Description

Executive Summary

I believe Otelco Inc. (OTEL) is likely to be acquired at a substantial (50%-250%) premium in the next 12 months. Given OTEL’s small size (<20M mkt cap), this is only suitable for small funds or personal accounts.

Business Description/ Background

OTEL was formed in 1998 for the purpose of operating and acquiring rural local exchange carriers (RLECs). Since 1999, they have acquired eleven RLEC businesses and three CLEC businesses.

In April of 2012, the company learned they would lose a significant contract with Time Warner. OTEL had been providing wholesale network connections to Time Warner Cable (“TW”) for TW’s customers in Maine and New Hampshire. The direct revenue from this contract along with the indirect revenue (access revenue from long distance carriers for calls destined to TW customers in Maine and New Hampshire) represented ~15% of total revenue for OTEL. When this contract was lost, it was clear the company would not be able to pay off their existing debt and proceeded through Ch. 11 bankruptcy: http://www.reuters.com/article/us-otelco-bankruptcy-idUSBRE92O0RO20130325

The company’s stock and subordinated debt were packaged as an income deposit security that was written up as a long by broncos727 in October of 2012.

Otelco emerged from bankruptcy in May 2013 with 122.2M in net debt (versus 244.5M pre-bankruptcy). EBITDA declined from 44.2M in 2012 (full TW contract) to 31.3M in 2013 (partial TW contract) to 27.8M in 2013 (no TW contract). EBITDA has been flattish since then with 28.2M in 2015 and 27.6M LTM.  The company has done a good job of controlling costs amid LSD revenue declines.

Finally, the company refinanced their debt in January of this year. They are now paying higher interest rates but significantly pushed back the maturity dates. Today, the company has $82M outstanding on a senior secured loan agreement with Cerberus paying 8.75%. It matures in Q1 2021. It has a 3.5% pre-payment penalty that goes down by 1% each year. The company also has a $15.5M subordinated loan agreement with NewSpring Mezzanine Capital with a fixed interest rate of 12.0% and a PIK interest of 2.0%. It has a 3.0% pre-payment penalty that goes down by 1% each year.

*Note, the debt amounts reflect payments since the last press release and were confirmed with the CFO as of yesterday.

Keys to the Thesis

• Underfollowed: Otelco is tiny (<20M market cap), has no research coverage, previously filed for bankruptcy, and is a secularly declining business.

• OTEL has performed relatively well post-bankruptcy: EBITDA has been flattish at $27-$28M/year since the company lost the TW contract. This has been a combination of LSD rev declines and tight cost control: SG&A is down in dollar terms relative to 2014 while gross margins are up over 200 bps. The company has reduced total debt from 133M post-bankruptcy to 97M today in ~3.5 years.

• Consolidation makes complete sense: the top 3 players in the industry control 97% of lines. There are significant cost synergies in acquiring smaller players and OTEL is a top 25 player.

• OTEL is the cheapest wireline player available: If you look at publicly traded peers, they trade between 4.5x-6.5x EBITDA on 1-year forward EBITDA estimates. Each company has their own characteristics, but I think this range is about right. I believe OTEL can generate ~$26.25M in EBITDA in CY 2017 (LSD decline), which means OTEL is trading <4x EBITDA, significantly below the low end of the range. 

• OTEL has fared reasonably well post-bankruptcy in terms of revenue and EBITDA trajectory, and given their smaller size, cost reductions would have an outsized effect on margins.

• Now is the time for a deal to happen for OTEL: The following quote from OTEL’s CEO was buried in the company’s last press release:

• “Looking at our industry, we believe that wireline telecommunications is poised for further consolidation,” continued Souza. “We intend to explore Otelco’s opportunities to participate in that activity. In that regard, the Company has retained The Bank Street Group LLC as its financial advisor to explore strategic alternatives that would enhance stockholder value. These alternatives could include a broad range of merger and sale transactions, among other things.”

• Bank Street is a private investment bank that focuses on the communications, media, and tech sectors. A list of their recent deal flow below:

• http://www.bankstreet.com/news.html

• The company noted that they spent ~250K in advisory costs in the latest quarter, a significant amount for a small company and one not worth taking unless they are serious about finding a buyer.

• M&A activity has picked up recently in telecom.

• When I spoke to the CFO, he cited that “There have been at least 4 M&A announcements in the last 2 weeks. Previous 4 years, there have been like 2 announcements.” The company is well aware that now is a good time for them to be put up for sale having somewhat stabilized EBITDA and refinanced the debt.  

• http://www.telecomramblings.com/category/mergers-and-acquisitions/

• The chairman of the board, Stephen McCall, has more than 15 years of private equity investing experience focused on growth capital and buyout investments in the telecom sector.

• http://phx.corporate-ir.net/phoenix.zhtml?c=184665&p=irol-govBioCorpGov&ID=127030

• It is worth noting that while management owns very little common stock, the senior management team does get a nice payday in the event of a change in control. Also worth noting: five directors bought stock in May, though admittedly for small dollar amounts.  

Valuation

I think the above table is a very reasonable way to handicap valuation. I have tried to be conservative on both the multiple and the level of EBITDA. A competitor could acquire this business for ~$125M in a base case even accounting for a 100% equity premium and the pre-payment penalties and still generate a 20% pre-tax yield on that purchase price (EBITDA yield). Many competitors have NOLs which could would effectively make this a post-tax yield. Furthermore, this deal would likely be accretive before any synergies. The risk/reward obviously gets even more favorable if an acquirer is willing to factor in synergies. It is worth noting that every turn in EBITDA leads to a whopping 140% more upside.

Risks

• Revenue decline accelerates, company is not able to cut costs as efficiently as they have the past couple of years

• I am modeling a LSD rev decline and EBITDA decline in line with revenue in my base case.

• OTEL has not provided guidance, but the company seemed confident in conversations in their ability to cut costs and raise prices to maintain a LSD rev decline and EBITDA declines a bit better than the revenue decline.

• No one is interested in acquiring the company, interest rates rise

• This is a levered equity in a crappy industry. Your ultimate downside is 100%. However, I think that scenario is unlikely and that the risk/reward is very favorable at these levels.

Catalyst

·         Buyout by larger wireline player