Description

 RCN is trading at 50% discount to its sum-of-the-parts value.  The company is a "hybrid" CLEC, incumbent cable company, and cable overbuilder serving 430k subscribers in the NYC, Washington DC, Boston, Chicago, and Lehigh Valley, PA areas.   Fred359 recommended as a long in 2007 and he did a good summary highlighting its history and emergence from CH11 in 2004.  RCN has essentially the same pay-TV fiber-optic system as Verizon's FiOS, which is costing approximately $5,000+ per acquired subscriber (RCN, ex CLEC is trading at $1,200 per sub).  While nothing is imminent on the strategic front and management has stated that it intends to remain independent, VZ or AT&T (as well as any other cable company) could easily acquire this company at a much lower price per subscriber vs. public multiples or buildout subscriber acquisition costs and gain access to one of the most advanced fiber networks in the industry, with decent market penetration in overbuild markets (typically 20%).  Moreover, traditional cable companies are aggressively targeting the small/medium business segment for voice and data, businesses that RCN is already in through its highly successful, above industry growth CLEC, which serves this segment as well as very large companies (RCN has even wired very large enterprises in prime Verizon/Time Warner Cable territory, including the Time Warner building, NYU, and GM's NYC office;  large enterprise comprise of 90%+ of CLEC revenues).

While many analysts/investors look at the overall valuation of the company, the key to appropriately valuing the businesses really rests on three components:  1)  the value of the CLEC; 2)  the value of an incumbent cable company (is the incumbent in the Lehigh Valley, serving ~100k subs); 3) the value of the overbuilder subs (the other 330k subs in NYC, Boston, DC, Chicago).

Intra-capital structure-wise, the  equity also trades very cheap versus RCN's bank debt, with a free cash flow yield of  20+%, versus the yield on its bank debt (only debt of the Co) of 5% on a current yield basis and 8% on a 'normalized' LIBOR level (more on this later).

 The Metro Business (CLEC):  Reported as the Metro division of RCN, it is expected to generate approximately $60MM of the $210MM of total RCN EBITDA for 2009 (representing approximately 23% Metro EBITDA growth for FY09 vs. total RCN EBITDA growth of ~8%-9%).   This segment targets Fortune 1,000 customers, offering Ethernet, SONET, wavelength and other transport services.  About 30% of revenue comes from telecom carriers, one-fourth from wireless carriers, one-fourth from financial services customers and the rest from other enterprise customers.  Its 6,500 route mile fiber network passes 20k large buildings connects 1,200 of them.  This network is a facilities-based CLEC (RCN owns & operates network), which carry higher margins driven by on-network traffic, versus other non-facilities based providers which lease network bandwidth from other providers (w/ a facilities based provider, margins expand as more on-net customers are added). Approximately 90% of Metro revenues are derived from carriers and enterprises that generate monthly billings in excess of $10k.  The route diversity of much of this plant has distinguished RCN from many of its peers, especially in the important Manhattan market.  The recent acquisition of Neon (2007) has brought additional scale and allowed for significant cost savings to be realized (purchase price was less than 5x EBITDA).

 Comps Time Warner Telecom, Cbeyond, AboveNet, Cogent, Paetec are essentially in the exact same business as RCN.   VZ, AT&T, LVLT, GBLC and S all have subsidiaries that provide network/data services which compete with the offerings of RCN.  Due to higher growth, CLECs are rewarded higher multiples from the market at an average of 6x-7x, compared to 5.0x-5.5x for cable multiples.  Including the recently acquired Neon communications (late 2007), 1Q09 Metro revenues grew ~12% in the 1Q, while EBITDA grew 44% (due to revenue growth and significant costs taken out post Neon acquisition).  Metro revenue is anticipated to grow in the high single/low double digits over the next few years, as the company offers a variety of high growth services such as Transport, Co-location, and Internet access and continues to wring out costs of  recent acquisitions.   

Ticker                                     EV/EBITDA (FY09 consensus est.)

Time Warner Telecom            6.3x

AboveNet                              5.7x

Cogent                                 7.1x

Cbeyond                               7.7x

CNSL                                    7.0x

Paetec                                   4.7x

Level 3                                 7.9x

Verizon                                 5.5x

AT&T                                    5.1x

Level 3                                 8.0x

Global Crossing                     4.3x

Qwest                                  4.5x

 Using a 6.0x multiple on RCN's  CLEC business (approximately $60MM in EBITDA for EV of $360MM) seems reasonably conservative, given the strong growth characteristics, improving margins, and high returns on capital

Cable:

RCN is the incumbent provider in the Lehigh Valley, Pennsylvania (serving cities of Allentown/Bethlehem), where it has over 105k subs.  This represents a 50% market share of all pay-TV subs in that market (typical large MSO market shares in a given area are typically around 30%.)  RCN competes in the Lehigh Valley with a small family owned TV operator with less than a 30% market share (and of course Dish & DTV).

In its overbuild markets, RCN generally has had a first-mover advantage as being the only true triple play alternative to Cable providers.  Triple-play bundling has been a part of RCN's cable offering since its inception.  Currently, about 88% of RCN's customers have taken two or more services, while about 45% take the triple-play offering.  This compares very favorably to Time Warner Cable and Comcast, which have double-play and triple-play penetration rates of 50% and 20%, respectively.

Performance of the cable business has been good over the past several years, reflecting modest basic sub growth of 1% (compared to losses for the MSO universe), good RGU growth and strong uptake of double-play and triple play services.  In addition, post the 2004 bankruptcy, the company significantly rationalized costs as it upgrades its network (fewer truckrolls), consolidated real estate, regional office overhead, etc.  EBITDA margins in the cable business are approaching an overbuilder-peer level of 30% (vs. the low 20s a few years ago).  As a cable overbuilder with less scale vs. a traditional MSO (less scale and not as advantaged in getting low programming costs) 30%-35% EBITDA margins is typically the ceiling seen with cable overbuilders (such as privately held WideOpenWest and Grande communications, and publicly traded Knology).

Due to the continued difficult economy, all cable companies are reporting that basic sub and RGU growth will likely be muted through 2009.  As such, RCNI management has provided guidance that effectively implies that cable EBITDA will be growing only modestly in FY09 (about 3-4% on similar revenue growth). 

Valuation:  The MSO universe trades at 5.0-5.5x cable-only EBITDA (if  you back out content from the EV), while CVC (with the highest triple-play penetration and superior demographics) at about 6.0x-6.5x.  Interestingly, the only publicly traded overbuilder, Knoledgy, is trading at 6.0x EBITDA.   For RCN, applying a 5.2x multiple on the cable assets overall implies a cable EV of $760MM.

Just on a simple public comp basis, RCN's equity value is twice as high as the current market value (Small changes in multiple because of leverage, will magnify returns through the equity).

 Is a 5.0x+ multiple justified?

 The largest wildcard to the RCN story is how to value the cable subs, given that it is a smaller, combination  overbuilder and incumbent cable provider.  Also, not all subscribers are created equal:  Overbuilders are seen to face more competition, thus have higher churn and lower price points.  Also, a triple-play customer generates significantly less churn and higher cash flow vs. a non-triple-play customer.

 In order to incorporate these factors, I have broken out the subscribers, average revenue per unit for single/double play subs (this is an average) on both an overbuild and incumbent basis, and did the same for RCN's incumbent subs in the Lehigh Valley. 

 While RCN management has stated that the pricing and churn characteristics for the overbuilt subs are very similar to incumbent subs, I have assumed a churn differentiation of about 10% per year (30% per year vs. 25%) and modestly lower pricing (15%)  reflecting the more competitive elements of being an overbuilder.  Maintenance capex/sub is very low for an all-fiber network, and subscriber acquisition costs have been fairly low $400-$500, given the minimal cost to extend plant to homes from existing nodes (essentially represents equipment cost).  I have also assumed a "cap rate" of 10%, reflecting the assumed required rate of return for owning cable assets on an unlevered basis.

 The blended EV of the cable subs under the above assumptions is ~$1.0BN, for an implied EV/EBITDA multiple of 7.0x.  Thus not only are public cable valuations supported by this analysis, but also actually imply that public cable companies are also under-valued.  The other takeaway from this is that not all subscribers are created equal, and some subs (i.e. triple play) need to be valued at a considerably higher premium vs. the "average" cable sub.  Under this scenario, RCN's intrinsic value would be approximately $18.

Intra-Capital Structure valuation

RCN's  $735MM of term bank debt matures in 5 years (revolver matures in 4 yrs, which is the likely refinancing date of the term debt), and current pricing is L+200.  Trading at 92 cents on the dollar, the bank debt has a current yield of 4.6%.  The paltry yield is due to the fact that LIBOR is trading at recession lows.  Assuming a more normalized long-term level of LIBOR of ~4%, the bank debt yield would be around 8%.  The senior secured bank debt has no debt below it (equity can be considered as next "layer" of debt).  On average, the high yield long-term senior/subordinated relationship is 1.2x (subs should be priced at 1.2x senior).  Assuming an 8% yield, this would indicate that fair value of the equity (treating as sub debt) is around 9.6%.  Instead the FCF yield to the equity of RCN is around 24%, and this includes growth Capex.  Maintenance capex is estimated to be around $90MM, which would further boost the FCF yield to the equity to nearly 50% ($100MM levered FCF after maintenance capex).  A 9.6% FCF yield on the equity (including growth capex) would imply a market cap of $833MM, or price per share of $22.8.  While more levered-small cap companies tend to trade at high FCF yields, this calculation implies that at least on a capital structure valuation basis, fair value of equity of $12-18/share seems realistic.

 Business Economics are Good & Improving:

RCN's intrinsic valuation is also justified, as it actually a high return on invested and incremental capital business.  RCNI's historical returns  on invested capital (total assets - net working capital - excess cash - intangibles) is in the  and importantly, return on  incremental invested capital (change in annual cash flow) incremental capex + acquisitions continues to be favorable (and will improve in FY09), despite the weak economy and increasing competition in both the CATV and CLEC spaces.

Risks:

 --Intensifying competition from VZ/AT&T/Cable companies in the NYC, Boston, Chicago, DC markets.  Despite this, RCN continues to net gain RGU's, has maintained strong market shares in markets served (about 20%), and for VZ/AT&T & MSO's, they can acquire RCN at a much cheaper price vs. what their current multiples reflect, and in the case of VZ, with $$1,200-1,500 of cost per home passed at 25% penetration, implies a cost/acquired subscriber of $5,000-7,000 (vs. RCN which, ex CLEC is trading at 1,200 per sub).  More insulated on satellite competition, given that 60% of RCN's subs are in multiple-dwelling units in the metro areas.  VZ FiOS buildout in Lehigh Valley is not a high priority and other cable competitor is much weaker vs. RCN.

 --Leverage of 3.7x, which while high, is actually lower vs. other MSOs such as CVC, MCCC, and in-line with TWC.

 --CLEC revenue growth slowing due to weakness in large enterprise and SMB market (economy).  Most of RCN's (90%) clients spend more than $10k a month, and large enterprises who are more price sensitive w/ the economy are emphasizing lower cost CLECs.  A combination of organic revenue growth with continued margin expansion (acquisitions & more on-net customers), should allow the CLEC business to weather the storm well (1Q results & mgm't guidance reaffirm this).

Catalyst

 --Sale of overbuild subs by VZ/AT&T or larger MSO given significant arbitrage of RCN's per sub valuation vs. buildout costs/public MSO cable & overbuild sub trading levels.

--Sale of incumbent subs to Comcast/TWC, where can get significant scale/deep market penetration in an attractive sub base w/more insulated  competition (Lehigh Valley).

--Management emphasis on growing CLEC business and recognition of the disparity in cable  vs. CLEC valuation.

--As FCF increases and absent a transaction, will likely increase share repurchases at highly accretive valuations.

--As a "levered equity" play, increases in cable/CLEC comp multiples will have significant effect on RCN equity price.  Leverage and debt service coverage are not issues (3.7x levered). 

--More normalized credit markets will make risk-seeking investors focus on high FCF yield companies (this has happened in other sectors, but not so much w/ RCN).

--Value recognition can drive price higher to above $10+/share and $500MM market cap will increase universe of buyers (purely technical factor).

--Significant NOLs ($1+BN) would be attractive to profitable acquirer.