Description

So, I attempt to keep apprised of cheap piles of assets that are way too cheap but going nowhere just in case something interesting happens providing an opportunity to buy in with a catalyst. With TDS, one such inflection has recently occurred with an asset sale, though interestingly the asset sale sent the stock down 15% that day. I decided to dust off my file and was pleased with what I found, though I must admit I am still puzzled by the negativity of the reaction the day the deal was announced.

For those of you that have not followed TDS over the years, it has been a heartbreaker. TDS is a family controlled company that owns 84% of US Cellular (ticker USM), as well as some local RLEC, CLEC, and hosted managed services assets. The controlling family owns 14% of the shares and controls over 50% of the vote. A few years back, during the frothy wireless consolidation days, this might have fetched a price upwards of $80-100 a share but they decided they would rather go it alone. What makes this worth a look today? Well, they are finally taking concrete steps to address their languishing stock price at the same time wireless M&A is going bonkers again. There are very few pieces left in the cellular puzzle and TDS is one of the last.

US Cellular (USM)

The main asset here is USM, which is a cellular business with over 5mm subscribers operating in 25 states. Importantly, USM wins tons of awards for having the best network coverage and customer service in their markets. This is not an underinvested, stale business. They own 4500 cell towers so as to protect their ability to roll out incremental capacity cost effectively and, while today 58% of their network has been upgraded to LTE, 90% will be upgraded by YE2013. In addition to the extremely valuable 700-800mhz spectrum and 5mm subscribers they maintain, they have substantial hidden assets in the form of owned cell towers and $90+mm they are earning in operating income from wireless JVs. Interestingly, 2/3 of the wireless JV income comes from the 5.5% stake they own in Verizon Los Angeles. These JVs are worth over $700mm on their own. The towers generate $40mm of rental revenue to third parties plus whatever value they have to USM’s network. Although they are not worth the $1mm per tower that AMT and CCI trade at, their 4500 towers could easily be worth $100-300k per tower or hundreds of millions of dollars.

TDS Telecom

Beyond USM, TDS has a telecom business through its ownership of RLEC, CLEC, and hosted managed services assets. Their RLEC and CLEC assets are not as good as cable systems, but they have been heavily invested in and are well run. They are constantly upgrading broadband speeds, rolling out IPTV, and focusing on bundling. They have done a couple hundred dollars of acquisitions in the HMS space as well. This is not a key value driver so I am going to put a 3x EBITDA multiple on these though they are worth more and could easily carry over that in leverage (inferior comps trade at 4-6x). 3x EBITDA puts the value of TDS Telecom at $720mm which is too cheap for it but did not want to start a debate about them.

Midwest Asset Sale

Before we get into what the other USM assets might be worth, I wanted to go over the Midwest asset sale they announced in November that should close mid 2013. US Cellular is selling roughly 10% of their subscribers and cellular licenses in their Midwest markets (Chicago, St. Louis, Minnesota, etc.) for $480mm. This works out to roughly $820 per sub and $1.74 MHz/pop. Though this is significantly above where the company trades, it is not a sky high price. The T-Mobile AT&T deal was at $1.70+ and T-Mobile Metro PCS is at $1.50+. It is a slightly complicated transaction where they have agreed to manage the network for 6-24 months and there are some interesting tax quirks but conservatively I am fully taxing this deal and saying after tax proceeds are $325mm. Interestingly, the transaction did not include all their Midwest assets, and management is exploring selling the other assets they have retained in those markets including over 500 towers and 500mm MHz/pop. Combined, these other assets are worth hundreds of millions of dollars that I am going to assume they monetize at $200mm after-tax over the next six months. This is not a big swing factor, but it seems they are a willing seller of these assets at a minimum.

The deal is interesting because USM earns circa zero dollars of EBITDA in these markets, so the deal is tremendously accretive. USM penetration was only 3% in these markets with 2.8% churn vs. 16% and 1.5% respectively in the rest of their portfolio. The rest of the portfolio has best in class spectrum positions and coverage with strong market penetrations. However, it is still only has 25-28% EBITDA margins. This is the rub. Verizon and AT&T have service margins in the 40+% range because of their scale. TDS has maintained a stance that they can compete on a local basis after conducting a large study looking at regional businesses like banking and waste and concluded that cellular is the same. The margins of the national players are 20% higher so my conclusion is different than theirs. Despite bringing on a senior executive from McDonalds, investing tons of money in their network, and offering loyalty programs, they have been unable to grow subscribers. Also of note, as a result of not having the iPhone, USM only has 38% smart phone penetration. Thus, they have significant upside to continued penetration and potentially even more if they strike an economic deal to carry the iPhone. The key questions here are: 1) if it is true that this is not a regional business any longer, how long does it take USM to realize they cannot compete with the scale of the national players, and 2) when they do, will they have kept up their assets and subscriber base so that value is not lost from here.

Why the Family Might be Changing their View Now

USM’s original regional hypothesis may have played out if not for the continued consolidation over the past few years. If you had spoken with them last year, they would have told you they were holding cash to buy up assets that AT&T was going to be forced to sell off as a result of the ATT/T-Mobile deal. Additionally, T-Mobile and Metro PCS are now combining (eliminating another regional), Sprint and Clearwire are trying to merge, and Dish is trying to disrupt things further. The regional guys are slipping away fast. The Carlson family seems to be following a rational path where they are responding to the changing times. They have gone from saying they are going to acquire assets to selling their Midwest assets, while also publicly stating they are looking to continue to enhance shareholder value. They have also collapsed their dual class share structure in the past year to clean up the story. I believe they are in real-time watching this cellular game of musical chairs and trying to figure out what to do. I have spoken with them before, and I believe they are nice and reasonable people who will act appropriately if it becomes clear to THEM that being solely regional puts them at a huge scale disadvantage.

With regard to the decaying of the asset value, I am not really worried about this given they are great operators and focused on a best in class network and brand. The way I think about it is that if a buyer could expand margins 20% on $3B of revenue, they could add $600mm of EBITDA. Capitalize that at 7x or whatever and you have $4B of incremental value whether that happens today or in a few years. The key is for them to continue adding revenue, and I believe they understand this well. That said, I do agree that on an NPV basis, the most value creation possible is if they pulled the trigger and sold the business today.  

The break-up of the AT&T/T-Mobile deal as well as the rampant consolidation over the past year clearly changes USM’s strategic options and has changed the Carlson family’s thinking. They are going to get over $300mm in after-tax proceeds from the Midwest sale without losing much if any EBITDA and are looking to monetize other non-core assets. They already have over $500mm of gross cash at USM and will get another $300-500+mm over the next six months or so from these asset sales. They have been buyers of their stock over the past few years and paid out a good dividend at TDS as well. While they may not sell the rest of the company today, it would be interesting if in the meantime they decided to continue to shrink the equity of USM and TDS at very low prices. Thinking about USM specifically, they own 84% and have said at a reasonable price they would be happy owning the rest. They can buy in shares there to push up their ownership and pay out dividends to shareholders and TDS so TDS can shrink the TDS share count. I do not think this is speculation. If you pull up their Midwest sale transaction, they specifically state they are going to look to “enhance shareholder value.” And, here are a couple of interesting quotes from a conference TDS spoke at yesterday:

“So, I think it is our job, right? Maybe we didn't articulate as well as we could have the things that we have been doing and that we are going to continue to do. If you look back now I think it's like over the last five years, we have bought back $860 million of stock between the parent and the sub. We have paid out about $50 million a year in dividends, okay? In addition to doing that, we changed -- tried to simplify the capital structure at the parent -- finished that last year. We have been reviewing some of the performance of different assets in this transaction. We continue to do the same thing in some of our telephone company assets. We have done four acquisitions, starting up this HMS area and so we are going to continue to, hopefully, manage the business in a way that does drive value. We have got a couple of other short-term things in front of us. As I said, we like the HMS area. We are going to continue to look at that one. Similarly, we are in a position where when we did the Sprint transaction we said that is about a $480 million cash sale that we are expecting to come in later this year. (inaudible) Cellular at the end of the third quarter had $500 million in cash, so suddenly it's at $900 million in cash and that is a use of proceeds is a topic for the U.S. Cellular Board that they are currently working their way through such that we don't have a position on what we're going to do with the cash now, because quite frankly the cash isn't there. Right? To say we are going to do this and then have something happen with the FCC on this deal doesn't make sense. But once the cash is there, we expect that we will be in a position to talk about use of proceeds at that level as one more step along this path.”

Then, when asked about their cash position and leverage:

“No and yes, okay? I say that because it's interesting the way this works is we would like to maintain investment grade credit rating. Investment grade credit rating, 2.5 times EBITDA is kind of a threshold and that is on gross debt, not on net debt, okay? So when I think about the Company, we are probably 2 times today, okay? So there is not a lot of room on the debt side, on the gross debt side. I think where the opportunity sits is on the balance sheet is on the cash side, right? And so its use of that cash is where you have got the best chance to kind of change what I would call net leverage as opposed to the gross leverage that the agency may look at.”

Valuation

With regard to the valuation of TDS and USM it is pretty darn cheap, though I concede up front the greater question is whether the assets are monetized. There is not much sell-side coverage on this, but it does not make sense to have a target price 20% above the stock or whatever. The outcome is rather binary. Either they do not create value for shareholders and the stock won’t do much, or they create value in which case this is a monster.

*Downside Valuation Case:  this is just to show without doing any sum of the parts math or using hidden assets that it is unlikely to get cheaper. Again, this is not taking into account partnership or tower assets and shows it is trading at 3x proportionate EBITDA.

*Conservative Breakup Valuation Case:  this is just to show an unaggressive breakup case. I am valuing TDS Telecom at 3x EBITDA (this is extremely low  only adjustments I am making are putting a $1000 per sub value on the USM subs (which is lower than the ATT/T-Mobile deal though higher than the Midwest sale because of the superior 700-800mhz frequency and breadth of spectrum; as a sanity check, this is circa 3x buyer’s EBITDA and 6x seller’s EBITDA), 8x EBIT on the equity JVs, and $200k per tower for their owned towers (given the tower operators trade at $1mm per tower and T-Mobile sold their towers for $350k per tower this seems low). This exercise shows the upside is well over 100%, and I think if they monetized it today the numbers would be much higher.

From here, the real question is how this plays out. The stock went down 15% on the Midwest deal announcement, presumably because investors thought they sold their crown jewel and thus are not planning to break-up the company. Spectrum assets are scarce in Chicago and the spectrum represented 1/3 of their population coverage so I get the argument; that said, I think investors are viewing this incorrectly. The incremental data point is that the family is showing they are serious about earning a reasonable ROIC and delivering returns to shareholders. Also, TDS lost money on these assets and was subscale, so this was clearly an intelligent sale. While I agree the rest of the business will not be sold in the next few months, they are clearly heading further down the path of monetizing assets and considering the future of their ability to compete on a local level. The other important data point is the continued hectic consolidation activity in the space.

I believe the stock is set up in an asymmetric way with catalysts. The next shoe to drop will hopefully be the monetization of their remaining Midwest assets and then the proceeds from the Sprint deal. From now through then, I would hope and expect TDS and USM to be buying in shares. They have admitted to being grossly overcapitalized and their debt matures between 2030 and 2060 (yes, you read that right). Over the next year or so, the stock should respond if/when people see that they are serious about creating value.  

From there, it is anyone’s guess as to how long it takes for the company to realize how tough AT&T and Verizon are to compete with without their same scale. I think the Midwest sale is a huge step in the right direction and I believe if/when the writing is on the wall they will ultimately be a seller.

To be clear, there are no guarantees here. I think this is an extraordinarily cheap pile of assets with positive catalysts in the form of asset sales, capital returns, and aggressive industry consolidation combined with a shift in strategy/tone from the family. No visible downside that I can see to concern you, but it could certainly be dead money.

***Full disclosure: please do your own work. This is not a recommendation to buy, sell, hold, rent or otherwise do anything with securities.

Catalyst