Description

Special Situation – Review of Strategic Alternatives (sale expected)

USM – US Cellular; PT: $65 (50% upside)

TDS – Telephone and Data Systems; PT: $35 (80% upside)

Note on USM vs. TDS. TDS owns 83% of USM. We think the process underway will lead to a complete sale of both businesses, but there is a path where they sell USM but continue to run TDS.  We think they are both attractive and will be highly correlated, but they each offer a slightly different flavor.

Summary Thesis

TDS/USM have long been two of the cheapest stocks in the Telco space: trading at 50%+ discounts to TBV and 60-80% discounts to SOTP (3-5x upside), but the value was trapped as the controlling family refused to sell for decades.  This all changed when the companies announced their intent to explore strategic alternatives with their Q2 2023 earnings release.

Even after more than doubling since the announcement, the stocks still have 50-100%+ upside to our expected deal prices. We have conviction that a deal will be consummated because: (1) the financial logic for the Carlson family is just too compelling – their TDS stake, which currently provides a $11mn dividend stream, is worth >$500mn in a sale; and (2) the balance sheet of TDS has become too stretched, and they need to sell USM if they want to continue the fiber buildout.

What is it:

• USM is the holding company for US Cellular, an also-ran cellular provider in select markets.  USM has ~5mn subs, with significant share in a few markets. They also own 4000+ cellular towers and an abundance of valuable spectrum, some of which they don’t use. Lastly, USM is a minority partner with some of the big three wireless providers in certain markets – the largest JV is with VZ in Los Angeles. Due to its small scale, USM has vastly inferior margins to the big three (VZ/T/TMUS).
• TDS owns 83% of USM, along with a wireline business.  They have been spending capital aggressively to overbuild their copper with fiber.
• The Carlson Family owns 13% of TDS, inclusive of supervoting shares that give them control.  They have long refused to sell.

Incentives:

• The Carlson Family has long refused to sell. It is a point of family pride, and many family members are employed by the business.  To wit, they had a Board member resign in protest a few years back. We think there are three things that have recently changed that are pushing them to sell here.
• First and foremost, the balance sheets have become stretched.  In particular, TDS is levered 6x (including prefs).  TDS’s strategy is overbuilding its copper network with fiber, which has consumed – and will continue to consume – a lot of capital. To continue to pursue this strategy, they need to sell some of their USM stake. Due to tax rules and fair treatment of minority rules, it is nearly impossible for them to get anything close to fair value for USM without selling the whole thing. Therefore, we think the odds of a full USM sale are high.
  • If they try to sell USM’s VZ partnerships and dividend up the proceeds, the tax leakage would bite (the gain will be over 80% of the proceeds).
  • If they try to sell USM’s towers and dividend up the proceeds, the tax leakage would be also be material, and the valuation multiple would likely be disappointing, with USM standalone as the anchor tenant.
  • They have some un(der)utilized spectrum they could probably sell without a huge tax bill, but regulatory issues would probably make a lengthy process, and they would probably need to use a decent chunk of these proceeds to pay down debt at the USM level, making it an inefficient way to upstream cash. Moreover, they would be selling USM’s growth engine; in which case, why not sell the whole thing?
• Secondly, valuations for their assets peaked a few years ago, and they risk further diminution in value staying in their hands versus a scaled player.  In particular, USM’s subscale customer base condemns them to EBITDA margins less than half that of the big three (and cash flow margins that are even worse). This is likely to get worse if wireless competition intensifies, which would also impact the value of their tower portfolio. Sell now or risk further value erosion.
• Third, the financial incentives for the family have shifted from “compelling,” to “outrageously, staggeringly compelling,” over the past few years.  The family currently gets $11mn/year in dividends out of TDS, which are now at risk due to the balance sheet. If they sell TDS for $35ps, they should net $400mn+ after tax, which would generate over $20mn/year interest in a simple money-market fund – nearly doubling the family’s annuity at much lower risk!
• There is a “partial sale,” path that could make sense: where they sell USM, recap the TDS balance sheet (likely paying out a significant special dividend to TDS shareholders), then attempt to merge TDS with a fiber-overbuilder peer (many which also have stretched balance sheets) to create a more-scaled, better-capitalized entity to pursue the fiber overbuilding strategy.  This would make some sense and also allow some Carlsons to continue running the business, though it would not be value-maximizing, likely leading to a realization $5-10ps lower, depending upon the structure.
• Though the Carlsons have full control, GAMCO, which is one of the largest minorities, recently announced they had lost faith in the company’s management, which may have been another factor in driving them to pursue a sale
• LT shareholder returns (pre-announcement) have been abysmal: 10-year returns of -60% TDS/ -55% USM; 20-year returns of -50% TDS/ -30% USM; 30-year returns of -35% TDS/ -25% USM.

The Buyers:

• The simplest & most likely buyer here would be one of the three major wireless companies.  One could argue VZ, given that they are the biggest of USM’s JV partners (and the obvious buyer of that piece, regardless).  TMUS arguably has the best geographic match.  They could then sell the tower portfolio to one of the REITs.
• DISH would make sense (and would be favored by regulators), but they lack the financial resources.
• A cable company could also be interested, as they already are competing with fiber and continuing to move further into wireless bundling.
• Finally, a financial buyer could step in if they felt like they would be better positioned to break up the pieces and maximize their value over time.

Valuation:

• There are four pockets of value at the USM level:
  • We value the 4,300-tower portfolio at $2.6bn.  This is a low value for US towers ($600k per), but the buyer will likely look to cull some sites as they integrate with their network.
  • We value the partnerships/JVs at $1.5bn, which is about 10x cash flow
  • We value the unused spectrum at $2.0bn.  USM paid $2.0-2.5bn for spectrum over the past three years (primarily auctions 107 & 110) that they have not begun using.
  • We value the wireless business at $2.6bn (4.0x EBITDA). This already-modest multiple is likely double (or more) the buyer’s multiple. This figure coincides with the book value of the underlying spectrum; alternatively, it represents $550 per sub.
  • USM has roughly $3bn of net debt
  • This gets to a USM SOTP of $65ps
• There are two pockets of value at the TDS level:
  • 71mn shares of USM = $4.6bn @ $65ps
  • a wireline business generating a bit under $300mn of EBITDA.  They are rapidly building out fiber, which is now over one-third of the footprint. We value this at $1.4bn (5x EBITDA), which is a 35% discount to their trailing five years of CapEx
  • TDS has $2.0bn in debt and prefs
  • This gets to a TDS SOTP of $35ps
• There are a variety of sell-side SOTP out there that are worth considering, generally getting to $50-80 per USM share and $30-50 per TDS share.
• One could also build up from the balance sheet. USM has a net book value of $4.6bn ($53ps), and book value is likely a floor for each of their assets.  For example, the JVs are valued at $450mn (3x cash flow). Net PPE, which includes network equipment and towers, is $2.6bn. Management has repeatedly talked about how taxes have been a major barrier to selling the JVs and the towers.  On the liabilities side of the balance sheet, there are nearly $10ps in DTLs whose value could potentially be reduced in a well-structured sale.
• TDS net book value is $5.7bn ($50ps), though the value of their wireline assets are probably overstated.

Risks:

• Regulatory intervention is the key risk, as further wireless consolidation will be met with resistance, especially under the current administration. There are several key mitigants.  First, USM/TDS has a more rural footprint, where the administration has been trying to incent greater investment. The buyer will be able to make the case that a better-capitalized entity will be able to better meet this mandate (and make tangible promises to that effect). USM could also make a “failed firm” argument, given their low margins and inability to generate FCF. Second, there are a handful of other strategics. Finally, there is room for a financial buyer to step in to realize the SOTP discount over time.
• There is the risk that the Carlson family refuses any deal. Despite the history, we think this is unlikely, given the incentives & changed circumstances outlined.
• Partial sale – there is a decent possibility of a partial sale.  For example, USM is sold in full, but TDS keeps a majority of the upstreamed cash and uses it on overpaying for fiber.  We estimate a 20-40% probability on a partial sale outcome, where the full value of TDS is not realized (but still likely material upside in TDS), but full value at USM is. This is the main reason why we like a mix of both, even though TDS has the greater liquidity and upside to a full sale.

Catalyst

Sale