|Shares Out. (in M):||13||P/E||0.0x||0.0x|
|Market Cap (in $M):||0||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||240||EBIT||0||0|
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(This moved up a dime since I wrote this; everything should still hold, however.)
Otelco is a scary, scary beast. The core business, the operation of 11 Rural Local Exchange Carriers (RLECs), is in decline, despite being located in such desirable locations as north central Alabama, central Maine, and southern West Virginia. They just lost their largest customer, a wholesale agreement with Time Warner Cable (12% of direct + 3% of indirect sales). The company suspended dividends on its common stock in April, and deferred interest on its junior bonds in August. As a result of the customer loss and other difficulties, the company evaluated its goodwill, intangibles, and PP&E, and took a $152 million dollar impairment ($11.50 / share). There is still $45 million in goodwill on the balance sheet, plus another $10 million of intangibles, as well as $60 million in remaining PP&E.
Speaking of the balance sheet, the company has total assets of $167 million; after subtracting goodwill and other intangibles one is left with tangible assets of $112 million. Against that, Otelco has $309 million in liabilities, primarily $271 million in debt, leaving a stockholder’s deficit of $142 million.
Amazingly, OTT was at $16 a year ago. Those days are long gone, but it still trades just under $2.
Obviously, this is a long. What! Have I gone crazy? Maybe. I did leave out a few details above, however, so stick with me. And remember that I did warn you that OTT is a scary, scary beast.
First, OTT is not a stock. Technically it is an “Income Deposit Security”, each IDS representing a share of common stock and a junior bond due in 2019. As far as I can tell, OTT is the only IDS trading in the US at the moment (I guess they won’t be pointing at the great track record here to make some more any time soon). The par value on the junior bond is $7.50 and the interest payment is 13% ($0.975 / IDS), so of the $271 million in debt, about $100 million is actually traded with the common under the symbol OTT. So, for $1.81, you’re buying a 13% junior bond at 24% of par, with a share of stock tossed in for laughs.
In terms of the rest of the debt, there is also a further $8.5 million in similar junior bonds without stock attached. Finally, there is the senior debt, a term credit facility from GE Capital, for $162 million; interest was 4.3% as of December 31, 2011. The credit facility is due October 31, 2013. As you can imagine, management is very interested in reducing debt after the debacle this year; the company engaged Evercore Partners to explore strategic alternatives “to address our existing levels of debt and to strengthen our balance sheet”. Evercore handles debt & capital markets, restructuring, and M&A.
As usual for companies reporting huge losses due to write-offs, the cash generation of the business is far better than net income. Otelco advocates an “adjusted EBITDA” (page 28 in the most recent 10-Q), which works out to about $22 million for the 1H of 2012. Sales have been going down slowly over the years (i.e., $104mm in 2010 vs. $102mm in 2011); obviously with the Timer Warner loss 2013 will be materially worse (perhaps $85mm?), but presumably some of that will be made back on expenses. EBITDA was $45 million in 2011, $50 million in 2010, and $48 million in 2009. They have projected $35 million for 2013, which seems reasonable given the Timer Warner loss and their resulting focus on reducing expenses; 2014 is projected from $29mm to $35mm. The company has reduced headcount by 13%, reduced senior management pay by 33% and board pay by 20%.
In terms of buyouts, I’ve seen multiples for RLECs from 3x to 7x on EBITDA (3x to 5x is more conservative), implying a value for the business between $125 million (3x *$35mm + $20mm cash) and $265 million (7x * $35mm + 20mm). With $162mm of senior debt in front of you, in the lower brackets you are looking at a total loss if Otelco goes into Chapter 7 (liquidation). However, I believe an outright liquidation is unlikely.
On the other hand, in a Chapter 11-type scenario (reorg), whether voluntary or involuntary, as an owner of the junior bonds, you should get something regardless of the “right” multiple. If you are only paying 24 cents on the dollar, I think you’ll come out ok.
As an example of what could happen in a reorg, (Scenario 1) if the senior debt takes a 30% haircut and gets 80% of the equity and extends their maturity date to 2019, while the junior debt takes a 50% haircut, has the coupon rate cut in half, and gets 18% of the equity (the remaining 2% of the equity staying with the original shares), then at the end you’ve got: a bond with par $3.75 and yielding 6.5% (13.5% on cost of $1.80) plus some common stock. If the new share count is about 650 million shares (~98% dilution), then the junior bond holders will have 117 million of them, and the IDS will get about 120 million (recall there is about $8.5 million in junior debt that is not in IDS form, but the IDS retain the 13 million original shares), implying about 9 shares per IDS.
What could these shares be worth? At that point the company has $113mm (senior) + $54mm (junior) = $167mm in debt, down from $271mm currently. The interest expense on that debt has gone from $7mm (senior) + $14mm (junior) = $21mm to $4.8mm (senior) + $3.5mm (junior) = $8.3mm. After making $35mm of EBITDA and subtracting $15mm in D&A, $8.3mm in interest, and $4mm in taxes, that leaves 7.7mm in net income, or about $0.0118 / share on the new share count of 650 million. Thus, your 9 shares should be earning about $0.106; since the company is now more appropriately levered, and is once again current on its debt, it’s probably going to pay out some of that in dividends; let’s assume $0.05 (50% payout). If we assume that the market assigns a 10x EPS (equivalently, a 5% dividend yield), that results in $1+ in value for the common. Together with your $3.75 bond paying interest of $0.24375 (6.5%), you’ll have $4.75 in value (2.6x cost) and a 6.2% yield (16.3% on cost).
The senior holders, by the way, took a $49 million haircut, but now also own $58 million in common stock, so they are happy (or at least not too unhappy) also. The people who got sent to the cleaners are the original buyers of OTT, who paid $15.20 per IDS.
Anyhow, the previous scenario is just to show one possibility; obviously the actual return will depend on the precise terms of the reorg, which also depends on the “right” EBITDA multiple, the exact amount of cash on hand at the time (some of which could go to the senior in order to induce them to leave more on the table for the junior), skill of the negotiators, etc. The real point is that as a holder of junior bonds purchased at 75% off, you’ve got quite a good chance of coming out ahead in a reorg, although success is by no means assured (“scary, scary beast”).
Without going through all of the details a second time (Scenario 2), if the senior took only a 20% haircut, and got 90% of the common, with the junior taking a 60% haircut (plus a 60% reduction in coupon, to 5.2%) and 8% of the common, then each IDS gets common worth about $0.56 and a $3 bond, for 98% profit and 10% yield on cost. Actually I think this is too harsh on the junior bonds, but I can live with it, even if the junior bond’s due date is extended to 2025. (Any situation that does *not* result in a haircut to the par & coupon of the junior – for example if they can sell some of their subsidiaries for fancy prices to reduce debt, or use their cash buildup to pay down the senior in exchange for a maturity extension – is so fabulous that it’s not really worth modeling.)
Finally, I don’t think the senior is really in a position to walk off with all the value. The biggest problem Otelco has is the interest rate on the junior bond (i.e., OTT), plus the total amount of net debt. The company is operationally ok, and will have $30mm+ in the bank when they negotiate (4Q 2012?). Consider the following: (Scenario 3) (A) The senior takes no haircut at all and the $30mm is used to reduce the senior debt, leading to $122mm. The senior certainly cannot complain, and if they don’t want to renew despite the lower balance then the company has until October 2013 to find another lender; it shouldn’t be that hard. (B) The junior takes a 80% haircut, from $108mm to $22mm. Total debt is now $153mm, down from $270mm. The coupon on the junior takes a 60% cut, to 5.2% on par of $1.50 per IDS. Interest on debt is now $6.8mm, down from $21mm. (C) Common goes 100% to the junior; each IDS now has 0.925 shares (down from 1 due to the $8.5mm in extra junior bonds not in IDS form). Each share should be earning around $0.65, or $0.60 per IDS. At 10x, each IDS is worth $6 for the common and another $1.50 for the bond; total value is $7.50 (4x cost) and total yield is $0.38 (21% on cost). It’s worth pointing out that the senior does better in scenario 1 when they take the haircut, since they get common worth $9mm more than the haircut they took. At any rate, since the real problem is the junior debt, I don’t think the senior is going to be able to play super-hardball.
Link to most recent 10-Q: http://www.sec.gov/Archives/edgar/data/1288359/000118811212002428/t74291_10q.htm
Link to most recent 10-K: http://www.sec.gov/Archives/edgar/data/1288359/000118811212000583/t72665_10k.htm
Link to prospectus for IDS (trades under symbol OTT): http://www.sec.gov/Archives/edgar/data/1288359/000104746904037574/a2148801z424b4.htm
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