On September 28, 2010 I wrote, "With Shrewd Management, Surewest Could Return to Previous Highs." I wrote again on December 1, 2010 and February 13, 2011 that Surewest would be an excellent takeover target. We even did two videos on YouTube in which we pounded the table on the company's fundamentals. Surewest sold for $6.54 per share before my first article was published, and was taken over for $23.00 per share by Consolidated Communications (CNSL) on February 5, 2012.
I believe that Alaska Communications (ALSK) is an even more attractive takeover target than Surewest was, not only for a strategic acquirer, but also for a private equity firm. Fundamentally, the way to view a telecom such as Alaska Communications is to view it as a stable utility whose effective Free Cash Flow Return on Total Assets (Free Cash Flow / Total Assets) is proportional to its spending on capital expenditures, given stable cash flow from operations.
For example, when one decreases capital expenditures, Free Cash Flow increases (the numerator increases), and depreciation may start to chip away at the denominator of the equation (Total Assets) if capital expenses decrease enough. With the Free Cash Flow, one can pay down debt, further decreasing Total Assets. Furthermore, paying down debt reduces interest payments, further boosting Free Cash Flow.
One might rationally respond that decreasing capital expenditures gradually chips away at cash flow from operations over the longer term, since continued competitiveness in telecom is predicated upon moving from fixed line to wireless business, 3G to 4G, phone service to broadband, etc. Rationally, I would respond to this objection by pointing out that telecom is a scale business, and that only the largest telecoms such as AT&T (T) and Verizon (VZ) have been able to overcome the capital expenditure hurdles required to maintain competitiveness while still generating free cash flow, and even they earn only very moderate Free cash flow returns on Total Capital. Therefore, the rational strategy for a smaller competitor is to sell itself to a larger competitor to achieve scale, as Surewest did, or to use the telecom business itself as a massive cash cow to acquire other businesses, as Berkshire Hathaway did with its original textile operations. And Alaska Communications is a fine cash cow indeed, generating over $83 million in cash flow from operations, on average, over the past three years. Indeed, I believe that the market will begin to realize in some years that small to mid-sized telecoms make even better cash cow vehicles for unrelated acquisitions than most insurers do.
We have outlined a framework through which we might view telecom firms fundamentally, but we have not yet explicated how they should correctly be viewed financially. I would posit that levered smaller to midsized telecoms with highly stable cash flows, such as Alaska Telecom, should be viewed as pre-packaged LBOs with the equity market capitalization of the company correctly being viewed as a very cheap call option on the legal ability to use the company's cash flows to pay down debt and use the company's considerable cash generation to buy the company itself.
Happily however, in practice, banks love extending credit to utilities, telecoms, and other stable cash flow generating plays. So in practice, the total debt of a stable cash flow generating infrastructure play is usually only maintained or moderately paid down, and almost universally refinanced to some degree. Hence, I have the view that Alaska Communications is a pre-packaged LBO with its equity market capitalization representing an extremely cheap call option on the control of its considerable cash generation abilities.
Having outlined both a fundamental and a financial framework in which to analyze Alaska Communications, let's dive into the numbers. Alaska Communications has a $78 million market cap, and generated a little over $83 million in cash flow from operations, on average, over the past three years. Its EV/EBITDA ratio is 5.22. The equity market cap is a cheap option indeed on a company selling for less than 1X cash flow from operations!
Moreover, an acquirer would be in a position to enjoy a very nice strategic kicker. Earlier, we discussed how cutting capex at telecoms dampens longer term cash flow from operations. However, Alaska Communications has recently completed an upgrade to 4G which has driven substantial growth without the need for another upgrade cycle for a while. In my opinion, this auspicious timing creates the happy circumstance that allows capital expenditures to be reduced, while simultaneously allowing for growth in revenue, EBITDA, cash flow from operations, and Free Cash Flow. Moreover, the mix of business from Broadband and Wireless Broadband is sufficiently large, that (unlike at many smaller telecoms) increases in revenue from these segments are more than offsetting decreases in revenue from traditional voice lines, leading to top-line revenue growth and growth in cash flow, Free Cash Flow, and EBITDA.
Indeed, in the latest quarter, top line revenue growth increased by 5.9%, Wireless revenue increased by 21.2%, adjusted EBITDA increased by 17.9%, Free Cash Flow increased by 85% (largely on the strength of capex reductions), and $15 million of debt was repaid. Wireless broadband growth (internet/data on smartphones as one might expect) is driving the overall growth in Wireless. Broadband as a whole hit 50% of revenue in the quarter.
But what is the big picture? What created this massive bargain, and why is Alaska Communications so attractive to an acquirer? We may have the Surewest situation all over again. Most institutions and individuals buy utilities or telecoms for one reason only -- their dividend yield. When a company such as Surewest or Alaska Communications eliminates its dividend, the whole reason d'etre for most passive investors to hold the stock is eliminated. So they sell in a trickle, which becomes a stampede. And this panic selling creates a bargain that is so compelling that a strategic acquirer or financial buyer is enticed to make a bid for the company. One can buy for $1.64 per share what others sold at over $16.00 some years ago.
The company eliminated its dividend in order to accelerate its ability to pay down debt and to deleverage. However, I believe Alaska Communications might very well reinstate its dividend in the next 24 months if regulators approve a joint-venture whereby GCI and Alaska Communications would combine their wireless assets to form the Alaska Wireless Network. Chief among this joint venture agreement's provisions are a $100 million payment to Alaska Communications upon the closing of the deal, and preferred cash payments for the first four years of the joint venture.
If regulators approve, Alaska Communications would significantly deleverage its balance sheet and unlock substantial shareholder value. The main rational for the deal is to compete with the entrance of Verizon into the Alaskan market, but I believe the strongest rational for the deal is to eliminate duplicative cell towers and infrastructure between GCI and Alaska Communications while retaining market share. Regulatory approval of this deal would be a massive catalyst for increasing shareholder value, not only because of the $100 million payment upon closing, but also because management calculates that the cost synergies of the deal would eliminate $15 million per year in operating expenses and $15 million per year in capital expenses related to the wireless business.
But valuation and fundamentals alone in a vacuum are not enough to create buyouts. Time after time, I have seen value investors make two huge mistakes when they buy in anticipation of a buyout. And they do it at both extremes. They either buy a company such as Telefonica (TEF) which is (or was) almost too large to be acquired, both financially and regulatorily, or they buy a firm which is so tiny that there is not enough cash flow, or meat on the bone, for any acquirer with the means to buy to even care, since the acquisition would be too tiny to move the needle on overall performance.
I believe that Alaska Communications, like Surewest, is in the acquisition sweet spot. It's small enough to be acquired, yet large enough in terms of cash flows for an acquirer to care. Moreover, a larger acquirer with a lower cost of capital could make the acquisition immediately accretive, which is extremely enticing. For my part, I am pounding the table and putting my money where my mouth is.
For the average retail investor, this situation may be inappropriate, but for an institution with the wherewithal and staying power to demand strategic change, and acquire the company if need be, I believe that Alaska Communications is an excellent investment.
Disclosure: I am long ALSK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Long ALSK calls.
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