Description

Summary Thesis

Consolidated Communications (CNSL) is a rural incumbent local exchange carrier (ILEC) that is embarking on a 5 year plan to overbuild the majority of its legacy copper plant with fiber. Searchlight agreed to invest $425m last fall in preferred and common shares to facilitate a refinancing of the capital structure and put enough cash on balance sheet to fund the fiber build plan. Today the company trades at 6.5x 2021 EBITDA; pro forma for the fiber overbuild completed by 2025 (and the fall off in high margin federal subsidy CAF II revenue), we estimate the company is trading at 5.5x EBITDA. We believe a high single digit EBITDA multiple is warranted on the backend, given the increasing involvement of PE infrastructure funds in the residential telco markets, the valuation of cable today, and the fact that your penetration on the new build fiber homes in 5 years will be below your long term target market share against cable (since it takes time to drive penetration for each build cohort). The opportunity exists today because (1) the fiber overbuild plans of the ILECs are an emerging narrative that so far have been mainly contemplated in credit/private markets (Frontier, Windstream, Ziply) and (2) there has been near term focus from the sell-side that Consolidated will lose almost all of their CAF II revenue / EBITDA in 2022, which is ~7-8% of total EBITDA.

Background

CNSL is a roll up of small ILEC assets across the country. In 2017 they acquired Fairpoint (old Verizon wireline asset in Main, New Hampshire and Vermont) and more than doubled their residential homes passed. The majority of the footprint is copper today, with only ~20% being fiber / cable. Their commercial business is more of a mix of fiber / next gen products like Ethernet vs copper / legacy products like TDM and appears to be further along in this transition than the other ILECs.

In Q1 2019, CNSL cut their dividend in order to prioritize deleveraging ahead of their capital structure maturing in 2021/22 (leverage was in mid 4x range, with the goal to bring below 4x). In fall of last year, Searchlight agreed to invest $425m in 2 stages in preferred and common shares to facilitate a deleveraging and broader refinancing of the structure. Searchlight cut themselves a pretty amazing deal. Can read through the structuring in more detail, but essentially they will put in $425m in exchange for a $395m 9% perpetual preferred and 35% of the common (at today’s price of ~$6.55, that common stake is worth [~$260m]).

Searchlight and mgmt. came to market with a plan to upgrade 1m homes to fiber (later revised upwards to 1.6m). This would leave >80% of the company’s (residential consumer) footprint as fiber.

Fiber overbuild opportunity

CNSL is one of several of the smaller regional ILECs that are embarking on an ambitious fiber overbuild strategy (along with Frontier, Windstream and Ziply / old Frontier Northwest asset). In terms of the “why now,” there are a variety of factors. Most of these companies, CNSL included, have been stuck in the old telecom mindset for a decade plus of milking the legacy revenue streams and paying out the majority of FCF in dividends, and it took a capital structure / ownership change event to alter the capital allocation strategy (bankruptcy for Frontier and Windstream, investments by Searchlight in Ziply and CNSL). But the fiber overbuild economics and value proposition have also become more and more attractive as broadband penetrations in the copper base have come down dramatically, high speed broadband prices continue to rise, and video becomes unbundled with broadband.

CNSL originally targeted 1m fiber overbuilds out of their 1.7m homes passed in the old Fairpoint footprint (Norther New England ie NNE – VT, NH and ME). In this footprint they primarily compete with Charter and Comcast. CNSL’s existing penetration in this market is in the low teens / high single digits. Later, CNSL updated their fiber overbuild target to 1.6m, including more homes across their non-Fairpoint footprint.

In terms of the build economics, CNSL has guided its cost to pass at around $500-600 per home ($450 for the original 1m homes in NNE and bit higher in the other parts of the footprint). Most of the overbuild is aerial, which is much cheaper than burying fiber (depends on density of footprint but buried typically closer to $1k). The cost to connect ie the fiber drop from the street to the home for those that sign up will be $700. For the penetration take up on a cohort basis, mgmt. is underwriting mid 30% penetration in 3 years. Our understanding is that this is similar to the assumptions of other ILECs doing fiber overbuilds, and is a reasonable target given mature fiber operators today have penetrations >40% (Verizon Fios, Frontier’s existing fiber and Cincinnati Bell) and more recent builds are in high 20% to mid 30% range (Lumen/CenturyLink and AT&T).

Finally, mgmt. has commented that they believe the build plan (and success-based drop capex) is fully funded given the ~$380m PF cash balance once stage 2 of the Searchlight investment closes. When we run the numbers, we agree and would point out that the company also has availability on the $250m RCF.

EBITDA projection

Below is a summary bridge from 2020 EBITDA (~$530m) to 2025 EBITDA (~$600m), when the fiber overbuild should be complete. For a bit of color on each major item:

1.       CAF II / RDOF revenue/EBITDA drop: -$38m CAF II was federal subsidy money given to ILECs on a ROFR basis to expand broadband to a greater part of their footprints. This is 100% margin revenue (but most ILECs have said they spent ~50% of the revenue/EBITDA on capex for builds). RDOF was the next generation of the program and was done on a competitive auction basis. Most ILECs did not win nearly as much RDOF subsidy dollars compared to their CAF II funding as competitors including fixed wireless, SpaceX, rural electric co-ops, etc. won through aggressive bidding.

2.       Consumer voice: -$63m Company has ~$170m revenue here today. CNSL and most ILECs have seen this revenue decline HSD/LDD on an annual basis. 2020 actually saw that rate of decline go down. The company thinks they can keep the declines closer to MSD to HSD range going forward, but we just assume a 10% annual decline. This results in a ~$70m revenue loss over 5 years, and at a 90% incremental margin, would be a $63m EBITDA headwind.

3.       Commercial/carrier: -$20m Historically CNSL has kept declines in this business to LSD, better than other ILECs that have seen MSD declines or worse. The general dynamic here is that ILECs are facing the long transition from legacy, expensive copper/voice products to more modern fiber products that are cheaper. We have heard that CNSL is further along in this transition owing to more aggressive investment in fiber, and in particular, the focus for Fairpoint coming out of their bankruptcy back in 2011 was to heavily invest in the commercial business and Fairpoint actually built a pretty good fiber-to-the-tower business. Management thinks they can get commercial/carrier to flat in 2021 and eventually grow it. The small business segment (~$100m revenue out of ~$590m total commercial/carrier) should also see topline perform better on the back of the fiber overbuild investment. A big part of commercial/carrier topline is related to how much investment $$ you put in, and it seems like Searchlight may be encouraging the team here to be more aggressive on spending (in the commercial enterprise and wholesale segments in addition to small business). This could all result in a flat or even growing topline. However, we still just assume a 1% annual decline. This results in a ~$30m revenue loss over 5 years and at a 70% incremental margin, is a $20m EBITDA decline

4.       Consumer broadband: +$210m Today we estimate that CNSL has 35% penetration on its ~500k fiber/cable homes passed or ~175k subs. We think these carry ARPUs in the mid $60 range for a ~$130m revenue contribution. We think the 1.88m copper homes passed have penetrations in the low teens (~240k subs) with ARPUs in the mid $40s, so copper also has a ~$130m revenue contribution. Pro forma for the fiber overbuild over 5 years, fiber homes passed will approach 2m from 500k today (bit less than +1.6m targeted overbuilds since some of the overbuilds will be for small business locations). We think penetrations on these 2m homes in 5 years will be ~30%, since your newer years 4/5 cohorts will still be ramping penetration. We project that these ~600k fiber subs will have ARPUs in the high $70s / low $80s, representing a 4-5% CAGR This is where we think one of the underappreciated parts of the fiber overbuild story is. CNSL is targeting ARPUs for fiber below their cable competitors today in order to drive penetration early on, but we think ARPUs will rise over the years to more closely approach cable competition. There will also be a mix shift to 1 gig vs the low/mid tier speeds, with 1 gig pricing in the $80-90 range vs the lower tier speed in the $60-70 range. Cable today prices its 1 gig product in the $80 to >$100 range, with lower speed tiers in the $50-80 range, so we think the targeted ARPU for CNSL around $80 in 5 years is reasonable. This results in fiber broadband revenue of ~$550m. The remaining copper plant will have low penetration and be a small contribution to overall revenue, we estimate just ~$10m. So consumer broadband revenue increases in aggregate by $300m. At 70% incremental margins, this would be a $210m EBITDA increase.

5.       Incremental marketing for fiber: -$20m CNSL will need to ramp up marketing spend a bit to drive fiber penetrations. Mgmt said they will roughly double spend in 2021 vs historically being ~$10m annually. We assume this is a $20m drag over 5 years.

Valuation and summary returns

We assume CNSL will trade at an 8x EBITDA multiple on the backend of their fiber overbuild. On a relative basis, we think this is reasonable: Cincinnati Bell was acquired for ~7x EBITDA by Macquarie Infra, but they had only 40-50% of total homes passed upgraded to fiber (vs CNSL PF at ~80%) and are more fully penetrated in most of their fiber footprint, since they have been overbuilding for a much longer time. Cable today trades at HSD/LDD EBITDA multiples and are pretty fully penetrated owing to their domination of the broadband business vs ILEC competitors over the last decade plus (although cable bulls argue there is still more room to run!).

On an absolute basis we also think 8x is defensible. Assuming $270m of normalized capex post fiber overbuild (high teens % of revenue) and $20m of pension contribution and $10m tax (we estimate CNSL will become full tax payer closer to 2027), CNSL would generate ~$300m of unlevered FCF or about 50% of EBITDA. Assuming a 5% cost of debt (company will likely take out the Searchlight 9% pref before it becomes cash pay), company would have $135m of interest expense, so $165m of levered FCF. 8x EBITDA therefore implies 16x uFCF or ~6.2% yield, and a ~7.9% levered FCF yield. We think that is reasonable for a company in a duopolistic market and selling a product that is increasingly critical for consumers to have for entertainment, work/school, etc.

8x EBITDA on the $600m PF 2025 EBITDA implies ~$2.1b equity value (against $2.7b debt as the Searchlight pref PIKs), about a 2.8x from the ~$740m market cap today (PF for conversion of Searchlight’s contingent payment rights and stage 2 investment). We think that is very attractive in this market today, especially for an investment story in a future proof product where there is a great secular backdrop of growing consumer demand for broadband. We also like the upside risk of the multiple on the backend, as PE infra funds have become increasingly active in the residential consumer broadband space; a fund could acquire CNSL in 2025 once the fiber build is completed and ride the upside to penetrations over the next 5 years.

Catalyst

Valuation re-rate, enhance sellside coverage