Description

Investment Thesis

NTELOS Holding Corp (“NTLS”) is a pure play wireless provider in VA and WV after spinning off its wireline business Lumos Networks in October 2011.  I believe it is reasonably positioned as a small market provider of post and prepaid wireless services, priced like it is in secular decline with a 10% dividend yield.   I recommend a long position in NTLS for both capital appreciation to a peer like multiple and a large sustainable dividend yield.  The catalyst to get to a peer like multiple should occur in the next several months as the roaming agreement with Sprint is extended.  Significant upside is possible over the next 12-18 months if Sprint decides to acquire NTLS like it has 7 other times in the last several years with its other rural affiliates.

Business

NTLS is based in Waynesboro, VA and is run by Jim Hyde, who has been with the company for nearly 3 years, previously at Voicestream for 12 years.  You may remember the old CFW name, which is the predecessor to NTLS and was around for 100 years.  Quadrangle and Citi bought CFW out of bankruptcy in 05 and took it public as NTLS in 06.  Quadrangle bought out Citi’s stake and now owns 27%.  

NTLS has over 5mm covered POPs (licensed for 8mm) mainly in VA, WV and a few surrounding cities in Ohio, NC and MD.   It has an additional 1.4mm POPs licensed, with no coverage in those respective cities yet.  Lastly, it has 20 MHz AWS spectrum covering 1.46mm POPs, which is hard to value but given Verizon paid $3.9BB for 60MM AWS POPs, it is worth somewhere between $0 and $100mm….(See Chart below)

AWS spectrum purchased in 06. 

It sells services under the nTelos brand, while providing national coverage through roaming agreements with Sprint and Verizon.  Across these 30 markets, it has a roaming agreement with Sprint in 14 of them, covering over 3mm people.  This deal is through July 2015 and is 30% of NTLS revenue, obviously a very important agreement.

NTLS has 425k wireless subs, 285k of which are post-pay and 140k prepay.  Both segments seem to be stable with the June quarter being the first in many that both had sub growth.  It’s no surprise the company struggles to win net subs against the big 3 national carriers, mainly through its retail network of 64 stores.  However, the company is nearly complete with a major overhaul of its retail stores, designed to be bright, simple, spacious and service oriented, clearly modeled after Apple.  Customer survey responses have been quite positive and analyst channel checks would indicate the same.  A third of new subs are added via NTLS network of 400 independent agent resellers. 

NTLS wins business by offering services and handsets 20-30% cheaper than the big 3.  The cornerstone of its brand is to not compromise on any services, network or customer experience, other than price.  It now offers the iPhone (started in April) at 25% off the big 3’s handset price, and data plans are running roughly 20% cheaper than the big 3’s.  I checked 5 different packages online vs. AT&T or Verizon packages, and the average savings was 21%.  An interesting cheap data option NTLS offers that hasn’t caught on yet according to management is the $15/month tethering option, allowing any NTLS device to act as Wi-Fi hub for other devices up to 5GB, which is much cheaper than AT&T.   The biggest recent enticement is offering to rebate the buyout cost for post-pay customers to drop their big 3 contract and switch to NTLS, up to $175.  This should help continue the current recent trend of sub growth.  It’s important to note that Metro PCS and Leap are not in NTLS markets so the competition is the big 3, and pricing is pretty stable right now. 

Churn has averaged 2.5-3.5% the last 5 years, with 2.6% blended last quarter mainly from prepaid losses.  This will be very difficult to lower further given market penetration, but NTLS did gain market share last quarter against all 3, which stands at 8.2% currently.  The key metric to offset churn is ARPU, which will drift up the next few years, as smartphones dominate new adds.  6% of post-pay subs are on the iPhone already and 80% of gross adds on getting smartphones.  Post-pay ARPU was +3% last quarter to $56.42/sub, mainly due to higher data plan rates from iPhone launch in April.  Of course, to drive smartphone penetration you need to offer cheap handsets and given NTLS offers iPhones and other devices cheaper than the big 3, these rebates will dig into profitability.  Management believes revenue will grow mid-single digits but EBITDA and margins will suffer from these rebates as well as upcoming 4G network costs, yet to be defined in both magnitude and timeline.

Sprint

Their CDMA network in WV & VA has a good reputation for signal strength locally, where AT&T/VZ struggle in some of the more rural markets.  The company wholesales its network service, mainly to Sprint covering 1.5mm POPs, with roaming revenue of over $40mm per quarter, almost 37% of revenue.  This is the main risk to the stock and I assume the reason for its recent weakness. 

Sprint pays NTLS wholesale rates for voice/data, which is calculated by taking a 40% discount to Sprint’s retail rates.  This rate calculation is currently under dispute, as you can imagine the moving needle here and both parties claiming it in their favor from time to time.  Sprint has a $9mm/month minimum under this agreement, which it is currently exceeding.  This agreement expires in July 2015, but Sprint has the ability to start construction of its own network if it wishes, beginning next year.  NTLS has renegotiated this much earlier than expiration twice before, and I would expect the same result again especially given its need to upgrade to 4G/LTE.  Capex usage is mainly adding sites to the network for coverage expansion, of which 60% are in the Sprint SNA territory.  Sprint’s turnaround is good for NTLS as increased smartphone penetration at Sprint boosts its data usage, which boots roaming revenue for NTLS.  This agreement has been in place for 8 years, the relationship is strong, and I expect the agreement to be renewed at fair rates for NTLS rather than Sprint going through the costly and disruptive process of building its own network.  In fact, Sprint has been very acquisitive in the past with its roaming partners, and I expect it to consider the same for NTLS especially given the recent run in Sprint’s stock.  There is a 2 year period in which NTLS has to avoid any M&A activity to preserve tax benefits of the Lumos spin, expiring in October 2013.  This doesn’t mean they can’t explore an agreement well before that date.  A 6x 2013 EBITDA acquisition multiple, well below prior deals, would yield $22.50/share.  8x would be $36/share. 

I should note the CFO of NTLS, Steb Chandor, spent 6 years at iPCS, which was sold to Sprint in December 2009 at 8.6x EBITDA in cash. 

Balance sheet/Liquidity

Liquidity is good with $58mm of cash and a $35mm line of credit untapped.  There is $400mm of net debt so its leverage ratio of 3.1x is fine vs. 4.0 covenant.  Coverage ratio is 3.0x and current coverage is nearly 7x. 

Free cash flow will be low to negative next 24-36 months most likely as NTLS continues its network buildout and LTE expansion for 4G compatibility.  The approximate cost and timeframe hasn’t been disclosed but management expects to provide more detail by year end.  I have maintenance capex at roughly $25mm which may be high, providing $50-65mm of annual FCF at operating level. 

Valuation

Price - $16.90

S/O – 21.3mm

Mkt Cap - $360mm

Net Debt - $400mm

EV - $760mm

2012 EBITDA guidance - $135mm (midpoint of guidance range); 2013 consensus - $145mm

2012 capex - $70mm (midpoint of guidance range).  Maint capex - $25mm

Expected 2012 dividend per share - $1.68/share, or 10% yield

Cash EPS expected at $135mm in EBITDA – $2.10/share given NOLs (used up in 2013)

GAAP EPS - $1.20/share

2012 EV/EBITDA – 5.6x

2013 EV/EBITDA (e) – 5.2x

Acquisition candidate

I had planned to wait a little longer to post this idea given the October 2013 date for Section 355 expiration, but with stock at a 10% yield and Sprint negotiations active, the risk reward is too compelling.  I assign a low probability of 20% to Sprint dropping NTLS and building its own network, as these markets aren’t Tier 1 markets and essential to Sprint’s nationwide 4G buildout to better compete with AT&T and Verizon.  NTLS would certainly raise roaming rates on Sprint and get aggressive on wooing its customers.  The same argument was made for Shentel, iPCS, Ubiquitel, Alamosa, etc.  Below are some deal multiples Sprint has paid in the past.  Obviously it is not 2006 anymore in terms of pricing and their ability to pay cash every deal.  However, Sprint’s reasoning for doing these deals, including the massive associated synergies in removing redundant costs and the analysis of cost vs build hasn’t changed much.  You can see that paying 8x for NTLS ($36/share or 110% upside) would not be a stretch given its strong network quality and coverage, retail footprint, low churn, FCF and valuable spectrum. 

 Risks

• Main risk is Sprint wholesale is not renewed at reasonable terms and Sprint decides to market and sell the territory on their own, greatly reducing EBITDA
• Recent retail sales momentum softens
• Dividend yield cut due to margin compression after postpaid subs soften and/or Sprint wholesale agreement isn’t renewed
• 4G network buildout capex costs higher than expected

Catalyst