UZF - United States Cellular's M&A And 5G Potential: Why It's Worth Holding

2023-11-07 15:52:39 ET

Summary

• UScellular is a key player in the telecommunications industry, with diverse services and a focus on 5G technology.
• The company has shown operational effectiveness despite a decrease in revenue, with a 35% rise in Adjusted OIBDA.
• A strategic review by TDS may signal potential M&A activity, influencing UScellular's valuation.
• Overall, USM's potential M&A event and valuable 5G assets negate the quantitative assessment, leading to a "hold" rating.

UScellular ( USM ) is a key player in the telecommunications industry, recognized for its diverse services, including specialized solutions for businesses and governments, device protection, and tower rent revenues. USM is making significant strides in 5G technology, notably by acquiring essential C-band spectrums necessary for improved connectivity and industry-wide innovation. Despite a decrease in revenue in some areas and a 30% drop in net income over nine months ending in Q3 2023, the company has shown operational effectiveness, highlighted by a 35% rise in Adjusted OIBDA in the three months up to September 30, 2023. However, my valuation model suggests an 18.4% downside for USM. Yet, I think qualitative factors like USM’s valuable 5G assets and the potential for a potentially lucrative M&A event, which typically adds a 20-30% premium, negate the solely quantitative assessment. Overall, I think a "hold" rating for USM balances both perspectives.

Business Overview

USM operates in the telecom sector, serving the communicative needs of consumers, local businesses, and government bodies. The company’s revenue streams extend beyond mere service plans to include device protection, fixed wireless home internet, prepaid plans, tower rent revenues, and specialized solutions for business and government sectors. A key facet of UScellular’s strategy is its aggressive push towards 5G technology deployment, meeting the growing consumer demand for high-speed data services. The shift towards the mid-band spectrum in 2023, from the initial low-band spectrum, is aimed at augmenting speed and capacity for both mobility and fixed wireless services.

Additionally, it's worth noting the continuous network enhancement, especially the 5G deployment, signals a commitment to staying competitive in the telecom space. The C-band frequencies that USM and other telecommunications companies bought in the FCC’s 2021 auction are nestled within the mid-band spectrum (1 GHz to 6 GHz). These frequencies are prized in 5G deployment for their equilibrium between capacity and coverage. They deliver faster data speeds and lower latency than lower bands, with superior coverage compared to higher bands. While 5G is compatible with a spectrum range including low-band (below 1 GHz) and high-band (above 24 GHz), the C-band emerges as a sweet spot for 5G. This facilitates amplified IoT capabilities, along with other applications like Enhanced Mobile Broadband, Ultra-Reliable Low Latency Communications, Fixed Wireless Access, and Augmented Reality, by ensuring rapid speeds, minimal latency, and the capacity to connect multiple devices concurrently. The synergy between 5G and these applications, especially IoT, catalyzes real-time data transmission and efficient management of extensive device networks, propelling innovation across varied industries.

Moreover, one of USM’s key assets is its recently acquired spectrums, ideal for future 5G services in the US. UScellular has launched its 5G mid-band network, utilizing the 3.45 GHz spectrum obtained from the FCC’s 2021 auction, representing approximately 4.47% of the US’s C-Band. Initially, this network was accessible in parts of Illinois, Iowa, and Wisconsin, expanding to select communities in seven other states. The aim is to extend this 5G service to over 1 million households within its operational regions by the end of 2023. The company, having invested significantly in spectrum auctions, sees the mid-band as crucial for delivering extensive coverage, lower latency, and high speeds, aligning with its goal to serve 100,000 High-Speed Internet customers by this summer. Thus, when considering USM, it’s key to consider its wireless interests, including the FCC auctions.

TDS and UScellular's Forward Look

The Q3’23 quarterly report reveals a concerning revenue decline across key segments such as retail service, inbound roaming, and equipment sales, with inbound roaming declining by 55% over nine months. This decline is reflected in the 7% decrease in total operating revenues over the nine months. However, on a positive note, UScellular has effectively managed its operating expenses, reducing them by 8% over the nine-month period, which contributed to an increase in operating income, particularly notable in the three-month period where it moved from a loss to a gain. Despite this, net income over nine months saw a 30% decrease. For the three months ended September 30, 2023, USM's Adjusted OIBDA increased by 35% to $220 million, up from $163 million in the same period in 2022. Over nine months, Adjusted OIBDA slightly decreased by 1% to $624 million in 2023 from $627 million in 2022. Similarly, Adjusted EBITDA for the same three-month period grew by 28%, from $205 million in 2022 to $263 million in 2023. For the nine months, Adjusted EBITDA remained relatively stable, with a small change from $754 million in 2022 to $753 million in 2023. The metrics of Adjusted OIBDA and Adjusted EBITDA show a steady performance over the nine months, which could indicate effective operational management amidst revenue challenges.

The main decline in revenue appears in the service segment, which may reflect challenges in the company's core business operations. For the three months ended September 30, 2023, service revenues were $762 million, a decrease of 2% from $781 million in the same period in 2022. Over the nine months, service revenues declined by 3%, from $2,351 million in 2022 to $2,289 million in 2023.

On August 4, 2023, a strategic review was initiated by Telephone and Data Systems, Inc. ( TDS ) and UScellular to explore potential alternatives for UScellular, aiming to align with shareholder interests. This review is supported by TDS Chairman Walter C.D. Carlson and UScellular CEO Laurent Therivel to evaluate various strategic options while continuing with the current operational plans. Unlike many other strategic evaluations, this review does not have a set timeline, theoretically prioritizing a thorough exploration over quick decisions. This is important for USM because TDS, which holds an 83% stake in UScellular, has brought on Citi as a financial advisor and has retained legal counsel. In parallel, UScellular's board has authorized independent directors to engage their advisors. As of June 30, 2023, TDS is a Fortune 1000 company, employing over 9,100 individuals and offering various telecom services through subsidiaries like UScellular, which serves a large customer base across 21 states. So, the future of both companies is intrinsically tied. Still, although the review's outcomes are not guaranteed, it demonstrates a proactive effort to redefine UScellular's strategic direction and potentially unlock untapped shareholder value.

Quantitative and Qualitative Valuation Analysis

The wireless telecommunications sector, where USM is situated, is poised for significant growth in the upcoming years. A look at the long-term CAGR forecasts from trusted sources paints a favorable picture for expansion. The US telecom market, a part of the global telecommunications landscape, is expected to grow at a CAGR of 3.67% from 2023 to 2028, increasing from $427.43 billion to $511.83 billion. Meanwhile, a wider view from the global wireless telecommunications services market predicts a stronger CAGR of 7.35% from 2020 to 2030, pushing the market value to around $1284.46 billion by 2030. Taking both perspectives into account, an average CAGR of about 5.51% seems reasonable for USM's long-term outlook. This figure blends the modest growth estimate for the US market with the more aggressive global market growth forecast. By aligning its strategies with both domestic and international market trends and innovating alongside technological advancements, especially capitalizing on 5G spectrum frequencies, USM is in a strong position to achieve this average long-term CAGR potentially. This approach ensures a balanced, sustainable growth strategy that taps into the potential of the telecommunications industry.

My USM valuation model incorporates analyst consensus on revenue projections, anchoring it to market expectations. I forecast a realignment of USM's revenue growth over time to the industry's average CAGR of 5.51% I estimated previously. I used as the model's inputs TTM margins for EBIT, and D&A expresses confidence in USM's steady operational efficiency, although it flags potential impacts from economic shifts. I also expect Net CAPEX to stay at roughly 13.1% of revenues, indicating a stable investment in growth-critical capital assets and consistent with its historical average since 2013. I also note an inverse trend between NOWC and revenue growth, with a historical 37.7% decline, which increases USM's FCFF and, by extension, its valuation. Lastly, I used the TTM effective tax rate of 41.2%, and for the rest of the forecast, the standard 21%. Moreover, USM's BB+ credit rating from Fitch Ratings as of March 30, 2023, suggested in its report ongoing financial stability for the foreseeable future. The corresponding bond yield is 7.4% , which I used as USM's cost of debt.

Overall, my valuation results suggest an 18.4% potential decline for USM. However, this assessment may not fully account for the company's intrinsic value, particularly when considering USM's strategic 5G assets. These assets are a considerable competitive edge within the telecom sector. Despite the conventional concerns over USM's high debt load, current bond yields are closely aligned with the CAPM rate, hovering around 7.4% , which mirrors USM's CAPM rate of 7.3%. This near-parallel suggests that the debt may not have a beneficial effect on the company's WACC, basically negating one of its main valuation advantages.

Adding a qualitative lens, the potential for M&A further informs my valuation. Historically, control premiums in M&A scenarios typically range from 20% to 30%. In some cases, they can command up to 50% above the market price, indicating that USM could command a substantial premium in such a deal. This prospective M&A activity, coupled with USM's ownership of approximately 4.47% of the optimal 5G spectrum in the U.S., bolsters the case for a higher price that essentially compensates my numbers-based valuation. Hence, I think it’s reasonable to give USM a "hold" rating.

Consequently, while the DCF model is a fundamental quantitative tool, it does not stand alone in the valuation process. The strategic importance of USM's 5G assets and the tangible prospect of an M&A event suggest a more comprehensive valuation approach, integrating quantitative and qualitative considerations. In this case, USM might have some potential control premium in M&A, which acquirers could pay over the current market price to gain control, and such premium usually falls within the range of 20% to 30%. However, it can vary significantly depending on the specifics of the deal and the perceived value of control. Thus, as a whole, I rate USM a "hold" position, advising close monitoring for any significant news, particularly on the M&A front, that could pivot the company's valuation markedly.

Conclusion

In my view, UScellular’s current state, characterized by its diversified services and aggressive 5G advancement despite a recent downturn in net income, coupled with its operational efficiency seen in the rise of Adjusted OIBDA, supports a cautious yet optimistic “hold” rating. My valuation model’s indication of an 18.4% potential downside is mitigated by the qualitative value of USM's 5G spectrum assets and the M&A potential, which historically adds a significant premium to a company's valuation. The telecom sector's projected growth, along with USM's strategic initiatives, including TDS's exploration of strategic alternatives, further bolsters the neutral outlook. The balance of these quantitative and qualitative aspects, particularly the potential for a control premium in an M&A deal, suggests that USM's intrinsic value might be higher than the numbers perspective reflects.

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