Description

While multiple variations and permutations of this trade exist, this specific idea is to:

• Buy USM Senior Notes of 2033
• Short USM Baby Bonds of 2060 on a long-biased, ~1.5x ratio
• Make up to 30+ points on the non-callable Senior Notes in the event of a sale to a high-grade buyer, while Baby Bonds will be call-constrained
• See assumptions at the end of this write-up, but I expect ~8% probability-weighted gross and ~24% net returns.  Low risk with potentially asymmetric returns

The Company, Chicago-based US Cellular (NYSE:USM), is the nation’s fifth largest network-based wireless carrier, with 4.8mm subscribers.  The Company’s $4.4bn enterprise value and key metrics are outlined below.  While EBITDA is growing as the Company laps several self-inflicted issues, the business is structurally disadvantaged given small size in a scale-driven industry. 

 USM has been topical, both on VIC and within the value investment community for years, given perennial under-performance and a seemingly long list of buyers.  Despite above-average service ratings and a good asset base, USM has been unable to demonstrate sustainable performance, let alone grow.  In the meantime, the wireless industry has become much less attractive – witness stagnant customer and ARPU trends, consolidation, ongoing price wars and the soon-to-come WiFi revolution (as seen in Europe).

The difficult industry outlook and increasingly leveraged balance sheet bring US Cellular to a crossroads, and prospective outcomes can be narrowly defined; either (i) operate status quo and grow profits modestly (maybe FCF breakeven?), (ii) descend into financial distress or (iii) sell to a strategic.  My insight, while not new, is perhaps more relevant than before given the stretched balance sheet, recent AWS auction and upcoming Broadcast Auction.  With ~1.6bn MHz PoPs in the low-frequency 700 and 850 MHz bands, the 1.9 GHz PCS and the 2.1 GHz AWS bands, USM’s spectrum portfolio is sizable and valuable.  Timing seems ideal for a sale, but of course am guessing like others before me.

This specific trade is a lower risk play on the Carlsons eventually selling the business.  Between spectrum, owned towers, non-core, equity-method investments and the core subscribers, USM could be worth $50-60 to Verizon or AT&T.  We can review SoTP details along with other (below) iterations of this trade in the Q&A:

• Buy USM equity
• Buy TDS equity
• Buy USM senior notes of 2033
• Buy these securities against either TDS or USM baby bonds, which have similar risk profiles but none of the upside given call constraints

USM’s Capital Structure

US Cellular’s historical financial posture has been conservative; $500-800mm of net debt against ~$750mm-1bn of EBITDA.  Things changed in 2013, when service revenue growth turned negative, competitive intensity increased, and several company-specific issues emerged.  With no iPhone and a botched billing system cutover, USM printed a horrendous FQ4 2013, driving EBITDA towards ~$500mm, stock price declines and rating agency downgrades.

The higher leverage profile creates a delicate balance; stakeholders want stress to force a sale, but, of course also want the Carlsons to hit the button before it’s too late.  I think we’re in that sweet spot; billing issues have been addressed and EBITDA has recovered – although equipment financing complicates prior period comparisons.  2015E guidance for ~$580mm of EBITDA is reasonable, but still implies ~$100-150mm of free cash flow burn when capex, interest and taxes are considered.  The Carlsons have plugged recent holes with debt financings and asset sales, neither of which are sustainable longer-term.

US Cellular’s 2033 Senior Notes, have regular-way investment grade terms including negative pledges and bullet maturities.  The Senior Notes are junior to the credit facility and pari passu to the Baby Bonds, which are NYSE-traded, $25 par securities – and actually screen as preferred equity on Bloomberg.

The Senior Notes and Baby Bonds are identical in seniority and covenants – except that Baby Bonds are callable; the 2060s in May 2016 and the 2063s in 2019.

The Trade

Buy Senior Notes and short Baby Bonds in a long-biased ratio, given I happen to think USM is a more likely seller in front of the Broadcast Auction.  The below scenarios are modeled on a ~1.5x ratio, assuming a December 2015 exit.

Specifically, under my three scenarios:

1.      Status Quo – USM’s operating performance improves, thanks to fewer self-inflicted issues.  2015 guidance is reasonable, but USM will never generate 15%+ EBITDA margins given the lack of scale.  Let’s assume both notes trade at 7% or roughly where they are today.  With a long-biased ratio, you make ~5% net.

2.      Financial Distress – Between a more competitive set and / or new operational issues, perhaps subscriber growth turns negative and USM moves back towards ~$300mm of EBITDA.  4.5x leverage and burning cash, let’s assume both notes trade at ~10%.  With a long-biased ratio you lose ~10% net.

3.      Strategic Sale – The Carlsons’ are finally convinced that wireless is no longer a growth industry, and that they can make more money selling the business versus chasing a turnaround.  If we consider a sale, the next question becomes ‘to whom’:

a.       Verizon – The industry leader and most likely buyer in my opinion given CDMA network overlap and financial wherewithal.  Verizon also supposedly bid ~$100 for TDS in 2007.  VZ’s 2033 bond trades at ~4.4%.

b.      AT&T – The next most logical buyer.  Plenty of financial capacity, although the network fit isn’t as natural given GSM (less of an issue as we transition to 4G).  T’s 2034 bond trades at ~4.3%.

c.       T-Mobile – More likely a seller, either to DISH or Sprint (or someone out of left field like Iliad).  The cultural overlap wouldn’t work, to quote Big Daddy, like ‘lamb and tuna fish’.  TMUS’ 2025 bond trades at ~6%

d.      Sprint – The network would fit, and Sprint bought several of USM’s large-market networks in 2012, but Softbank and Sprint have too many financial and strategic issues right now.  Sprint’s 2028 bond trades at ~8.1%.

                                                  i.      Probabilities are subjective, but in the event of a sale, I assume 45% likelihood that VZ buys, 45% that T buys and 10% that S buys.  These probabilities and yields imply a 4.8% weighted 2033 reference yield.

In summary, if USM treads water you make some coupon, if they fall into financial distress you lose and if they sell you do very well on the 2033s, while Baby Bonds are call-constrained (I assume T+50 pricing).  Readers, of course can adjust the dollar size, hedge ratio, exit date or other assumptions, but in short, it’s difficult to lose money and easy to make significant, above-average returns in the event of a sale.  The below table summarizes my thinking. 

Catalyst

Sale of the business