Who Needs Who?

The phoenix has risen again…I’m referring, of course, to the rumor that suggests that AT&T (NYSE:T) should buy out Dish Network (Nasdaq:DISH).  (This bird has a sister, by the way, who insists Verizon (NYSE:VZ) should acquire DirecTV (NYSE:DTV), but I’ll save that story for another day).  This time the speculation also includes Dish Network’s kissing cousin, Echostar (Nasdaq:SATS).

Credit Suisse analyst Jonathan Chaplin released a report on February 10 that suggested talks between AT&T, Dish and Echostar are, if not already ongoing, a real likelihood.  His report was obviously taken seriously—at one point that day shares in Dish were up more than 8%—though disappointing subscriber results in the fourth quarter have since pushed the stock back down. 

Notably, shares in Echostar have been very strong since the Credit Suisse report came out.  SATS is up about 18% compared to its closing price on February 9 and is trading at its highest level since mid-2008.

The rationale behind the speculation, which has surfaced several  times over the years, is that with Dish’s DBS service AT&T can offer a compelling video/wireless bundle nationwide that will lessen churn on the wireless side and provide several billion dollars worth of synergies to improve margins overall.  AT&T Wireless reported an impressive churn metric for the fourth quarter of just 1.32%, but that will no doubt rise some now that rival Verizon Wireless has the iPhone.  It’s also assumed that AT&T would be able to garner more attractive programming rates with the addition of Dish’s 14.1m subscribers. 

A combination of AT&T and Dish would result in a company with around 18m video subscribers, based on fourth quarter results and assuming that about half of AT&T's DBS subs are already Dish customers. By way of comparison, DirecTV had 19.2m subscribers at the end of last year and Comcast (Nasdaq:CMCSA) had 22.8m basic video subs.  #2 cable operator Time Warner Cable ended 2010 with 12.2m video subscribers--but it's worth noting that of the top four video providers (Comcast, DirecTV, Dish and TWC) only DirecTV grew its subscriber base in the fourth quarter.

But even more important, and the real impetus behind the latest resurgence of rumor mongering, are the satellite and 700 MHz spectrum assets that Dish/Echostar chairman Charles Ergen has been maneuvering to acquire.  Through Echostar, which has been acquiring the distressed debt of bankrupt Terrestar, Ergen is attempting to gain control of 20 MHz of S-band satellite spectrum.  Echostar also announced on February 14 a $2b sweetheart deal for Hughes, which offers satellite broadband service in rural markets with poor cable or DSL coverage.  Finally, Echostar also owns a bit of 700 MHz spectrum, which AT&T has been selectively acquiring for the past year.  For its part, Dish made a $1b offer for bankrupt DBSD in early February, which owns another 20 MHz of S-band spectrum. 

Combined, nearly 50 MHz of spectrum is in play, and while all of these deals are works-in-progress and by no means a sure thing, the Hughes deal already has board approval on both sides.  The outcome of the Terrestar and DBSD situations remains murky, however. Harbinger Capital, backer of LightSquared, has reportedly made a competitive offer for DBSD and Terrestar’s other creditors/ hedge fund backers are also said to be unhappy with the idea of an Echostar takeover.

Finally, regulatory approval of an AT&T/Dish combination is also a question mark, but it does seem that the current environment is relatively tolerant of vertical integration—think Comcast/NBCUniversal.  Even combined, AT&T/Dish would only be the third largest video provider.  Given other approvals that have gone through over the past few years, it seems likely to me that the deal, probably with certain concessions (like existing resale arrangements with other ILECs have to be honored), would be given a green light.

But what really caught my eye in the latest round of news was the value applied to Dish and Echostar in the Credit Suisse report, and what the implications might be for both Dish and AT&T. Chaplin suggested in his report that AT&T could acquire the equity of both Dish and Echostar for about $20b, and specifically, he said the target price for a Dish takeover would be in the $39/share range—well above the $22-$23 it's been trading at.

I decided to run discounted future income (DFI) models on Dish and Echostar in order to see what kind of assumptions Chaplin may have been making, and also looked at what current trading prices imply.  While I was at it, I also took a gander at AT&T.

First I ran a DFI looking at Dish and its current trading price.  Based on historic results, I projected net free cash flow for 2011 through 2013, and applied a perpetuity growth rate.  I used the company’s actual cost of debt and then backed into an implied cost of equity to see what investors are currently discounting into the stock price.

Given Dish’s recent subscriber losses—down 157,000 in the fourth quarter—I predicted low single-digit revenue gains for the next three years.  While subs were falling at the end of 2010, the company did post a solid increase in ARPU for the year, reporting $73 in 2010 versus $70 in 2009.  I assumed minimal OIBDA margin improvements and held the capex margin steady at 9%, about where it’s been for the past two years.  Based on the company’s recent trading price of $22.87/share, it appears investors are demanding an 11.3% return on equity.

Next, holding all other assumptions the same, I determined that Chaplin’s $39/share target, if his operational assumptions are similar to my own, implies a cost of equity of just 7.4%.  At that price the enterprise value for Dish would be $23.5b, which translates to 1.8x revenue and 7.5x OIBDA, and $1664/subscriber.  These are actually conservative compared with some recent cable deal multiples we’ve seen, but as I mentioned, Dish has been struggling somewhat competitively in recent quarters.  At this price, the equity would be valued at about $17.3b.

The implied 7.4% cost of equity also makes sense if you think about AT&T’s cost of equity.  As a check, I ran the DFI model for AT&T.  Based on conservative assumptions and AT&T’s capital structure and interest expense, its recent closing price of $28.08/share implied a cost of equity of just 6.1%.  The relatively low return requirement isn’t surprising considering AT&T’s status as one of the two biggest, strongest telecom companies out there, and it also pays a decent dividend, which investors appreciate.

Finally, a quick look at Echostar and its recently higher stock price also indicates a low cost of equity, at just 6% if my forecast is in the ballpark.  The recent trading price values total equity at just under $3b, which when combined with the Credit Suisse Dish value of $17.3b gets us to Chaplin’s $20b+ target should AT&T take the two companies out.

What’s important to note here is that the projections for each company in the DFI analyses are based solely on existing business lines—they don’t include incremental cost or revenue associated with the combination of spectrum assets that AT&T might theoretically get a hold of with a two-way, Dish/Echostar purchase. 

If you believe, like Credit Suisse’s Chaplin does, that the satellite spectrum Dish and Echostar are amassing is worth a good deal more than the companies are offering, it translates to instant equity for AT&T as a buyer. And if you believe that the Dish/wireless bundle that AT&T would then bring to market provides measurable synergies and a reduction in churn, the incremental value created for AT&T investors is even greater.

At the end of the day, I think AT&T is probably watching Ergen’s fancy footwork very closely.  The dance isn’t over yet, though, and while Charlie’s been out trying to buy up airwaves, those left watching the shop back in Colorado have been letting the subscriber base erode.

Still, Ergen’s moves are proving prescient in light of the FCC’s recent waiver grant to LightSquared to allow it to develop a terrestrial-only service using satellite spectrum.  If AT&T thinks it can bully the deals through the FCC and Justice Department, then it could very well step up to the plate.

We’ll Say It Again:  Sprint Doesn’t Need T-Mobile

The perennial rumors regarding a combination of Deutsche Telekom’s (NYSE:DT) T-Mobile and Sprint Nextel (NYSE:S, “Sprint”) have surfaced again, and despite our argument last fall (The Deal Advisor, 10/09, p.2) that Sprint doesn’t need to combine with T-Mobile, we decided there was enough “smoke” to examine anew whether or not there might be a fire smoldering…

It seems fairly certain that DT executives might be trying to light that match—the U.S.’ number four wireless carrier is in need of greater mass, spectrum and a 4G evolution plan—but based on our analysis, number three ranked Sprint is doing just fine right now and has a great deal of its future hopes tied to affiliate Clearwire (Nasdaq:CLWR).  It simply doesn’t need T-Mobile, and in fact, a messy merger with an incompatible technology company (a la Sprint/ Nextel) could do far more harm than good.

That said, Sprint is hardly out of the woods, but both it and CLWR reported better than expected second quarter results, and both seem to be moving in the right direction.  Can they compete with the likes of Verizon Wireless or AT&T Mobility in the long run?  That remains to be seen, but Sprint’s $70 per month unlimited voice and data plan is getting a lot of attention, and it doesn’t hurt that CLWR is, in fact, the only wireless carrier out there with a 4G option available today.

Investors have been waffling on Sprint, and our discounted cash flow (DCF) analysis indicates that they are demanding a pretty hefty return on equity at current prices—higher even than early-stage CLWR.  But were Sprint to combine with T-Mobile—and if investors then required that same equity rate of return on the T-Mobile enterprise—by our calculations the net effect on Sprint’s equity would be negative.

Here’s our logic.  First, we updated our DCF analysis for Sprint, and using its current stock price, backed into an implied equity rate of return.  We believe Sprint will generate about $6b in OIBDA this year and in the next two.  Assuming it keeps its capex margin low (as expected), free cash flow should be around $4.5b a year.  Based on the company’s capitalization structure, its 6.8% cost of debt, and an assumed 1% perpetuity growth rate, the recent $4.58 per share price implied that investors were demanding a whopping 31.6% rate of return on equity.  Clearly Wall Street still considers the equity highly speculative.

We then ran a similar DCF analysis for T-Mobile, which we’ve said in the past might be worth about $20b-$21b.  But using the number of Sprint shares outstanding and the 31.6% equity rate of return demanded of Sprint, T-Mobile’s equity value would actually be negative, and cost Sprint shareholders in excess of $2 per share.

Would Wall Street reward the combined companies with a lower equity return requirement?  We don’t think so.  As we mentioned above, T-Mobile’s GSM base isn’t compatible with Sprint’s CDMA infrastructure.  And Sprint, when you factor in CLWR, has a healthy spectrum position nationwide.  There simply isn’t a great reason we can imagine for Sprint to get involved with T-Mobile, even at a bargain-basement price—which DT isn’t likely to offer.  On the other hand, should DT step up with a hefty offer for Sprint, Dan Hesse and the team would be forced to consider their fiduciary responsibility to investors, but after the Nextel debacle, a compelling argument could be made against the deal.

Just for fun, we also took a look at what CLWR’s current trading value implies.  Investors seem to like their chances, although a DCF analysis on a company that may not turn free cash flow positive for several years is admittedly “loose”.  CLWR said in its second quarter earnings release that it now expects to end the year with 3m subscribers (retail and wholesale combined), and we’re guessing the impressive gains continue for at least the next two years, as its cable partners and other sales partners (like Best Buy) continue to rack up the sales.  Due to negative net cash flow for the foreseeable future, we based our terminal value on 4x projected 2012 revenue of $4b and discounted it.  Our analysis indicates that investors are requiring just under 20% for their equity—well below what they want in order to buy shares in Sprint—but of course, CLWR doesn’t have more than $20b in debt… 

At the end of the day, we just don’t see a Sprint/ T-Mobile combination making sense to anyone except DT…and it isn’t likely to buy high enough OR sell cheap enough for Dan Hesse to allow himself the distraction.

The Qwest for Scale

Rumors have swirled in recent weeks that Qwest Communications (NYSE:Q) might get taken out by a smaller LEC.  Most of the speculation has pointed to either CenturyLink (NYSE:CTL) or Windstream (NASDAQ:WIN) as the most likely buyer, though analysts also pointed out that both companies are still digesting recent acquisitions, and it’s unlikely that either one would make a move in the near-term. 

The Denver Post went so far as to value the company’s assets in its coverage of the rumors, coming up with about $20b via a simple ‘back of the envelope’ analysis based largely on a $1,500 per connection valuation metric for the landline and broadband businesses, with a few extra billion thrown in for Qwest’s data centers, fiber network and connections.  Our analysis indicates that the company could be worth upwards of $24b, based on a discounted cash flow analysis—but over time negative trends in connections could put additional pressure on our conclusion, which further highlights the company’s need to do something. 

We agree with most analysts that Qwest has largely done what it can to contain costs and that its underlying business faces serious challenges—in the 12 months ended September 30, 2009, Qwest lost 11% of its voice connections and revenue had fallen to $12.6b from nearly $13.5b in calendar year 2008.  But the company recently said that cash flow for 2009 would come in at around $4.4b, the high end of its previously released guidance, and its cash balances are now in excess of $2b.  So what should Qwest do next? 

We’re taking a longer-term view than most analysts when pondering this question, and our answer is…not only should all three companies—Qwest, CenturyLink and Windstream—get together, but they might want to consider throwing Sprint Nextel (NYSE:S) into the stew as well. 

Unless you’ve been under a rock for the past year, you’ve probably noticed that AT&T (NYSE:T) and Verizon Communications (NYSE:VZ) are taking over the United States telecom world with their dominant wireline, wireless and fiber operations.  Cable companies like Comcast and Cox are trying to stay in the game on the backs of their established video offerings and generally faster broadband connections, but to date they have little going on with wireless. 

As AT&T and Verizon get their 4^th generation wireless networks deployed over the next few years, there will be few places where consumers don’t have at least one of these two providers as an option.  In order to compete, communications service providers are going to have to match—or at least come darn close to—the service bundles and pricing offered by AT&T and Verizon.  In our minds, that means including wireless. 

All four of these companies face challenges—in particular Qwest and Sprint are heavily leveraged.  But, based on year end share prices and 3Q09 debt levels, the four companies had a combined market cap in the neighborhood of $83b, comprised of about 60% debt and 40% equity.  Revenue (adjusted for Windstream’s pending acquisitions) would be about $56.4b and OIBDA of $16.3b—but we bet synergies here could be significant over time.

By way of comparison, AT&T had a market cap of $240b and Verizon’s was $157b, and revenue for each was more than double that of our hypothetical roll up—meaning, we think, that the Justice Department wouldn’t object too much to the deal. 

We’re not saying, necessarily, that all of these companies will merge in the near future…but if we’re going to speculate about future combinations, then why not?  It might just work.

Looking Ahead, a Windstream/ Consolidated Combo?

With its $1.1b planned buy of Iowa Telecommunications (NYSE:IWA), announced (see p.1) so closely on the heels of its NuVox (The Deal Advisor, 11/09, p.1) and Lexcom (The Deal Advisor, 9/09, p.1) deals, not to mention the close of its D&E Communications buy (The Deal Advisor, 11/09, p.7), Windstream Corp. (Nasdaq:WIN) has firmly laid to rest market fears that it was being left behind in the race to consolidate. 

But even after the close of all of these deals, we imagine ceo Jeff Gardner and his team will continue scouting for additional targets—though perhaps not until later next year when their integration work is mostly behind them.  In our minds, one of the most logical companies for WIN to consider would be Mattoon, Ill.-based Consolidated Communications (Nasdaq:CNSL).  Based on the company’s 11% share price increase since the IWA deal was announced, it seems the Street agrees…

WIN’s reconfigured strategy includes a heavy focus on the business and broadband segments, as evidenced most clearly by its NuVox buy.  Cfo Tony Thomas pointed out, in a presentation given December 8, 2009 at a UBS Global Media and Communications Conference in New York, that pro forma all announced deals, more than half of WIN’s revenue will come from business/ broadband, up from 38% as of the end of 2007.  Over the same time, residential revenue will fall from 34% of the top line, to 29%.

For its part, CNSL has been performing admirably given the challenging environment, and seems to fit WIN’s criteria for acquisition targets. 

For one thing, WIN has emphasized higher broadband speeds as a way to improve customer retention and attract not only business customers but also generate incremental revenue from services like video on demand, home networking, online backup, etc. 

CNSL has been deploying pair bonding technology in order to deliver higher speed services, and reported record IPTV additions in the third quarter, along with its best quarter in nearly two years for access line losses. 

Both companies have been de-levering over the past couple of years, and have dividend payout ratios below 60%. 

Also, CNSL’s three geographic clusters fit well with WIN’s footprint, with contiguous markets in both Texas and Pennsylvania, and CNSL’s Illinois exchanges are just a stone’s throw away from WIN’s Kentucky and Missouri markets as well as it’s future IWA markets. 

We estimate WIN’s total connections, pro forma D&E Comm., Lexcom, NuVox and IWA, at just over 5m, including 3.3m access lines, 130,000 CLEC customers, 1.2m high speed Internet connections and 370,000 video connections.  The addition of CNSL into the mix would increase that total by another 9% based on 3Q stats, and bring WIN’s total connections to nearly 5.5m. 

In order to determine what kind of return investors are demanding of each company, we’ve run discounted future income (DFI) models on each and backed into an implied cost of equity, based on recent share prices.  Then, we combined the projected financial performances of the two and applied what we consider to be a reasonable cost of equity to the model, in order to see whether or not there’s any upside in a combination, keeping in mind that possible synergies might bolster the value even more. 

First, we looked at WIN.  Based on pro forma financials and expected free cash flow growth of 2%, it seems the Street is demanding a 19.7% return on equity—a bit rich, but given the low growth in the industry and the potential for snags integrating four deals, it’s not too surprising. 

Following CNSL’s recent share price run-up, our estimates indicate that investors are requiring a 16.3% return on equity, valuing the company at more than $1.2b, or about 3x revenue. (Note: we’ve estimated the value of CNSL’s wireless partnership interests at $200m over book value in reaching our equity cost estimate.)  By way of comparison, the IWA deal was cut at about 3.5x revenue. 

Finally, we combined the projected stats for each company and ran our DFI model using a 17% cost of equity assumption.  Where the current market values of each company, when combined, total less than $11b, we think the private market value of a WIN-CNSL combo could be more than $13.3b—implying an opportunity for a better than 20% upside—before possible synergies.  That should be good enough to get Mr. Gardner and company to at least kick the tires.