Description

RCN Corp equity is a great terminal short opportunity with an extremely high chance of bankruptcy in the next year or so. The obvious caveat is that the borrow is extremely tight. If you can get it, however, and not get bought in, it is about as close to "free money" as exists in the markets. The stock trades at $1.37 per share but still constitutes an equity market cap of over $150mm.

The company is a holdover from the telecom bubble and was initially funded by Paul Allen who decreed it part of his “wired world” strategy along with Charter Communications. RCN currently includes one pseudo incumbent, or ILEC, cable system in the Lehigh Valley, PA area and numerous overbuilt cable systems in Boston, Manhattan, Queens, Chicago, Philadelphia, San Francisco and Los Angeles. The company also owns 50% of an overbuilt JV in Washington, DC with 40,000 cable subs, 99,000 dial-up Internet customers and 21,000 long distance customers. For purposes of simplicity, I’m going to refer to the aforementioned subscriber base on a consolidated basis. In addition to these assets, RCN has a 49% interest in Mexican cable operator Megacable and owns the RCN Entertainment television production studio. The company also has $380mm in cash pro forma for the post June 30th sale of its Carmel, NY cable operation.

Despite this array of assets, however, the company faces a wholly untenable capital structure including $1.7bn in debt and $2.4bn in preferred securities owned by Paul Allen and Hicks, Muse. In Q2, the company generated a best ever $8.7mm in adjusted EBITDA (company defines as before extraordinary items, etc.) giving it a last quarter annualized EV / EBITDA of around 110x. Also of note is that the $8.7mm in EBITDA included the approximately $2-4mm from the recently sold Carmel system.

The company has managed to survive this seemingly insurmountable burden thus far for a few reasons:

Deferred Cash Interest: Over half of its unsecured notes did not begin to pay cash interest until the last few quarters so the company was able to defer much of the cash costs of its debt until recent quarters. At this point, all debt securities are cash pay. During Q2, the extent of this burden was seen as the company paid out $45.3mm in cash interest. All in, the company burned a total of $84mm in cash including $26mm in capex.

Asset Sales: RCN also managed to sell off its two prized incumbent cable systems in Princeton, NJ and Carmel, NY during the last year raising cash proceeds of $365mm. These systems, which both represent traditional, monopoly cable businesses also enjoy some of the wealthiest customers in the US and traded for per-sub valuations of well north of $3,000 per sub. These sales prices, however, give little indication of what the remainder of the company’s subs would trade for in a liquidation scenario. Also, RCN is bound by the recent amendment to its bank debt to use 80% of the proceeds for any further sales to repay bank debt as opposed to taking out high cost unsecured debt at severely discounted prices and realizing the subsequent value creation. The fact is, however, that the remaining assets would likely not generate substantial value relative to the company’s current debt load:

--Lehigh Valley System: This system is the closest the company has remaining to an ILEC but it is actually a legacy overbuilder that operates in an ILEC-like duopoly market environment alongside Service Electric Cable TV. The Lehigh Valley asset is not likely to fetch anything like the very lucrative $3,800 per sub that the Carmel sale produced for a few reasons. As mentioned, it is not exactly an incumbent provider given the overbuilt, duopoly dynamic. Also, unlike Carmel, this system is not technologically equipped to provide telephone service and thus the marketed bundle commands a lower monthly ARPU. Furthermore, the demographic profile of the Lehigh Valley areas is greatly inferior to Carmel. According to US Census data, medium household income in this area is around $35,000 per year compared with $55-65,000 in Carmel. Demographics are critically important to cable companies as more wealth makes driving incremental revenue and leverage through digital and high speed data product sales much more feasible. Consequently, I think a fair sale price might be something in the $2,000 - $2,500 per sub range or around $200 - $250mm in total value.

--Overbuilder Ops: RCN has made some progress with its overbuilt operations but there is nothing to indicate that they would trade for subscriber valuations anywhere near ILEC cable operations. The basic value proposition to customers is a deeply discounted bundle of phone, data and video products. It’s difficult to split out precisely, but it appears that these assets are currently slightly EBITDA positive.

Chicago, with over 100,000 subs, is the largest overbuilt market and RCN is suffering there from heavy competition from Comcast and others, a network that is not fully built out, lawsuits from various communities and a host of other issues. Much of the Chicago specific issues likely stem from the fact that the system was purchased from 21st Century Telecom in 1999 for $500mm and not built organically by RCN. This follows because RCN spent well in excess, on a PP&E per sub basis, for its buildouts on average than other cable companies (as of year-end 2001, RCN had spend an average of $803 in PP&E per home passed vs $622 for Charter and $503 for Comcast).

RCN also faces the problem that many of its systems including Los Angeles, San Francisco, Philadelphia, and Queens have not thus far achieved anyhere near the scale required for profitability. All of these markets serve less than 15,000 customers each and should probably just be shut down. Overall, I think the overbuilt subs are worth, at most, $1000 - $1,200 per sub or around $350mm in total value.

-- Megacable: RCN’s 49% interest in this Mexican cable provider would seem to represent decent value if it could be monetized. As of December ’02, it served 463,000 customers including over 100,000 data subs and was growing its base around 25% per year. Unfortunately, the privately held Mexican group that owns the remainder of Megacable has shown no public interest thus far in buying out RCN or paying a substantial dividend. As such, and because this interest represents a minority stake in a developing country telecom play, I ascribe a value of $1,000 per sub or $211mm in equity value to RCN.

-- Dial-Ups: RCN has a total of 208,000 dial-up Internet customers down from over 300,000 one year ago. Given this alarming rate of attrition and the fact that nearly half of the subs are housed in the 50% owned DC joint venture, I’m attributing around $200 of value per sub putting total value at around $41mm.

Total Value: Assuming the higher end of the ranges presented for each asset above, total enterprise value is around $880mm. This assumes that the company burns around 50% of the current $378mm pro forma cash balance in the next year or so before bankruptcy ensues. Incidentally, that represents recovery value on the senior notes of around 44 cents on the dollar (they’re currently trading mid – high 40s up from around 20 cents a few months ago) and full value for the bank debt. It’s worth noting again, though, that some $2.4bn in preferred securities are sandwiched between the senior notes and the common.

Recent Events: The only realistic risk to the short thesis is that the company is able to raise significant capital with which to delever. It appears, however, that the window on such a raise is effectively closing. The bonds and the stock ran up this summer as the company made a few last-ditch efforts to delever. Under its bank deal, the company has the ability to utilize up to $125mm in cash to buy back senior notes and commenced a tender offer in August to repurchase such notes at 32 – 37 cents on the dollar. Despite two time extensions of the deal, only $28mm worth of notes, or face value around $75mm, were tendered. Yet the company refused to pay more than 37 cents for its own bonds. Additionally, the only capital the company managed to raise was a 12.5% PIK $44.5mm 3-year note from Evergreen Investments. In early October, the company fired its financial advisors and hired Merrill to again evaluate the situation. It appears, however, that options are limited. There were numerous rumors during the summer that Paul Allen would step in and re-capitalize this company but he has shown no willingness to do so. Also, the logical time for such a recap would have been a few quarters back before the senior notes went cash pay and interest payments started really eating through the value of his preferred interests.

Catalyst

Chapter 11 likely in next year or so.. Exact timetable difficult to say