The relative market prices of Telephone & Data Systems (TDS) and U.S. Cellular (USM) have recently diverged significantly.  I attribute this mainly to recent speculation in the wake of the AT&T / T-Mobile merger that USM is a takeover target.  This speculation rarely mentions TDS, which is USM's parent, owns 82.8% of USM and is the more likely seller (but still unlikely to be sold).  The mispricing could also be due to selling pressure from one or more large TDS shareholders.  Regardless of the reason, TDS shares are down 7% YTD while USM shares are up 4%.  Over the past year USM is up 23% while TDS is down 1%.

This has created an interesting "negative stub" situation where TDS's market price is well below that of the USM shares it owns.  TDS has two publicly traded share classes but I'll focus on the lower-priced Special Common shares (TDS/S on Bloomberg), which closed today at $29.18 per share.  This is a whopping $6.00 per share discount to the market value of the 0.681 USM shares each TDS share owns, or $35.18 per TDS share ($51.66 USM share price times 0.681).  This is a five-year low in the implied market price of the TDS stub, whose implied price typically ranged from $0 to $4 over the past 5 years but has been as high as +$6 and as low as -$6.  TDS also owns net assets outside of USM (the TDS stub) that I value at $4.80 per TDS share but the market is pricing at -$6.00.  A low risk long-short position can be taken to exploit this mis-valuation by going long one share of TDS/S at $29.18 and selling short 0.681 shares of USM for proceeds of $35.18.  The potential return on long capital invested of $29.18 should the market price of the TDS stub rise from -$6.00 to $4.80 (a $10.80 rise in TDS's price) is 37%, while the return to the market pricing the TDS stub at $0 (a $6.00 increase in TDS's share price to $35.18) is 21%.

I should stop and mention that this opportunity is subject to limited trading liquidity as both TDS/S and USM shares trade $2-3mm of daily volume.  The main risk in a negative stub trade, the potential purchase of the subsidiary at a high price by the parent a third party, is a very remote risk in this situation.  A sale of USM would be highly tax inefficient for TDS shareholders.  If the Carlson family (which control TDS) chooses to sell out, they are far more likely to sell at the TDS level.

I will first go through the corporate structure, ownership, and capital structure of TDS and USM.  I will then briefly review USM's business as it is not terribly relevant to this trade since it is hedged out.  I will then detail the TDS stub business and finally describe risks to the position and potential catalysts to close the valuation gap.

TDS was founded in 1968 by LeRoy Carlson Sr. to provide local telephone service to rural parts of the Midwest.  The Carlson family controls 56% of TDS's voting power through super-voting shares and has maintained a lack of interest in selling the company, reportedly turning down an offer at $100 per share several years ago.  In 1983 TDS founded U.S. Cellular to provide cellphone service in its footprint.  TDS IPOed a minority stake in USM in 1988 but retains 82.8% ownership of USM.

USM has 85.5mm shares outstanding, spread across two share classes: 52.4mm publicly traded Common shares and 33.0mm unlisted super-voting Series A Common shares.  Of the total 85.5mm USM shares, TDS owns 70.8mm (37.8mm USM shares and all 33.0mm unlisted shares), which represent 82.8% ownership.

TDS has 103.9mm shares outstanding, spread across three share classes:

6.5mm non-traded TDS Series A common shares carrying 10 votes each, all owned by the founding Carlson family;

49.9mm Common Shares publicly traded under symbol TDS and carrying one vote each; and

47.5mm non-voting Special Common shares trading under TDS/S.

The TDS shares have more trading liquidity and trade at a 10-15% premium to the TDS/S shares.  Since the TDS/S shares are cheaper, they will be used for the long portion of this trade.

Based on each company's 12/31/10 financials, USM held $491.1mm of cash & investments and had outstanding $878.4mm of debt; while TDS's total consolidated cash & investments was $873.2mm and total consolidated debt was $1,511.9mm.  Subtracting USM's cash and debt from TDS's consolidated totals yields TDS-level cash of $382.1mm and TDS-level debt of $633.5mm.  TDS-level net debt is therefore $251.4mm or $2.42 per TDS share.  The correct way to value the TDS stub is counting only the TDS-level net debt, since USM's cash and debt are already accounted for in USM's market value.  USM is at no risk of going bankrupt so assessing whether TDS is on the hook for USM's debt and it should be included as a potential TDS-level liability is not particularly relevant.

USM is the last independent regional cell phone business following a wave of consolidation ending in 2008 with Verizon's acquisition of Alltel and AT&T's acquisition of Centennial.  The Carlson family's control over TDS and USM and lack of interest in selling out is the only reason USM remains independent.  USM is subscale, earns low margins, struggles to keep up with network upgrades to 3G & 4G, and its competitive position is being squeezed from both above (by Verizon & AT&T with exclusive smartphones) and below (by Tracfone, Sprint's Boost, Leap Wireless & MetroPCS with low pricing).

Still, USM's business is fairly stable, albeit under pressure.  It provides cellphone service to 6mm customers.  In 2010 USM generated $4.2BN of revenue, $784mm of EBITDA, $207mm of EBIT and $133mm of net income ($1.54 per share).  USM had guided for similar results in 2011.

USM shares closed today at $51.60.  Of the 85.5mm USM shares outstanding, TDS owns 70.8mm.  With 103.9mm TDS shares outstanding, each TDS share owns 0.681 USM shares.  Each TDS share's stake in USM is therefore currently priced by the market at $35.18.

Outside of its USM ownership, TDS owns and operates fixed-line telecommunications businesses in rural areas of the Midwestern and Southeastern United States (a CLEC and an ILEC to get technical).  These businesses are collectively called TDS Telecom.  TDS Telecom provides consumers and businesses with old fashioned local and long distance telephone service and DSL internet access.  TDS also owns a small printing company called Suttle-Straus which is slightly profitable, but when netted out with TDS's corporate costs outside TDS Telecom combines for roughly break-even profitability.  So TDS Telecom is the only relevant asset at the TDS level.

TDS Telecom's financials have exhibited a slow decline in sales and profit.  It is clearly not the most attractive business out there, but it is fairly stable and free cash flow positive, so it is still worth something.  Like most of its LEC peers, TDS Telecom has been gradually losing access lines and voice revenue while adding DSL customers.  The company has lost access lines at a rate of 5% per year over the past few years and so voice revenue has been declining at a similar rate.  At the same time DSL customers have grown steadily and DSL pricing is stable.  On a combined basis TDS Telecom's sales have declined slowly in recent years, dropping from $906mm in 2005 to $796mm in in 2010.  EBITDA margin has been stable at 35% and in 2010 TDS Telecom generated EBITDA of $275mm, EBITDA-CAPEX of $118mm and unlevered free cash flow of of $77mm (EBITDA-CAPEX less 35% taxes).  Since I don't need to get too precise here considering the business is currently ascribed a negative value by the market, I'll argue TDS Telecom is worth at least $750mm, a valuation of 2.7x 2010 EBITDA, 6.4x EBITDA-CAPEX and 9.8x unlevered FCF.  Larger peers CTL & WIN trade at higher multiples.

Adding it all up, each TDS share owns 0.681 shares of USM, valued at market at $35.18.  At a $750mm valuation, TDS Telecom is worth $7.22 per TDS share.  TDS's net debt of $251.4mm amounts to a liability of -$2.42 per share.    Therefore the TDS Stub is worth $4.80 and TDS's total net asset value per share (with USM at the current market price) is $40.00.  This compares to the TDS/S share price of $29.18 and the implied stub value of -$6.00.  Buying one share of TDS/S and shorting 0.681 share of USM creates a low risk long-short position that stands to benefit from the revaluation of the TDS stub from -$6 to fair value of $4.80.  A revaluation to fair value generates a return on long capital of 37%.  Should my TDS Telecom valuation of $750mm seem questionable, at the very least it is worth $250mm and so it covers the TDS-level net debt and so the TDS stub should trade at $0.  The return on long capital should the negative stub appreciate to this level is 21%.

I should note that TDS also offers a $0.47 annual dividend (a 1.6% yield for TDS/S shares) while USM does not pay one.  IBKR shows 1mm USM shares available for shorting at a small negative rebate of 0.1% so the TDS dividend should offset shorting costs and provide a modest positive carry.

Catalysts

I expect a combination of a few things to gradually boost the implied price of the TDS Stub from -$6.00 to $4.80.  First, a dying down of any USM merger speculation and associated selling by fast money.  USM is unlikely to be acquired because the Carlson family controls it and is not willing to sell.  Should they choose to sell out, they would almost certainly sell TDS rather than USM as selling USM would be tax inefficient.  In fact, if anything gets sold it will be TDS; while this is unlikely, it would be a huge windfall as TDS holders would accrue the control premium rather than USM, allowing this stub trade to be unwound with what would likely be a huge gain.  I consider this an unlikely but still possible catalyst.  Finally, the gradual effect of TDS's buyback of TDS/S shares should help to correct this mispricing.

Both USM and TDS maintain share repurchase programs but USM's is only intended to offset equity compensation while TDS's is larger.  TDS repurchased 2.4mm shares in 2010, 6.4mm shares in 2009 and 5.9mm shares in 2008.  TDS has been concentrating its purchases in the lower priced TDS/S shares.  With only 47.5mm TDS/S shares outstanding, and the Carlson family owning 7.2mm TDS/S shares, the free float is 40.3mm.  Should TDS maintain its 2-5mm share annual buyback and concentrate it in TDS/S shares it can have a meaningful impact relative to the free float.

Risks

A sale of USM by TDS is unlikely for the reasons discussed above.  Similarly, a purchase by TDS of the publicly traded USM minority is also unlikely.  TDS would have to pay a premium to the market price and this doesn't make sense given where USM shares are trading relative to TDS.  A far better use of capital is to repurchase TDS/S shares at their cheap valuation as the company has been doing, which also increases the family's ownership of both TDS and USM.  Negative mark to market is another risk and has become extreme in some prior stub trades.  The TDS stub is already a large negative misvaluation, although I admit there's no telling how low it can go.  There should be some support from the TDS buyback, which could be increased should the negative stub get extreme.