Telephone and Data Systems (TDS) is an intriguing combination of asset play and special situation, but it is unclear if and when value will be unlocked for shareholders. TDS is a holding company whose two main holdings are an 83% stake in a wireless carrier, U.S. Cellular (traded separately as USM), and a 100% stake in a wireline phone company, TDS Telecom. The founding Carlson family has majority voting rights, although they only own about ten percent of the company.
U.S. Cellular is now the fifth largest wireless provider in the U.S. (assuming the AT&T / T-Mobile merger is approved), with 6 million customers and provided 84% of TDS revenues in the past fiscal year. TDS Telecom runs two businesses with a total of about 1.1 million subscriber lines- an ILEC (incumbent local exchange carrier) serving rural areas and a CLEC (competitive local exchange carrier) in select metro markets.
Both businesses face serious challenges. U.S. Cellular has seen its subscriber base slowly fall for the past several years, and is struggling to stay competitive as the wireless industry consolidates. USM lacks a national network, which means it is dependent on striking deals with competitors to utilize their networks outside of the U.S. Cellular coverage areas. From a marketing standpoint, the company is stuck between the premium carriers like AT&T (T) and Verizon (VZ) and the value oriented carriers like Metro PCS (PCS). On the TDS Telecom side, the wireline business is facing competition from many angles, including cable carriers, VOIP providers, and consumers choosing to ditch their landlines altogether.
TDS has responded to these challenges to at least be able to tread water financially for the last three years. On the U.S. Cellular side, it has gone after increased penetration in its local markets with customer satisfaction innovations like a customer loyalty rewards program. It consistently wins consumer satisfaction awards from J.D. Power, but while that has reduced customer churn, that hasn’t thus far translated into subscriber growth. At TDS Telecom growth in broadband customers has enabled it to partially make up for the drop in voice subscribers.
While both companies appear to be well run given the competitive challenges, the problem I see is that they are spending increasing amounts of capex for earnings to remain stagnant. U.S. Cellular has to build a next generation wireless network just to keep up with the competition. It has accelerated the roll out of its LTE network to this year and plans to spend between $750-800 million on capex compared to $583 million in the past year. TDS Telecom will have large capex expense over the next several years to condition its broadband networks to be able to deliver television. It also hopes to acquire more companies in the data hosting business, which the company has gotten into in the past year as a potential new growth avenue. But it seems more likely than not that all of this spending will enable TDS to just maintain current cash flows.
TDS has a decent balance sheet and is very cheap on a trailing EV/EBITDA basis, at a little over 3X. But even if it manages to maintain current EBITDA, it will not be generating much free cash flow with the increased capex levels. The margin pressure-- particularly in the wireless business-- might lead to declining EBITDA going forward.
From an asset perspective, TDS is more intriguing. U.S. Cellular is the largest non-national wireless network left, making it an attractive takeover target, with Verizon (VZ) being the most obvious suitor. The wireline business has been consolidating as well, and given the strong rural market share of TDS Telecom, it would be an attractive asset for a larger player like Centurytel (CTL). Giving TDS’ combined 7.1 million subscribers a modest $1000 a subscriber valuation yields a $7.1 billion enterprise value.
U.S. Cellular also holds a valuable 5.5% stake in a partnership that operates a wireless network in the Los Angeles area. The partnership consistently distributes about $65 million a year to U.S. Cellular. Valuing that stake at 10X cash flow or $650 millions gets us to $7.75 billion. That is before assigning any value to any non-utilized wireless spectrum that U.S. Cellular holds, which is hard to value but could be worth another $500 million. So let’s call it a conservative $8 billion in private market value for a company with a $3.5 billion enterprise value on the public markets (assuming one buys the special shares-- more on that in a bit).
Of course, I’m not the first one to think of this angle. Mario Gabelli, popularizer of the private market value (PMV) school of investing, has been looking for TDS to sell out since at least 1999, and his funds maintain a 15% stake in TDS. Now I’ve heard about value investors being early, but that is a long time to wait. Mason Hawkin’s Southeastern Asset Management also has a 15% stake in TDS and has publicly pressured management to sell, even asserting that TDS was offered $100 a share in writing by a competitor (presumably Verizon) in 2007.
The Carlson family that maintains control of TDS is clearly in no rush to sell. One of the founder’s sons, Ted Carlson, serves as CEO of TDS and several family members are on the board. But they probably aren’t irrational. The business was growing until a few years ago, so they were justified in holding on to the business if they enjoyed running it and intrinsic value was rising. It seems highly unlikely they will run the company into the ground given the kind of money they stand to make through a sale. The question is how much of a decline in earnings or return on investment will they have to see before selling?
At the recent J.P. Morgan Telecom Conference Ted Carlson was asked point blank whether he thought U.S. Cellular was still a viable business, given the industry consolidation. He responded with a strong yes. His reasoning was that the wireless business is really about penetration in local markets, so U.S. Cellular does not need a national network to survive. That is a difficult thesis to accept as U.S. Cellular is the only carrier of any size left without a national network! Whether Carlson’s answer was just posturing (of course as the CEO he can’t really answer that the company's main business is not viable) or a bit of delusion is impossible to know. But the Carlsons are clearly not giving away any public signs that they think the end for U.S. Cellular has finally come.
A Special Situation?
The special situation part of the story involves the multiple share class structure and a negative stub.
TDS actually has three share classes:
- Series A super voting stock, which the Carlson family holds in its entirety
- Regular common shares (TDS)
- Special common shares that only have voting rights for directors (TDS.S)
TDS created the special common shares in 2005 when it wanted to buy the stake in U.S. Cellular that TDS does not own with TDS shares, but still allow the Carlson family to retain majority voting control. USM stock ran up once the special class was created, and TDS backed off its plan. The special common trades at an approximately 15% discount to the regular common, despite the fact that the lack of voting rights is practically meaningless because the Carlsons hold majority control anyway.
TDS has said on the past few conference calls that the company is committed to finding a way to close the gap between the regular and special shares. It has been buying back special shares, but part of the discount is the lack of liquidity in the special shares, and a buyback will not help that. I am not sure what else it can do to close the gap, other than just turning the special shares into regular shares.
The negative stub is created by netting out the market value of the USM stake from the TDS share price. One TDS share holds about .681 shares of USM. That currently comes to $33.05 per TDS share, while the TDS special shares trade under $30. The market is ascribing a negative value to TDS Telecom despite the fact that it is a stable business with sizable earnings.
One could play the arbitrage on these special situations by going long TDS.S and short TDS or USM. But note that the TDS Telecom stub has been negative for most of the period that TDS.S has traded, and it is unclear how TDS will close the valuation gap between TDS and TDS.S.
Tread Carefully with PMV
TDS is also an interesting story in which to analyze the potential pitfalls of the private market value approach to investing. The approach certainly makes sense, and Mario Gabelli has done amazingly well with it. In the case of TDS it actually worked initially. Gabelli bought into TDS at around $40 in April 1999 (see the end of this article) and Voicestream acquired TDS’ Aerial subsidiary in early 2000, with stock valued at $69 at the time of the deal closing. (Voicestream was then acquired by Deutsche Telekom with stock and then the telecom industry blew up. I don’t know if Gabelli got out in time.) But Gabelli has continued to stick with TDS for the last 11 years hoping for a U.S. Cellular buyout. Even if TDS does sell off its parts for $70 or $80 in the next year or two, that will be a mediocre annualized return.
The analysis is, of course, much easier with 20/20 hindsight. The Carlsons had a clear reason for selling Aerial-- it was operating a wireless technology that could not easily be integrated with U.S. Cellular and was thus clearly more valuable to another wireless provider. On the other hand, U.S. Cellular was still very much a growing business in 2000 and the Carlsons took great pride in running it. So why would it sell? A lesson learned: Carefully consider the motivations of majority shareholders when applying a private market value approach.