cushion the fall.

Given that a transaction appears to be possible given the presence of activists, I believe a look at comparable company valuations is appropriate:

EV/EBITDA EV/Sub/Line
ALSK 7.7x $2,262
CBB 6.9x $2,969
CTL 6.0x $3,327
CZN 7.9x $3,713
CTCO 6.1x $2,151
IWA 8.4x $4,088
FRP 9.1x $4,182
VCG 7.4x $3,747
Average 7.4x $3,304
Source: Baseline

Based on these valuations, it is reasonable (and conservative), I believe to assign a range of values on a takeout of $3,000 to $3,500 per line for the RLEC as a low and high bound on the valuation with the thought in the back of the mind that it could be higher. I discount the CLEC and DSL lines by 50% as the CLEC markets are more competitive and carry lower margins, while the DSL relationship is typically lower revenue per sub. I then spot-check these numbers against an EBITDA multiple:

Total RLEC Access Lines: 70,000
Value/Line (Low) $3,000
Value/Line (High) $3,500
Total RLEC Value (Low) $210 Million
Total RLEC Value (High) $245 Million
Total CLEC Access Lines: 60,000
Value/Line (Low) $1,500
Value/Line (High) $1,750
Total CLEC Value (Low) $90 Million
Total CLEC Value (High) $105 Million
Total DSL Lines 15,000
Value/Line (Low) $1,500
Value/Line (High) $1,750
Total DSL Value (Low) $22.5 Million
Total DSL Value (High) $26.3 Million
Total Line Value (Low) $322.5 Million
Total Line Value (High) $376.3
LTM EBITDA $50 Million
LTM EBITDA Multiple (Low) 6.4x
LTM EBITDA Multiple (High) 7.5x

I think a 6.5-7.5x EBITDA take-out multiple is a conservative assumption and the numbers could certainly end up higher, but I think it serves as a reasonable place to begin valuing NPSI. With some comps in excess of 7x EBITDA, this is particularly low if the company enters into a value maximizing process, which has been the MO of the activists to force. Please note that the Value/Line estimates are discounted substantially for the CLEC, which has lower margins and a more difficult competitive environment.

Wireless Value

These businesses all generated $6 million of equity income to NPSI (equivalent to Operating Income). These assets should have D&A of a total of about $55 million based on its PP&E, the equivalent of about $4 million allocable to NPSI. As previously noted, these assets have seen strong growth and growing profitability over the past two years. The following comparable companies are relevant in analyzing this asset:

Comparable Company
EV/’05E EBITDA EV/Sub*
Dobson 9.0x $1,934
Leap 11.0x $1,137
Ubiquetel 11.5x $2,503
Average 10.5x $2,036
* Modestly dated information

Comparable Transactions

Date Acquirer Acquiree EV/LQA EBITDA EV/Sub
11/18/05ALLTEL Midwest Wireless 10.5x
8/30/05 Sprint/Nextel Gulf Coast Wireless 8.6x
8/30/05 Sprint/Nextel IWO Holding 9.3x
1/10/05 ALLTEL Western Wireless 8.7x $2,042
12/15/04Sprint Nextel 8.3x $3,045
12/8/04 Alamosa Airgate PCS 9.3x $1,640
2/17/04 Cingular AT&T Wireless 10.5x $2,151
3/19/02 ALLTEL CenturyTel Wireless 10.1x $2,400
Average 9.5x $2,256

Based on these valuations, I think it is conservative to take a sizable haircut on the average EBITDA multiple of approximately 9.5x, using 8x on the low end and 9.5x on the high end. Additionally, it is necessary to make an adjustment for the tax effect if these assets were to be sold (basis is approximately $13 million):

Wireless EBITDA Allocable to NPSI: $10 Million
Low Multiple: 8x
High Multiple: 10x
Low Value: $80 Million
High Value: $100 Million
After-Tax Proceeds (Low): $52.2 Million
After-Tax Proceeds (High): $65.2 Million

Balance Sheet

NPSI has the cleanest balance sheet in the entire industry (as far as I can tell). As of 3/31/05, the company should have approximately $35 million in net cash. Additionally, the Company will be receiving approximately $12 million in cash (post-tax) from the liquidation of the Rural Telephone Finance Company. This will leave the company with $45-$50 million in net cash, while most of the comps are highly leveraged.

Sum of The Parts
RLEC/CLEC (Low) $322.5
RLEC/CLEC (High) $376.3
Wireless Assets (Low) $50.0
Wireless Assets (High) $60.0
Net Cash $46.0
Total Value (Low) $428.5
Total Value (High) $492.3
Value/Share (Low) $27.91
Value/Share (High) $32.16

As previously mentioned, another way to think about this is to adjust the valuation for a sale of the wireless assets and the cash. If we were to do this, it would leave us with a TEV of around $235 million, leaving the core LEC trading at around 4.7x EBITDA, too cheap if you believe the activists can force NPSI into a shareholder value enhancing transaction (please see below discussion on this).

Financial Engineering Potential

While the potential for a sale of the Company is the most attractive outcome, management may have the ability to placate the activists by taking a more aggressive approach toward managing its balance sheet.

As I have stated, NPSI is extremely underleveraged and has the most conservative balance sheet in the sector (to shareholders detriment, IMHO - note they are generating a 25% ROE despite this fact). This strategy makes no sense when one considers that the RLEC’s have access to cheap financing via CoBank, a co-op financing source, which drives down financing costs for the sector. With the hidden assets, conservative balance sheet, and low valuation of the RLEC, the potential for financial engineering is attractive. Most players in the sector have levered up and a number of them (FRP, IWA) are paying out virtually all free cash flow as dividends (these companies have received premium valuations):

Net Debt/EBITDA
ALSK 3.5x
CBB 4.7x
CTL 2.1x
CZN 3.7x
CTCO 1.5x
IWA 3.9x
FRP 5.1x
VCG 4.3x
Average 3.6x
NPSI 0.0x

The potential to leverage the balance sheet, sell off non-core assets and retain significant value in the stub is real:

Net Cash $46 Million
Sale of Wireless $55 Million
EBITDA $50 Million
Cash @ 4x EBITDA $200 Million
Cash @ 5x EBITDA $250 Million
Cash Availabe (Low) $312 Million
Cash Available (High)$361 Million

Under a dividend scenario (vs a stock repurchase scenario – the ultimate value is the same if all cash available is used to repurchase shares or pay out a dividend):

Leverage Leverage
4x EBITDA 5x EBITDA
1-Time
Dividend $302 Million $351 Million
Dividend/Share $20.14 $23.46
Operating Inc $30 Million $30 Million
Int Expense@ $16 Million $20 Million
8%
Pre Tax Inc $14 Million $10 Million
Net Inc $8.4 Million $6.0 Million
EPS $0.56 $0.40
P/E 16x 16x
Free Cash Flow $15.4 Million $13 Million
FCF/Share $1.03 $0.87
FCF Multiple 8.7x 7.4x
Stub Price/Sh $8.96 $6.40
TEV/EBITDA 6.7x 6.9x
Val. To $29.06 $29.86
Shareholders

In an aggressive scenario, the Company could potentially pay out a dividend in excess of the current market cap! The Price/FCF multiples in this scenario are conservative, I believe, and the resulting TEV/EBITDA valuations are certainly not aggressive. Additionally, if NPSI were to adopt a “payout” strategy whereby it paid out free cash flow as dividends, the valuation could certainly exceed 6.9x EBITDA (as many of the comps reflect), so I view this as a modestly conservative scenario that leaves you with significant upside from current levels.

Industry Consolidation

I found the following article very interesting and a worth while read. It appears that the players in the industry are looking for consolidation to occur and NPSI would be a natural beneficiary of this trend, as larger companies could afford to invest in video services, and fiber to the premises as well as offer wireless services to help “own the home” and own the customer relationship as it relates to media distribution and communications:

Citizens, CenturyTel mull rural consolidation
Wed Mar 29, 2006 8:03 PM ET
By Sinead Carew
NEW YORK, March 29 (Reuters) - Citizens Communications Co. and CenturyTel Inc. may take part in the consolidation of the U.S. telecommunications industry, according to top executives who laid out criteria for potential deals on Wednesday.
As Alltel Corp. and Sprint Nextel Corp. spin off their local phone units, and AT&T Inc. plans to buy BellSouth Corp., some investors are expecting another spate of deals in the local telephone service market.
Citizens' President Jerry Elliott said mergers should help local providers operate more efficiently by pooling costs for information technology, accounting and human resources.
"There's no reason to have a bunch of stand alone companies. As many of them as possible should be combined," Elliott said on the sidelines of the Bank of America's Media, Telecommunications and Entertainment conference.
A banker familiar with the industry believes CenturyTel and Citizens are ripe for consolidation because they need more phone lines and services to compete against larger rivals.
Elliott said Citizens was "agnostic" as to whether it would be a buyer or a seller, but if it was to buy another company, it would ideally be in another rural market, where there is less competition and customers are more loyal.
The U.S. south-west and mid-west would be Citizens preferred geographic location for potential mergers and any deal would have to allow the company to maintain its dividend to free cash flow ratio of around 60 percent, Elliott said.
Stamford, Connecticut-based Citizens, which operates in 24 states, plans to pay a 25 cent dividend on March 31.
Elliott did not name any potential acquisition targets and said he did not "know of any today."
CenturyTel's Chief Financial Officer Stewart Ewing said his company would be most interested in deals for phone lines close to its operating region, unless they were big enough deals, with 50 to 100 thousand lines, to be worth going further afield.
"There's certainly properties we'd look at if they were to come on the market," he said at the same conference. CenturyTel operates in 26 states in rural areas and small- to mid-size cities.
He would not comment on specifics but said any deal would have to look more attractive to shareholders than CenturyTel's repurchases of its own shares. CenturyTel said last month its board authorized a stock repurchase of up to $1 billion.
Asked if CenturyTel would entertain any acquisition offers, Ewing told the audience: "I'm convinced our board would do the right thing if we were approached with an attractive offer."
But he said a sale would not be a requirement.
"We think we're large enough to have the scale ... to manage the access lines we have," he said.
He said CenturyTel may consider raising its dividend if it does not find other suitable investment opportunities. Monroe, Louisiana-based CenturyTel's dividend is just over 6 cents per share. (Additional reporting by Jessica Hall in Philadelphia)
This trend ties in nicely with activist investors getting involved in NPSI.

Activist Probability of Success

In terms of credentials, the activists in the name are solid, particularly as it relates to this industry.

One of the activists, Opportunity Partners, invested in HCT at around $20 and has been integral in convincing HCT to pursue a strategic alternatives process. The stock has run to almost $30. They also identified and bought into NULM prior to its sizable run last year, but have not needed to be active given the performance of the stock. Another of the activists, Santa Monica Partners, has been battling with WWVY for years and his efforts have resulted in the company hiring an investment banker to pursue strategic alternatives.

The most interesting piece of this part of the story is that the board ALREADY seems to have lost the support of some of its shareholder base (prior to the activists getting involved). In the 10-Q filed 8/9/2005, a sizable portion of the shareholder base WITHHELD votes from the incumbent directors:

Name Shares in Favor Shares Withheld % Withheld
Brown 9,899,602 2,956,699 23.0%
Cole 12,108,471 747,830 5.8%
Crowley 12,085,081 771,240 6.0%
Kimble 9,960,774 2,895,527 22.5%
Kraskin 11,150,192 1,706,109 13.3%
Nelsen 12,127,838 728,463 5.7%
Thomas Jr 9,873,210 2,983,091 23.2%

It should be noted that these shares were with held from management with no active stance taken by a shareholder opposing them. Prior to the activists filing, about 25% of the shares were held by institutional investors who likely voted for management without much thought. These types of investors would, at a minimum, give considerable thought to an activist agenda. This bodes well as shares now should continue to trade with buyers representing institutions who believe the company should be sold, resulting in a favorable change in the shareholder base. Finally, the board of directors is unclassified, meaning the activists could run an entire slate in opposition to the current board. Undoubtedly, management realizes this as well. With these issues, I view it as very likely they will cave to either a sale of the company or a large distribution of cash to shareholders via a large dividend or large share repurchase.

Risk Factor

The most significant risk I see is that Armstrong Cable has recently launched a competitive voice service in the company’s less rural markets. NPSI has noted that access line losses have picked up a bit, but not significantly. The lone analyst that covers NPSI reduced his EBITDA estimate slightly as a result of the competition. It should be noted that NPSI has not yet rolled out a competitive video product, which is ineveitable and will result in NPSI taking share right back from Armstrong on the video side of the business. There are some mitigating factors that suggest NPSI will retain significant profitability in its LEC:
- Cost Differential: For those who don’t use a great deal of long distance, NPSI’s pricing is at a significant discount to Armstrong
- Growing Market: The Company’s core markets are growing, so while market share will slip, the overall pie is growing.
- Up-take of DSL lines (17% penetration rate vs. 12% for comps) suggests customers have some loyalty to NPSI.
- Future roll-out of video will allow NPSI to offer triple play, making customers more sticky.
- Satellite Penetration is already high in Armstrong’s markets, suggesting a number of households do not have a relationship with Armstrong and are therefore less likely to switch.
- NPSI has refused to cooperate with number portability under the argument that VOIP offering is different from fixed line products. While competitors fight this, it will likely provide a barrier as subs would need to switch phone numbers.
- There will undoubtedly be quality issues with Armstrong’s product at least in the short-term. Most individuals I have spoken with that utilize a cable/VOIP offering have had quality/connection issues.

Conclusion

I view NPSI as an undervalued, non-followed situation which is not correctly valued by the marketplace in the current context. I view a purchase of NPSI as an interesting event driven situation through either continued telecom consolidation or a large return of capital to shareholders.

Catalyst

Large shareholder repurchase (Dutch Auction) at a premium
Large dividend
Sale of the Company