RCN Corporation (RCNI) is a post-reorganization small-cap cable overbuilder with a growing commercial CLEC business that is trading at a significant discount after being ‘Tudored’ during this past summer’s market dislocation. In August, RCN’s largest shareholder, Tudor Investments, was forced to liquidate its entire 7 million share stake (almost 20% of the float) at $12/share, apparently due to liquidity issues affecting the firm.  For a stable, growing business with clear opportunities for subscriber growth and further margin expansion – and a growing, underappreciated commercial business – RCN’s valuation under 5.5x EBITDA (2008) appears severely depressed – even ignoring an NOL tax asset of $1.1 billion (equivalent to the current enterprise value).  Based on corporate actions and recent discussions, management seems committed to maximizing shareholder value in coming quarters.  With slight margin improvement (below management’s target of 30%) and a reasonable 7x EBITDA multiple, the stock could easily be worth $18-$20/share or 25-40% more than the current price.

In the past three years since emerging from bankruptcy, the company has sold non-core assets, paid down significant debt, raised operating margins and evaluated a sale of the company.  Before the credit market turmoil this summer, the company took advantage of easy credit terms to recapitalize its balance sheet by levering up and issuing a special cash dividend of over $9/share.  RCN also recently announced an acquisition of Neon Communications (NGI) to continue building its solid commercial business.  Currently, RCN trades at approximately 5.5x EBITDA for 2008 – and under 6x proforma the pending acquisition of fast-growing NGI.  The stock should move higher on continued operating improvement in its core residential business and expected recognition of the faster-growing and higher-valued earnings at its expanding commercial business.

RCN Corporation is a facilities-based provider of video, high-speed data and voice services in the United States.  The Company provides these services over its own fiber-optic local network to over 400k residential and small business customers in Boston, New York, eastern Pennsylvania, Washington, D.C. and Chicago.  The Company provides telecommunications services to residential customers in each of its geographic markets.  RCN Business Solutions (“RBS”) also provides bulk video, high-capacity data and voice services in the markets to Fortune 1000 and medium-sized business customers.

Recently, RCN announced the acquisition of Neon Communications (NGI) for $260 million.  NGI is a wholesale fiber optic data transport service provider to telecommunication carriers and a small number of non-carrier customers such as universities, colleges, and financial institutions.  The NGI acquisition expands the commercial business segment, with a regional and metro network in the 12-state Northeast and mid-Atlantic region.  NGI’s network consists of 4,800 route miles and over 230,000 fiber miles from Maine to Virginia, which can be utilized by RCN’s services and customer basis.  The acquisition would be a key strategic move for RCN’s growing commercial business segment and is expected to close in Q4/07.

 

Founded in 1997, RCN expanded aggressively during the telecom bubble but failed to sign up enough customers to pay debts amassed while it built out its network.  In May 2004, RCN and four of its subsidiaries files for reorganization under Chapter 11.  In August 2004, five additional subsidiaries of RCN filed Chapter 11.   In December 2004, the Company emerged from bankruptcy and completed its reorganization plan.  The plan converted $1.2 billion of unsecured debt into RCN equity and eliminated about $1.8 billion in preferred stock obligations.

In March 2006, RCN acquired the stock of Consolidated Edison Communications Holding Company, Inc. (“CEC”), the telecommunications subsidiary of Consolidated Edison, Inc. for approximately $42 million.  CEC was a competitive local exchange carrier (“CLEC”) in the New York metropolitan area.

Also in March 2006, RCN completed the sale of its 49% interest in Megacable, S.A. de C.V., a cable television and high-speed data services provider in certain parts of Mexico, and Megacable Communicaciones de Mexico S.A., a provider of local voice and high-speed data services in Mexico City, to Teleholding, S.A. de C.V. for net after-tax proceeds of $300 million.

Also, later in 2006, RCN hired Blackstone to evaluate selling the Company but decided to pursue the recap and special dividend.

In March 2007, RCN completed the sale of its San Francisco operations to Astound Broadband LLC, a subsidiary of Wave Broadband LLC, for a purchase price of $45 million in cash.  In addition, RCN decided to exit its operations in the Los Angeles, California market.

In June 2007, RCN completed the recapitalization of its balance sheet, which included a $595 million senior secured credit facility, consisting of a $520 million term loan and a $75 million revolving credit line. The proceeds were used to complete a $145 tender offer for RCN’s second lien notes, repay a $75 million first-lien term loan, and return $350 million to its shareholders in the form of a $325 million special dividend and $25 million share repurchase plan.  The $9.33 per share special dividend was paid on June 12, 2007.  The share repurchase is ongoing.

 

 

RCN has a financing commitment from Deutsche Bank to issue bonds and secured loans to fund the NGI deal.  The transaction debt will increase the current net debt / LTM EBITDA of 2.8x to a proforma net debt / EBITDA level of 3.8x (assuming $30mm proforma EBITDA for NGI).  The shareholder vote to approve the merger is scheduled for November 6, and closing is expected by mid-November.

The Company organizes its business into several operating segments:

     Note: Excludes revenues and costs attributable to discontinued California operations.

 

Management has targeted 30% EBITDA margins in the intermediate term, after achieving a current run-rate in the mid 20% range.  The following table outlines RCN’s key revenue drivers of Revenue Generating Units (“RGU”) and monthly Average Revenue Per Customer (“ARPC”) over the last six quarters:

     Note: Excludes customers, RGUs, ARPC and Avg. RGUs / Customer attributable to California operations.

      

NGI is expected to generate $20 million of pre-synergy EBITDA on $80 million of revenues in 2007.  RCN expects to realize $10 million from cost synergies and $10 million from revenue synergies.  Forecasts have included only expected cost synergies.  Management guidance for 2007 implies proforma EBITDA above $180 million.

 

At its core residential business, RCN sees a great return on investment through adding subscribers by building out the last-mile of customers in their current subscriber markets at under $500/customer and is targeting 75,000 new homes per year.  While easy costs have been taken out since emergence from bankruptcy, additional margin improvement should be achieved through lowering sales & marketing expense to 6-7% of revenue from current 9-10%.  RCN expects to finally implement CRM and data warehousing solutions while maximizing efficiencies in field operations.

 

            As the commercial business becomes a larger portion of the overall company, RCN should break out the division early next year in segmented financials.  With CLEC valuations much higher than cable and telecom, the blended multiple of RCN should expand beyond the valuation ascribed to the core residential business.

 

For valuation reference, using EBITDA margins of 27-28% and an EBITDA multiple of just 7x, RCN would be valued at $18-$20/share on current revenues.  This excludes potential value from the $1.1 billion NOL tax asset.

 

 

For reference, here are some recent cable industry transactions:

*Cablevision: the pending $22 billion deal (at $36.26 per share) implies a cable valuation of 12x adjusted operating cash flow (AOCF) for 2006 – assuming $5 billion of value for non-cable assets.

*Insight Communications: the $3.6 billion take-private in 2005 by Carlyle and management was valued at 8x LTM EBITDA.

*Cox Communications: the $8.5 billion management buyout in 2004 was valued at 12x LTM EBITDA.

 

*Competition from larger cable and telecom players.

*Leverage increase from recent recap and pending acquisition of NGI.

 

*Market begins to give separate, higher value to RCN’s commercial business after NGI deal closes and segment financials are broken out early next year in the 10K and 1^st quarter’s 10Q.

*Continued operating improvement in core residential business through margin expansion from sales/marketing efficiencies and profitable subscriber additions from low-cost subscriber build-outs.

*Stock repurchase plan of $25 million, representing about 5% of outstanding shares.

*Sale of company or commercial division at premium multiple.