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Bonhoeffer Capital Management, an investment management firm, published its first quarter 2021 investor letter – a copy of which can be downloaded here. A net return of 13.8% was recorded by the fund for the Q1 of 2021, compared to 4.2% and 8.1% returns of the MSCI World ex-US and the DFA International Small Cap Value Fund, respectively for the same period. You can view the fund’s top 5 holdings to have a peek at their top bets for 2021.
Bonhoeffer Capital Management, in its Q1 2021 investor letter, mentioned Consolidated Communications Holdings, Inc. (NASDAQ: CNSL), and shared their insights on the company. Consolidated Communications Holdings, Inc. is a Mattoon, Illinois-based broadband and business communications provider that currently has a $653.8 million market capitalization. Since the beginning of the year, CNSL delivered a 66.67% return, while its 12-month gains are up by 43.99%. As of May 06, 2021, the stock closed at $8.07 per share.
Here is what Bonhoeffer Capital Management has to say about Consolidated Communications Holdings, Inc. in its Q1 2021 investor letter:
"Consolidated Communications (CNSL) provides local telecommunications services to consumers, businesses, and other telecommunications firms in the United States. CNSL provides legacy voice and data services and some fiber-based services to firms and individuals. Currently, CNSL has 780,000 voice subscribers, 76,000 video cable subscribers, and 792,000 data subscribers. In addition, CNSL’s network includes 46,000 fiber miles and has 20,900 on-net buildings.
CNSL is a rollup of local exchange carriers (LECs), some of which have rolled out fiber to their customers. CNSL acquired N. Pittsburgh Telephone (PA) in 2007, SureWest (CA and MO) in 2012, Eventis (MN, IA, WI, ND, and SD) in 2014, and FairPoint (ME, NH, MA, and VT) in 2017. As a result of these acquisitions and paying a high dividend, CNSL accumulated a large amount of debt. The firm is in the first year of a five-year fiber rollout where 1.6 million additional homes will be passed with high-speed internet (HSI) primarily in the Northern New England footprint. Currently, CNSL passed 400,000 homes with highspeed internet. Historically, the HSI penetration rates where fiber has been laid have varied from the high-30% to mid-40% range. In Northern New England (CNSL’s largest service area), most of the connections between and within communities are completed. The remaining connections/equipment are to connect individual residential and commercial customers to the network.
The company’s value proposition is to provide broadband services in suburban and rural markets. This service is provided for $45 to $75 per month depending upon speed. In most markets, CNSL has one competitor (81%) and in about 11% of the markets CNSL is the only provider. In the remainder of the markets, CNSL has two competitors.
CNSL’s last purchase was its largest, FairPoint. FairPoint’s main asset is legacy LEC lines acquired from Verizon Communications in Northern New England. FairPoint’s network was complete, but connections to end users required more network investment. Going into 2020, CNSL had two choices: (1) continue to slowly roll out its fiber to customers, or (2) find external financing to more quickly roll out its fiber to customers. CNSL chose the latter. After a search process, CNSL partnered with Searchlight Capital. Searchlight received 35% of CNSL’s equity and $396 million of preferred stock in return for $425 million of cash to accelerate the fiber rollout. Searchlight will also get a board seat. Searchlight has experience in larger fiber rollouts with some of its current investments.
Other larger incumbent LEC players (like Frontier Communications) are using the slow rollout approach as they are debt constrained. This approach results in continued revenue declines and a much more difficult task of converting existing broadband customers to their service. The CNSL thesis is a bet on a fully funded, quicker network rollout to reinvigorate CNSL’s organic growth. Other changes include hiring the former head of Google Fiber’s southeast region to lead the Northern New England rollout. Google Fiber has great customer service, as evidenced by the highest net promoter score (NPS) in an industry with poor NPSs overall. Management’s incentives have also changed in 2021 to include the fiber rollout metrics and other operational metrics like NPSs, in addition to revenue and operating profit growth.
Consolidation and Fiber-optic Rollout
The US rural and suburban telecommunications services market is a local, fragmented market. Consolidation has occurred over the past ten years amongst these local players and the next generation of technology (fiber-optic connections) is being rolled out. Fiber-optic rollouts are generating organic growth and economies of scale with high incremental user profitability. Consolidation can create economies of scale depending upon the geography of the acquired telecommunications firm. There is also the possibility of vertical integration across telecommunications services (like voice, data, cable, and hosting) in a given geography. With these rollouts, telecommunications companies compete with the local cable companies and, in some cases, wireless providers to provide HSI and other services to customers in their local footprints.
Historically, telecommunications and cable firms have had poor customer service, as evidenced by low NPSs. Keith Rabois, a founder of PayPal, has tweeted, “Formula for startup success: Find large highly fragmented industry w low NPS; vertically integrate a solution to simplify value product.” Part of simplifying the solution is providing multiple services and good customer service. The telecommunication services market fits this description. The new fiber rollouts are analogous to organic startups, and thus can also be successful in the vertical integration into these markets.
Business and Service Analysis
One way to look at telecom business is to divide it into growing and declining segments. Generally, data services are growing while voice, video, direct subsidies, and network access revenue are flat to declining. If you look at CNSL’s core data revenue, from both businesses and consumers (which is the growing part of the business), it represents 58% of revenue and grew by about 2.5% in 2020. The remaining segments are declining. As a benchmark versus other rural LECs (RLECs), Nuvera Communications (NUVR) has about 50% of its core revenue increasing while LICT Corporation has 84%.
If we project CNSL’s segments out to 2031, the revenue decline rate will decline from -4.4% in 2022 to no growth in 2031. See Exhibit B. This is the situation with no accelerated fiber rollout. If we overlay the fiber rollout revenues on top of these numbers, then we see the advantage of rollout acceleration with increases in revenues. The rollout penetration assumptions are based upon management’s experience with broadband penetration given the local competitive environment (none, one, or two competitors). The timing of the rollout is based upon management’s fully funded rollout plan. Revenues on a composite basis start increasing in 2023 and grow going forward (from 1.3% to 6.3%). The portion of total revenue in growing segments will increase to 76% in 2031, versus 58% currently. Given the large, fixed costs in telecommunications services, increasing revenue leads to increasing margins. See Exhibit A for details.
If we look at unit economics of the fiber rollout, it is also quite favorable. The estimated cost to pass each new customer is about $500; and the cost to connect a customer is $400. If you have a final penetration rate of 40% using the current HSI monthly charge of $56/month, and a steady-state EBITDA margin of 50% (which management believes are achievable at scale; the current margin is 40% and a smaller RLEC comp LICT has a 45% margin), then the payback time is between six and seven years, and the unlevered IRR is 16%. See Exhibit A for details.
Local Telecom Market
The local telecom business in the US is a fragmented market on a national basis. The market is a local market, so many smaller markets only have a few competitors. For CNSL, most of their markets have one competitor (81%), no competitors (11%), or two competitors (8%). This leads to less price competition for CNSL than in more urban LECs where there are more competitors.
Since most of CNSL’s competition is from cable companies (that have low NPSs), CNSL has an opportunity to provide improved customer service versus the cable companies. This highlights the importance of hiring the manager from Google (who has the best NPSs in the cable business), the expertise of Searchlight in large-scale fiber rollouts, and including NPSs in management’s incentive compensation.
Of the other publicly traded smaller LECs, CNSL has the largest potential to increase organic revenues (by 30%) via a fiber rollout in its incumbent territories. This can be seen in the projections based upon the currently planned and financed fiber rollout shown in Exhibit B. As the rollout is completed, CNSL will have amongst the highest portion of segments with growing revenue when compared with other smaller LECs (LICT and NUVR).
The Searchlight transactions allowed CNSL to extend the maturity of its debt to 2027 and lower its debt interest rate to 5.2%. CNSL has a decent amount of net debt and preferred stock at 4.3x EBITDA. The EBITDA coverage ratio is high at 4.0x which is projected to increase to over 5x by 2025 as EBITDA increases with the fiber rollout. This would imply a debt rating of between B and BB based upon these coverage and leverage ratios per the Strong Horse method described in “How to Make Money with Junk Bonds”.
CNSL is in a defensive business—telecommunications services—which has a large amount of recurring revenue. Data revenues are increasing, while the legacy services are declining in volume. The crossover point to increasing revenues for CNSL will be 2023. See below for projections and Exhibit B for more detailed projections.
Management and Incentives
In 2020, the CEO’s management compensation was 20% base salary and 80% incentive based, of which 75% is equity based (CNSL shares) and 25% is cash based. The 2020 bonus compensation was 50% based upon an EBITDA target, 20% on net leverage, 20% on revenue growth, and 10% based upon qualitative targets. The 2020 equity-based compensation was 50% time-vested shares and 50% performance-based vesting. The performance-based vesting is based upon under or overperformance of CNSL versus an index of comparable firms. The 2020 equity-based shares were issued at $7.08 per share, and the 2019 shares were issued at $10.90 per share.
In 2021, the bonus will be based upon metrics focused on the fiber rollout including: FTTP penetration rates, FTTP passings for installs, adjusted EBITDA, revenue, and other operating metrics like NPS. The shares were granted in March 2021 and had an issue price of $6.31 per share. These incentives have a focus on rapid fiber network rollout in addition to revenue and EBITDA growth.
Overall, 1.1 million shares were granted in 2020 (about 1.0% of shares outstanding per year). The management team owns 1.6% of CNSL common stock. CNSL has stock ownership guidelines of 5x the salary for the CEO and 3x for other senior managers.
The valuation of CNSL is an interesting exercise because of the fact that its expected growth rate is accelerated by the fiber rollout described above. The implied growth using the Graham Formula adjusted to today’s interest rates ((8.5 + 2g)*(4.4/AAA bond rate)) and the current P/E is -1.6%, clearly implying the market expects that CNSL’s cash flows to continue to decline. Some benchmarks for growth are the projected sales growth rates of 4% per year (based upon the fiber rollout), EBITDA growth rate of 6% per year, and adjusted earnings growth of 19%.
The question is whether this growth rate is sustainable over the next seven years. Given the key penetration, margin, investment, and timing assumptions in the projection model, I believe it is. CNSL is the only US publicly traded telecom firm that has a rollout of this magnitude (adding 30% to revenue) scheduled over the next five to seven years. Two firms that have similar projected earnings growth to CNSL are Cincinnati Bell and Intred. Cincinnati Bell trades at a multiple of 34x, and Intred trades at a multiple of 24x. So a conservative 20x multiple on $0.86 EPS yields a value of $17 per share, which I believe is a reasonable 12-month target. If, over the five to seven years, a 19% EPS growth is attained, then the earnings will be $2.80. Applying a 23.8x multiple to these earnings (implying a 4% growth rate over the subsequent seven years) means a value of $67 per share is obtained.
Another way to look at valuation is on an enterprise basis. If we value CNSL on a forward EBITDA basis of 9x EBITDA (the current multiple of cable overbuilder WOW!), then the resulting value range is $52 per share. If we consider both benchmarks, then a $55 price target is not unreasonable. See Exhibit B for details. This results in a seven-year IRR of about 35%.
Given the fiber rollout and the size of CNSL, the comparable firms include US and Italian small-cap telecommunications firms. The following are the comparable firms in the US telecommunications and Italian telecommunications markets. The smaller Italian telecom firms have smaller floats than the US firms and are majority controlled (70%+) by the original owners.
There have been some private equity acquisitions in the US RLEC space, namely Cincinnati Bell and Alaska Communications. These firms have a similar dynamic associated with their respective fiber rollouts, and private equity firms have invested in these firms for similar reasons that make CNSL attractive. Cincinnati Bell has been purchased by the private equity firm Macquarie Infrastructure Partners, which outbid an original offer from Brookfield Asset Management. Alaska Communications is also in the process of being purchased by ATN International and Freedom 3 Capital. The EV/EBITDA paid by these buyers was 6.5 to 6.9x EBITDA for assets with lower margins than the current price of CNSL (5.8x EBITDA).
In comparison to other US and Italian firms, CNSL has below-average, but good, ROEs and a high EBITDA margin. CNSL’s fixed asset turns lag the other US and Italian firms. With CNSL’s fiber rollout and customer take-up, the fixed asset turns and ROEs should increase closer to the other US and Italian firms. With these favorable operational metrics, CNSL has one of the lowest current and 2016 P/E ratios of either group.
The primary risks to achieving a target valuation of $55 per share for CNSL include:
• a lower-than-expected broadband penetration of fiber rollout communities; and • a quicker-than-expected decline in the legacy telecom lines.
The primary upsides/catalysts include:
• faster-than-expected penetration of uptake of broadband services; • operational leverage due to economies of scale; and • re-rating to reflect higher growth.
The short-term target is $17, which is more than double today’s price. I think the investment thesis can play out over the next three to five years. By that time, CNSL’s net income and earnings should have appreciated by more than two times, and the fair multiple could double with a 4% increased growth rate. If that is the case, then CNSL will attain an 8.0x return to $55 over five years. This is similar to a “Davis double,” where both underlying earnings increase along with the fair value multiple."
Our calculations show that Consolidated Communications Holdings, Inc. (NASDAQ: CNSL) does not belong in our list of the 30 Most Popular Stocks Among Hedge Funds. As of the end of the fourth quarter of 2020, Consolidated Communications Holdings, Inc. was in 13 hedge fund portfolios, compared to 15 funds in the third quarter. CNSL delivered a 38.16% return in the past 3 months.
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Disclosure: None. This article is originally published at Insider Monkey.