Alaska Communications Systems Group, Inc. (NASDAQ: ALSK) - a local Alaskan Telecom company providing "leading integrated communications services to consumer and business customers in and out of Alaska"- recently caught my eye because it was priced at 0.65 times earnings and 70 percent of book value. Upon further investigation, I discovered these numbers were the result of one-time expense deductions as the result of ALSK's divestiture of its wireless assets to form a joint venture Alaska Wireless Networks (AWN) with its main competitor GCI Communications. (NASDAQ: GNCMA).
It is my intent to provide the reader a clearer picture of both the financial position of ALSK and the Alaskan Telecom Market to reveal the intrinsic value of this local Alaskan telecom company. It should be noted that I make every attempt to be as accurate as possible in my analysis but the reader should realize that my projections are estimates and may be subject to error.
Why is the Market Pessimistic about Alaska Communications?
Shares of ALSK have declined nearly 80% over the last three years primarily for three reasons:
1) The company was forced to slash its dividend - which ALSK was funding with about 94 percent of its free cash flow.
2) Competitive pressures primarily due to the entrance of Verizon (NYSE:VZ) in the Alaskan Telecom market.
3) The company's substantial debt load has concerned investors.
The Alaskan Telecom Market
ALSK's management has estimated the Alaska telecom market to be a $1 billion industry growing at five percent annually. (Alaska Communications Systems Group, Inc., 2014) As of this writing, AT&T Alascom was estimated to have 50 percent market share, GCI 30 percent, and ALSK 20 percent. (Alaska Communications Systems Group, Inc., 2013) Verizon has recently turned on its 4G LTE network and has invested $110 million in its Alaska operations.
My belief is that the Alaskan telecom market displays characteristics of an oligopoly because it has four major players and there is substantial startup costs associated with building a network - which limits competition. Oligopolies consist of high barriers to entry with a few firms that can raise prices, limit competition and maximize long run profits while stabilizing revenues and cash flows. To illustrate, since 2004 ALSK has averaged about $351 million in revenue and $19.7 million of free cash flow per year. (Morningstar, Inc., 2014) The synergies that will result from the Alaska Wireless Network transaction will serve to only strengthen these already dependable cash flow streams. The Alaska Wireless Network between ALSK and GCI will have close to 300 cell sites of the approximately 647 in all of Alaska or about 46 percent of all cell sites in The Last Frontier. (Statewide Broadband Task Force, 2013) The AWN network is expected to cover 95 percent of Alaska. AT&T (NYSE:T) owns 187 cell tower sites covering about 90 percent of the state. (Richardson, 2012) For some perspective, Verizon had built nine cell sites as of July 2013 with plans to build 25 in the state and its 4G LTE network reaches 65 percent of Alaska. (Alaska Business Monthly, 2013) The takeaway here is that the market has become overly pessimistic of ALSK due to Verizon's entry without fully analyzing the facts. ALSK is now one-third owner of the most extensive wireless network in Alaska. Let me rephrase this. The Alaska Wireless Network is slated to have 12 cell sites for every one that Verizon has with a 30 percent greater reach than Verizon's 4G LTE network. It would make more sense for Verizon to buy ALSK if it wanted to further its presence in Alaska.
Valuing ALSK's Earnings Power and Assets
Bruce Greenwald's earnings power value and reproduction cost formula provides valuable insight as to the earnings power of a company and the costs a competitor/buyer would need to pay in order to enter a market. Greenwald has theorized that the reproduction cost of a company is the investment a competitor would need to make in order to enter a marketplace and compete with that company. Earnings power value is the reasonable earnings power that can be expected from a company given its capital allocation and financial position. A company with earnings power in excess of its reproduction costs can be assumed to be operating with a competitive advantage because it is able to consistently earn in excess of a competitor's initial investment. (Greenwald & Kahn, 2001)
The Alaska Wireless Network produced net income of $56.34 million, had $19.72 million of depreciation expense, and $18.53 million of capital expenditures in the second half of 2013. (Alaska Communications Systems Group, Inc., 2013) Doubling these numbers gives an investor a good idea of AWN's annual projections. If we take a rough estimate and assume that AWN will annually generate roughly $100 million of net income and $40 million of both depreciation and capital expenditures, we are left with free cash flow or owner's earnings of $100 million. ($100 million net income + $40 million of depreciation - $40 million of capex) It should be noted that GCI management estimated $120 million in EBITDA and $40 million in capital expenditures for AWN's first year of operations. (GCI & Alaska Communications Form the Alaska Wireless Network, LLC., 2012) ALSK will receive a $50 million preferred distribution from AWN for the first four years plus 33 percent of the residual. Put simply, ALSK should receive about $60 million ($50 million preferred distribution + $10 million equity interest) from AWN for four years and then 33 percent thereafter. I include this $60 million figure when calculating the earnings power of ALSK.
Let's start with ALSK's investment in AWN, which is worth $267 million. (Alaska Communications Systems Group, Inc., 2013) I'm going to assume that it would take three years of selling, general and administrative (SG&A) expenses for a competitor to establish its customer base and other business operations. ALSK had SG&A average expenditures of 28% of sales for the last five years, which equates to $98.2 million. I adjusted the selling expense figure down to 10 percent of average revenues to account for the transfer of its wireless business to AWN. That leaves us with about $31 million in SG&A expenses for 2014. Three years of selling expenses equates to $93 million. ($31 million x 3) A competitor would need to pay about $91 million to its account reps, executives and in all other expenses directly related to running day-to-day operations. Add to this $120 million of capital expenditures that a competitor would need to invest getting its broadband operations up and running. (ALSK's 2014 capex guidance of $40 million x 3) Remember, Verizon has spent $110 million so far in its Alaska operations. I believe it is therefore reasonable to assume that a competitor would value ALSK at $480 million ($267 million AWN investment + $93 million in SG&A expenses + $120 million in capex) which equates to $9.81 per share of reproduction costs.
Earnings Power Value
ALSK's management has projected $310 million of revenue for 2014. Multiplying 2014 revenue by the last five years average operating margins of 14.68 percent (excluding 2013 margins due to one-time expense deduction associated with AWN transaction) equates to normalized operating income of about $45.9 million. Deducting projected interest expense of $33.74 million (ALSK 2014 first quarter interest x 4) leaves us with income before taxes of $11.75 million. If we then subtract average taxes of 29.41 percent from $11.75 million, we are left with net income of $8.3 million. Add back 2014 depreciation projection (ALSK 2014 first quarter depreciation x 4) of $35.16 million and AWN earnings of $60 million (see AWN Transaction section) to get normalized earnings or operating cash flow of $103.46 million. Subtracting 2014 capital expenditure projections of $40 million leaves us with owner's earnings (or Free Cash Flow) of about $63.46 million. We then divide the owner's earnings by the weighted average cost of capital of 6.7% to get $958.70 million for earnings power value of the business operations. Adding back cash in excess of one percent of sales (cash not required for operations) leaves us with a company earnings power value of $987.52 million. We then must subtract total debt outstanding of $438 million to arrive at the earnings power value of the equity, which is about $549.52 million. Divide this number by the shares outstanding and we find that ALSK has an earnings power value per share of $11.23.
Discounted Cash Flow
Discounting owner's earnings of $63.46 million over the next five years assuming a five percent owner's earnings, three percent terminal growth rate, 6.7 percent weighted average cost of capital, and 12.89 percent capitalization rate (owner's earnings/enterprise value) equates to an intrinsic value of $14.48 per share. Is it any coincidence that ALSK's stock price hovered near or exceeded the $14 mark on many occasions over the last 15 years? I think not. And this was at a time when ALSK was competing with GCI for the highly competitive, capital intensive wireless business. With the newly formed AWN structure, ALSK has strengthened its balance sheet, can focus on growing the more lucrative business broadband segment (ALSK grew business broadband revenues 15.29 percent from 2012 to 2013) while receiving passive wireless income from its investment in AWN.
What About the Debt?
The biggest hurdle facing ALSK is its task of reducing its debt load to decrease the chance of defaulting on its debt. While ALSK's debt ratio of about five to one is higher than the industry average, management has taken swift, decisive actions to pay down its debt since closing the AWN deal. ALSK used the approximately $100 million it received from the AWN transaction to pay down its senior debt obligations and decreased its debt $105.6 million or almost 20 percent in 2013. My belief is that the company must issue new debt in order to retire its senior obligations of about $319 million due in 2016. Current debt covenants prohibit ALSK from issuing new debt or paying dividends until the company is at or below 3.5 times adjusted EBITDA. As of Mar. 31, 2014 ALSK's total debt to adjusted EBITDA was 4.25. ALSK's adjusted EBITDA was $106.5M at the end of 2013. (Alaska Communications Systems Group, Inc., 2013) In order to avoid selling off its assets to retire its senior credit obligation, ALSK needs to reduce its debt to a level at or below $372.75 million by 2016. ($106.5x3.5). As of March 31, 2014, ALSK had $438 million of total debt. So if over the next two years ALSK uses all of its preferential distributions (not including its equity interest) from the AWN transaction of $100 million to pay down debt. It would have $338 million of outstanding debt - well below the required terms of the debt covenant.
Up to this point, management has strived to deliver shareholder value through debt reduction and has stayed true to its commitment. Given management's commitment to de-levering, backed by last year's 20 percent debt reduction, there is no legitimate reason to believe ALSK will not be able meet its debt obligation before 2016.
Does a Margin of Safety Exist?
With an Aug. 5 closing price of $1.76, I believe the real price to earnings ratio of ALSK is about 1.36 and its price to reproduction cost is 0.19. This gives ALSK investors an earnings yield of over 70% with an 80% discount to reproduction cost.
While the upside is great, ALSK does not come without risks. There is a possibility that ALSK could miss an interest payment, be forced to sell off its assets to meet its obligations, or be unable to issue new debt in order to retire its senior credit facility due in 2016. With this in mind, ALSK's intrinsic value is at least $9.81 per share or about $480 million, a price in which a potential buyer and/or larger competitor would need to pay in order to enter the Alaskan telecom market. The current market price of $1.76 represents a more than 80 percent discount to intrinsic value of both earnings power value, DCF, and reproduction cost. I believe ALSK's large discount to intrinsic value more than compensates investors for the risks associated with ALSK's debt and competitive environment. This situation is a classic example of market inefficiency and if "Mr. Market" does not acknowledge ALSK's economic value in the short run, I plan to keep on buying from him until he does.
Is ALSK truly a hidden gem? I believe it is.
Alaska Business Monthly. (2013, July 9). Verizon Alaska Adds Cell Sites, Opens Anchorage Office and Business, Government Sales Channels. Retrieved August 5, 2014, from Alaska Business Monthly Website: here
Alaska Communications Systems Group, Inc. (2014). 10-Q (Quarterly Report). Washington, DC: SEC.
Alaska Communications Systems Group, Inc. (2013). Form 10-K (Annual Report). Washington, DC: SEC.
Greenwald, B. C., & Kahn, J. (2001). Value Investing: From Graham to Buffett and Beyond. Hoboken: John Wiley & Sons, Inc.
GCI & Alaska Communications Form the Alaska Wireless Network, LLC. (2012, June 5). Retrieved August 5, 2014, from GCI Website: here
Morningstar, Inc. (2014, August 1). Growth, Profitability, and Financial Ratios for Alaska Communications Systems Group Inc. from Morningstar.com. Retrieved August 1, 2014, from Morningstar, Inc. Website: here
Richardson, J. (2012, July 28). Verizon plans to join Alaska wireless market in 2013. Retrieved August 5, 2014, from NewsMiner.com Website: here
Statewide Broadband Task Force. (2013). A Blueprint for Alaska's Broadband Future. Anchorage: Alaska Broadband Task Force.
Disclosure: The author is long ALSK. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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