Description

Interested in owning a company that: (1) has no direct exposure to current macro headwinds such as China weakness or US dollar strength; (2) maintains a recurring/predictable revenue and cash flow business model ; (3) has grown revenue organically by 5-6% per annum in the last few years; (4) is managed by some of the best operators in the industry; (5) trades at +20% discount to a mark-to-market SOTP ($48-50); and (6) recently announced a highly accretive and potentially transformative acquisition that could result in 50% upside (~$60) over the next few years?

Shenandoah Telecom (SHEN) is a four-state regional communications provider in rural areas of Virginia, West Virginia, central Pennsylvania and western Maryland.  SHEN generates the majority of its EBITDA through its wireless business as a Sprint affiliate, but also owns towers and has a respectable cable and wireline business. At a recent price of ~$40.89/share, the company has a market cap of $1BN and enterprise value of $1.1BN. I expect SHEN to generate standalone EBITDA of ~$160 million in 2016, implying a ~7.0x EV/EBITDA multiple. Pro forma for the pending acquisition (expected to close in 1h2016), SHEN trades at 6.2x ‘16e EV/EBITDA. Over the next few years, as SHEN integrates the acquisition and completes the network upgrade of the acquired properties, I expect the company to generate $4.50-$4.90/share in free cash flow. Taking the mid-point, the company is currently trading at 8.7x ‘18e FCF.

Summary Thesis

SHEN is underappreciated for three principal reasons:

(1) SHEN has a variety of hidden assets that are not appreciated by investors who value the company purely on the basis of their wireless business. In particular, SHEN owns its own wireless towers, has a competitively positioned cable business, and owns a considerable fiber footprint – all of which would trade at 6-12x for the wireline and cable assets to ~18x forward EBITDA for the towers if independent versus the ~6-8x typically afforded to nationwide pure play wireless businesses (such as Sprint and T-Mobile);

(2) the company’s recent investments in their cable and wireless businesses are just beginning to bear fruit and as a result their organic growth profile should exceed the publicly-traded peer group; and

(3) SHEN recently announced an accretive and potentially transformative acquisition of contiguous rival wireless service provider nTelos (NTLS) and amendment to affiliate agreement with Sprint (the “transactions”). The terms of the deal are complex (discussed below), but in effect allows SHEN to more than double its wireless subscriber base (from 442k to +1 million) and convert them to a Sprint affiliate agreement, all at an attractive multiple and without issuing additional equity. I believe SHEN’s management team has the ability to optimize the NTLS assets and generate significant further value for the combined entity.

Business Overview

SHEN has three main businesses, each of which is managed out of discrete, wholly-owned subsidiaries of the parent:

1. Wireless (current: 56% of revenue, 70% of EBITDA / pro forma for the transactions: 72% of revenue, 82% of EBITDA) – the company’s wireless business is conducted by its Shenandoah Personal Communications, LLC (“SHEN PCS”) subsidiary and is a Sprint PCS affiliate with exclusive rights to use the Sprint brand and its wireless spectrum/infrastructure in its four-state coverage area extending from Harrisburg, York to Harrisonburg, Virginia.  As a Sprint affiliate, SHEN PCS gets access to Sprint’s spectrum, brand, national platform, marketing, billing, customer care, and other services in exchange for a percentage of gross revenues. The specifics of the contract with Sprint are as follows: Sprint takes a 14% service fee and 8% management fee for postpaid customers or 6% for prepaid customers. So for every $1 of postpaid revenue, SHEN receives 78c; and for every $1 of prepaid revenue, SHEN PCS receives 80c. Revenue is reported net of the payment to Sprint. The contract runs to 2029 with two 10-year renewals, and if terminated by Sprint would trigger a “buyout” clause that forces them to purchase SHEN PCS at 90% of “fair value”. Under no circumstances can Sprint “overbuild” in SHEN PCS’s territory. The company has grown its market share from ~15% (of covered POPs) five years ago to ~20% today and now has 442k subscribers (296k postpaid subs and 145k prepaid). SHEN PCS has 537 base stations in its service territory covering 2.1MM POPS, and recently upgraded its network to 4G LTE. The company now has ~4k POPs/cell site which is denser than the competitors in the region such as AT&T that have over 10k POPs/cell site. SHEN’s superior network (higher quality, fewer dropped calls) coupled with more focused marketing in its region has enabled the company to reduce churn and grow market share. The company also owns 154 towers outright which it manages out of Shenandoah Mobile LLC, another wholly owned subsidiary, and leases space to SHEN PCS and other wireless carriers. It is important to note that SHEN PCS is subject to Sprint’s umbrella pricing plans and does not have the flexibility to alter pricing within its coverage area. Interestingly, SHEN PCS has generally outperformed Sprint in terms of customer metrics: (1) postpaid churn: SHEN PCS posted 1.4% in the most recent quarter vs 1.6% for Sprint; (2) market share: on a standalone basis, SHEN PCS has 20% vs 17% for Sprint.  

The Transactions:

On August 11^th, SHEN announced its acquisition of NTLS and amendment to its agreement with Sprint:

NTLS deal: all-cash acquisition of NTELOS Holdings Corp. for $9.25/share and assumption of debt for total consideration of $586MM; SHEN will receive NTLS’s 290k subscribers and wireless infrastructure assets (excluding spectrum), and commit to upgrading NTLS’s West/Western Virginia network (cost: $150MM) and shut down the Eastern markets (cost: $50MM). Total: $786MM

Revised Sprint agreement: As part of deal with NTLS: (1) NTLS subscribers will be converted to Sprint-branded customers; (2) the existing exclusive wholesale network service agreement between NTLS and Sprint will be canceled; (4) NTLS’s spectrum will be transferred to Sprint; (5) the existing contract between Sprint and SHEN will be extended 5 years from 2024 to 2029 (no change to extension options) and the “buyout” valuation will increase to 90% of “fair market value” (as determined by three independent investment banks) from 80%; (6) Sprint will contribute 291k additional subscribers; and (6) SHEN will receive $252MM in a cash settlement spread over 5-6 years (present value ~$225MM).

Summary transaction economics:

($MM)

Deal Terms:          NTLS equity                                           $208

                                     Net Debt                                                   378

                              Total NTLS EV                                          586

                              Plus: NTLS 4G capex                               150

                              Plus: Eastern mkts shutdown                 50   

                              Plus: one-time costs/fees                        85

                              Total Cost                                                 871

                              Less: PV of Sprint fee reduction          (225)

                              Less: NTLS accounts receivable             (57)

                              Total Consideration                                589                                      

                              NTLS run-rate EBITDA                             115  

                              Multiple of EBITDA                                   5.1x                                                

                              NTLS/Sprint Subscribers                         580k                       

                                    Multiple of Subscribers                     $1,014/sub (vs ~$1400/sub for SHEN wireless prior to NTLS/Sprint deal announcement)             

SHEN expects to finance the transaction with $810MM in bank debt. This equates to ~3.0x PF leverage.

2.  Cable (current: 27% of revenue, 13% of EBITDA / pro forma: 17% of revenue, 8% of EBITDA) – Shenandoah Cable Television, LLC (“SHEN CABLE” provides video, voice and high speed data (HSD) services to customers in a portion of its four-state coverage area. SHEN’s cable plant is built out to 172k homes passed and has circa 71.5k customers subscribing to a mix of single products or the triple-play bundle. With ~40% market share of homes passed, the company is now focused on growing services within existing customers versus adding new customers. There is significant opportunity to increase margins after the company’s recent capex spend to upgrade the cable network, which it completed in 2012/13. Over the last three years SHEN has increased penetration of HSD by 25% (from 40k to 51.4k data customers) and voice by 50% (from 12.3k to 18.3k). This has enabled the company to increase ARPU from $78.65 in Q2-2012 to $104.96 in Q2-2015. As a result EBITDA margins have increased from 14% in 2013 to 23% in Q2-2015. While the improvement has been impressive, there is still a way to go given the wide EBITDA margin gap relative to the rural comps (generally in the 25-35% EBITDA margin range). Management thinks high 20s/low 30s is a reasonable target through basic blocking and tackling: continued shift in focus from lower margin video subs to higher margin voice and HSD. However, assuming no change to the 23% margin, SHEN CABLE should generate $23MM in EBITDA per annum.

3. Wireline (17% of revenue, 17% of EBITDA / pro forma: 11% of revenue, 10% of EBITDA) – the wireline segment has two businesses:

1. Shenandoah Telephone Company provides regulated and unregulated voice services, DSL internet access and long distance access services throughout Shenandoah County and other rural areas in Virginia; this business is a rural ILEC that is losing ~2% access lines per year (compares favorably to other ILECs which are losing 3-5% per year); and

2. Shenandoah Communications, LLC owns 4,400 route miles of fiber and fiber optic facilities that it leases to other SHEN subsidiaries for backhaul traffic and some external corporate customers; the company has recently increased its focus on building more relationships with commercial customers and expects to grow revenue ~5-10% per annum.   

 The wireline segment generated ~$63MM in revenue in 2014, up ~6% y/y as fiber-leasing revenue more than offset the decline in access line revenue. Of the $63MM, ~$25MM came from the fiber-leasing business at Shenandoah Communications, LLC at +50% EBITDA margin.

Current Valuation:

Capital Structure (today, $000s):                                        

 Standalone ‘16e EBITDA             160,165

 TEV/EBITDA Multiple:                      7.0x

PF Capital Structure ($000s):

 PF ‘16e EBITDA                           288,820

 TEV/EBITDA Multiple:                       6.2x

Why does the opportunity exist?

1. Hidden assets: over the last 15 years, the company has essentially transformed itself from a regulated rural ILEC into a provider of multiple communication services. I believe the right way to think about SHEN today is as a platform of regional communications assets managed by an operating team with a strong track record. Given that the assets are managed by distinct subsidiaries (and management has publically stated that it is not married to any of its businesses), SHEN’s tower, fiber and/or cable assets could easily be monetized (and there is no shortage of M&A interest for these types of assets) without disrupting the remaining businesses. Therefore, one legitimate approach to valuation is sum-of-the-parts (based on peer group trading multiples not asset sales):

($000s)

2. The transformed SHEN: Pro forma for the transactions, SHEN PCS will have 708k postpaid and 314k prepaid, equating to ~24% market share. The transactions will position SHEN as the 6^th largest wireless carrier in the US. Given management’s impressive operating track record, there is no reason to believe that SHEN can’t optimize NTLS’s underperforming asset base relatively quickly and grow subscribers meaningfully, potentially reaching 30% market share in the next five years. Now that SHEN has built a distinct brand and customer goodwill (through good customer service, “local” positioning), the company has developed a strong competitive position in their regional markets and it would be prohibitively expensive for anyone else to make a real attempt to gain share in any of their segments. It is worthwhile noting that Quadrangle, the PE sponsor of NTLS with an 18% stake, ostensibly wanted equity in the pro forma entity instead of cash – any equity issuance was a deal-breaker for SHEN so Quadrangle had to settle for cash.

I am using 2018 as a steady-state year given the elevated capex in 2016/17 to upgrade the NTLS network and the costs associated with shutting down a portion of the acquired territory. Employing relatively conservative assumptions for market share gains in wireless and wireline fiber, and higher EBITDA margins in cable, I get to the following:

($000s)

Using a 15x multiple of FCF, discount rate of 8% per annum (discounted back to 2016) and some share repurchases over the next few years, I get a value of ~$60/share, approximately 50% upside from here.

Catalysts:

• M&A – monetization and/or roll-up of cable, fiber or tower assets

• Successful integration of NTLS

• Continued strong execution and market share gains

Risks:

• Sprint bankruptcy – highly unlikely but worth highlighting nonetheless. The company believes that “our agreement would survive (a Sprint) bankruptcy since without our network, there would be over a million customers who would not be served”.

• NTLS deal risk – low! financing in place, no material antitrust considerations, both boards have approved the deal.

Catalyst

M&A – monetization and/or roll-up of cable, fiber or tower assets

Successful integration of NTLS

Continued strong execution and market share gains