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Opportunity:

Shenandoah Telecommunications Co (SHEN) is a holding company with wireless, cable, and wireline operating segments serving customers located in the "I-81 corridor" from Harrisonburg, Virginia to southwestern Pennsylvania. Based on the analysis below, SHEN is currently priced at a 25% discount to a conservative private market value, the company's wireless and cable segments have attractive operating leverage providing tremendous optionality to the business' future value, and there is clear downside asset support close to today's valuation. SHEN presents a unique asymmetric investment opportunity for long-term investors; if it can stay public long enough, upside could be above 100% from today's levels.

Current Valuation:

SHEN's current enterprise value is just north of $500 mm, with a market-cap of $350 mm. With $104 mm of EBITDA in FY '12 (adjusted for one-time items) on $311 mm in revenues, SHEN is being valued at an EV/EBITDA of roughly 4.9x. ROIC has exceeded 10% on a normalized basis for years, the company is currently priced at a free cash flow yield above 14%, and SHEN's young asset base has over 2/3 of its useful life remaining (the opposite of most diversified communication services businesses today).

Business Overview:

The largest of SHEN's three operating segments is the wireless business which represented 58% of revenues and 72% of earnings before interest, taxes, depreciation and amortization (EBITDA) in FY 2012. The wireless segment has served as the exclusive digital wireless network provider of Sprint Nextel (S) branded wireless services to the region since 1999. The cable segment has been growing the fastest of all three segments over the past several years, representing 25% of revenues in FY 2012, up from 17% in FY '10, but just 6% of EBITDA in FY '12 from 0% in FY '10. All but one operating entity within the cable portfolio is fully equipped with fiber optic cable (over 2,000 miles of fiber routes total). Finally, the wireline segment has grown the slowest of the three and represented 18% of revenues in FY '12, down from 22% in FY '10, and 22% of EBITDA down from 26% in FY '10. Wireline customers receive voice services and DSL/dial-up internet services.

Wireless Industry Overview:

The global wireless industry is in the early innings of a massive increase in wireless data demand. Estimates vary, but most expect wireless data demand in the US to increase at a CAGR above 40% for the next decade, resulting in a 20-fold increase from the current data used per subscriber. Prior to 4G LTE roll-outs at the top carriers in the US, it was estimated that carriers' capacity had reach 80% utilization rates during peak traffic periods, with close to 40% of certain locations at full capacity. Once the 4G LTE build-out has been completed nationally (late 2013/early 2014), capacity should increase by roughly 3-5x for most wireless carriers performing the upgrade (compared to 2010 statistics on those networks), meaning utilization should be closer to 60%. However, the networks will be fully utilized by mid-2015 based on the exploding growth in data demand, unless things change.

As a result of this dire situation, the big wireless carriers (Verizon (VZ), AT&T (T), Sprint , and T-Mobile) have and will continue to spend on massive infrastructure improvements to absorb as much of the demand as possible. Combination solutions have also gained traction where many of the carriers are offloading peak demand to Wi-Fi networks in metropolitan areas.

SHEN is in a very unique position relative to the industry as a whole, it operates in a more rural market which historically has had much lower per-user data demand levels compared to metropolitan user-levels (perhaps due to longer commutes during peak traffic periods and the fact that much of their end-users are located out of network in the metropolitan centers during the work week). However, we're not going to dwell on this point, in fact we'll assume that these users demand the same amount of data as the average user later on in the analysis to be conservative. The more important fact for investors is that SHEN's network is still up-to-date with most technological advancements (their entire network will be upgraded to 4G LTE by late 2013). So, capacity constraints aren't going to be as big of an issue for SHEN. In fact, SHEN's operating leverage potential (i.e. economies of scale) is the #1 reason this business has tremendous upside for investors.

Economics of SHEN's Wireless Segment:

SHEN currently owns 516 wireless base stations and has roughly 391,000 subscribers (roughly 1/3 are prepaid, the rest are postpaid). We know that in 2012, the company earned $15.1 mm in postpaid revenues from $10/month data plans, meaning that conservatively there were 153,500 data plan subscribers, or 58% of postpaid subscribers had data plans. Sprint takes an 18% management fee/royalty on revenues, so all revenues are reported net-of-fees, hence our conservative figure here. We don't have wireless data figures for the prepaid segment, but smartphone penetration hit close to 50% of prepaid subscribers in 2012, so we'll assume that they all pay for data plans. Thus, 64,000 of SHEN's prepaid subscribers had data plans. Combining prepaid with postpaid subscribers, we find that SHEN had a total of 217,500 data subscribers, or 420 data subscribers per wireless base station. That is great news for an investor in this business!

Why? Well, studies performed by 4G Americas and Nokia Siemen's Networks suggest that a wireless network similar to SHEN's fully deployed 4G LTE network (that will be in place by the end of 2013), should be able to handle roughly 2,000 data subscribers per base station at full capacity (lots of assumptions behind this number, but most factors in the calculation far exceed SHEN's current demand structure on a more constrained infrastructure, so this should serve as a reasonably conservative statistic).

Additionally, economies of scale play a huge factor for network providers. Each additional subscriber on the network defrays more of the total network's costs (including operating and capital expenditures). So, assuming each of SHEN's data subscribers use roughly 0.750 GB/month of data (again a conservative assumption given this is an average statistic), if their demand usage increases 10x as is expected nationally by 2020 (this type of infrastructure asset has an 8 year depreciable life and will have one year in service by the end of 2013's roll-out), SHEN's upgraded network will have the capacity to grow the number of data subscribers by more than 200% before placing too much stress on the network by 2020!

This puts them in a much better competitive situation than their national counterparts who will be hitting their max capacity five years earlier. Additionally, free cash flow margins should actually increase by 5-12% annually in the wireless segment, from just over 16% today ($29 mm in adjusted free cash flow on $179.6 mm in revenue during FY '12), as a result of increased scale from the additional subscribers (according to Nokia Siemens Networks' research referenced above).

While there are a lot of assumptions in the above analysis, we have been conservative with respect to each factor, so margin expansion could actually be much greater, SHEN could potentially add well above 200% more data subscribers based on assumed current and future data usage levels, and the size of the current data subscriber base could be much lower allowing for greater benefits with scale.

Value Proposition:

1. Wireless Segment's Operating Leverage: SHEN has the ability to add at least 200% more data subscribers to their existing network before hitting full capacity by 2020. The growth in subscriber base, plus the scale efficiencies could add an additional $20 mm in annual EBITDA. This value is calculated by assuming SHEN's $10/month data plan pricing stays constant (which is fairly conservative given all major carriers have started to go to tiered pricing to combat the future capacity problem), Sprint's royalty reduces data plan revenues to $8/month, and SHEN adds 430,000 new data subscribers to their network, at an average EBITDA margin of roughly 48% (a 5% increase from current wireless EBITDA margins). This data subscriber growth could come from increased data plan penetration among existing subscribers, from new subscribers, an increase in monthly data fees, or a blend of all three.

New Subscribers: As larger network providers experience more strain on their infrastructure, cost disparities and performance will provide SHEN significant competitive advantages to accelerate market share grab in their market (note, their current market share is 16%, roughly in line with Sprint's national market share average of just over 15% at the end of 2012). These new subscribers will contribute new data usage fees, as well as voice and text fees which represent a small portion of network usage and thus flow through mainly to the bottom line. So, if purely new subscribers are added, a total of 100,000 new subscribers will drive the $20 mm increase in EBITDA (assuming data penetration rates stay constant, all network cost ratios remain the same, operating expense ratios are constant, and royalty rates are held constant). That means a market share increase of 4.2% from today's levels.

Data Plan Price Increase: Alternatively, if SHEN is able to raises the prices of their data plans to an estimated $20/month by 2015 (roughly in line with what national carriers will have to charge based on Tellab's study referenced above), they'd generate approximately $20 mm in EBITDA from existing data plan subscribers alone, without a single new subscriber/conversion needed.

Data Plan Penetration: SHEN's current penetration rate among postpaid subscribers stands conservatively at 58% and we've assumed a 50% penetration rate for prepaid subscribers, though that number may also be too high. Thus, if they were to increase penetration rates to 80%, this would drive an additional $4.5 mm in EBITDA a year; while not enough to make a big dent, it is certainly doable as data demand skyrockets over the next few years.

2. Potential for Collaboration Using Existing Wireless Platform: SHEN's existing wireless platform is well suited for other network providers to collaborate with SHEN by leasing space to collocate assets with SHEN's cell site assets, in order to increase their own networks' capacities. It's too early to determine how much this collaboration could add to the bottom line, but SHEN's tower leasing component generates roughly $9 mm in revenue annually, so doubling this certainly wouldn't be out of the question given the scarcity of new cell sites due to zoning, regulatory, and other factors. With relatively high margins from leasing, the bulk of this revenue would flow through to cash flow.

3. Cost Structure Advantage: SHEN possesses a key advantage when it comes to absorbing increased traffic on its network: its cable segment. Backhaul in this business is a huge component to cost and quality (17% of free cash flow annually is spent by larger networks on backhaul). Backhaul is where the wireless signal is transferred among towers via cable lines to offload some of the demand and to patch holes in an existing wireless network. Most wireless network providers must use outside cable companies, but SHEN is able to reduce some of these costs by utilizing intercompany assets, similar to Verizon and AT&T's models, providing all competitive edges in their cost structures versus non-integrated network providers (as much as 5% in margin terms). This will help keep their own costs down and provide additional leverage to attract collocation of other network providers' assets (driving additional revenues through their cable segment).

4. Cable Segment's Operating Leverage: While we haven't spent too much time discussing this segment, there is tremendous growth opportunity now that SHEN has finally hit the scale needed to earn positive cash flows. Penetration rates in the markets they serve are in the mid-30% range for SHEN's TV offerings, but for internet it is in the 25% range. SHEN's operating leverage in their cable segment is quite attractive, with the opportunity to add close to 50% of every dollar in revenue to cash flow. The market size at current prices is worth an additional $21 mm in EBITDA and most customers in their market are served by no more than three broadband providers, including SHEN. With Verizon being the dominant player in this market, SHEN has an opportunity to grab share (we've seen them increase share by more than 3% over the past two years alone, even while building out their network).

5. Intelligent Management Team: SHEN has doubled the size of its balance sheet over the past four years by expanding the number of wireless base stations by roughly 25% and ramping up its cable segment from basically zero. One could argue that this was done strategically by management to take advantage of smaller players hurt by pricing weakness and an inability to scale their business due to more difficult financing conditions. Inorganic growth has been executed with the benefit of cheap credit and at valuations that have still afforded ROICs above SHEN's cost of capital, meaning this activity seems to have been deliberately timed and effective. Given the scalability of SHEN's primary two businesses and the cash flow generation potential, it would seem obvious that management will continue to tack-on small regional communications providers at attractive valuations and without the need for increased leverage.

6. Dispelling Customer Concentration Risk in the Wireless Segment: Through Sprint-Nextel's affiliation agreement, SHEN has generated the vast majority of its wireless revenues. Thus, one might argue that the durability of SHEN's future cash flow hinges on Sprint. To dispel this risk, look to the data and competitive dynamics in the industry: (1) as discussed already, wireless network usage in the US is expected to grow at a CAGR above 40% over the next decade and carriers aren't looking to shrink capacity; (2) network infrastructure growth (# of cell sites) has been decelerating since 2002 in the US, with penetration rates now above 100% nationally; (3) SHEN possesses highly desirable infrastructure that operates over two "beachfront sections" of the radio frequency spectrum, and as sole provider within those bands locally, competitive entry isn't feasible; (4) Sprint Nextel is the number three largest wireless carrier in the U.S. and is here to stay (supported by enormous barriers-to-entry and recent anti-trust rulings effectively creating a ceiling on AT&T and Verizon's inorganic carrier expansion plans); and (5) SHEN has a put-option to sell its wireless segment to Sprint at an 8% - 14% discount to fair value at the time of sale (per the contract: fair value assumes SHEN owns their spectrum, so reversed annual royalty fees to reach discount). This provides significant leverage for SHEN to maintain margins going forward in any contract negotiation with Sprint (a sale could actually occur at any point SHEN desires, but the steeper 14% discount would apply). Based on AT&T's Alltel acquisition in January, SHEN's current wireless business could be valued at or above $450 mm alone.

7. Consolidation of Telecommunication Service Providers: The big risk to the long-term thesis here is that SHEN gets acquired through a partial acquisition (i.e. break-up), or through a full sale. Given SHEN's wireless infrastructure and licenses are all attached to Sprint's radio frequency spectrum, it would make the most sense for Sprint to simply tuck-in SHEN after completion of the 2013 4G LTE build-out to achieve the largest economic gain. With Sprint already taking 18% off the top in management and services fees, SHEN could offer a very attractive IRR for Sprint (even at a nice premium to our current private market valuation below).

Intrinsic Valuation:

SHEN is capable of doubling cash flows over the next three years once the 4G LTE roll-out is fully completed this year. The 2015 capacity hurdle facing the larger wireless carriers will act as a significant catalyst for SHEN to execute a blend of the three strategic options listed above under its wireless segment's operating leverage potential. Additional inorganic acquisitions can also be expected, and probably would be executed using their current cash balance or through cash flows without having to increase leverage.

Using conservative private market values for SHEN's three segments (wireless: 6x LTM EBITDA; cable + wireline: blended 5x LTM EBITDA) and noting cap-ex for their 4G LTE conversion is completed in 2013, the company is currently priced at a 25% discount to a conservative private market value. On top of this, SHEN possesses tremendous optionality in the wireless and cable segments, affording an extremely attractive margin-of-safety along with fairly clear downside asset support. Lastly, once the 4G LTE build-out is complete, SHEN can de-lever in as little as three years from cash flow, adding an additional $160 mm in equity value.

Determining a fair intrinsic value based on all of the future growth prospects is difficult and as a value investor, we don't put much weight into growth valuations. The bigger point is that SHEN is trading at a discount to a fair earnings power value, assuming no growth. However, SHEN clearly has many avenues to exploit in order to grow cash flow. Factoring in the potential $20 mm in EBITDA expansion achievable from new wireless subscriptions alone, SHEN could add $120 mm to enterprise value. Adding this upside to the current private market discount calculated above, and a fair value for SHEN's equity stands at a 65% premium to today's price. Then factor in an additional $100 mm from the reduction in net-debt by the end of 2015, and SHEN's equity value could stand at $670 mm, resulting in a 28% IRR from today's prices.

Source: Shenandoah Telecom: Discount To EPV And Operating Leverage Means 2x Upside