Significant Network Investments Should Drive Long-Term Growth At Hickory Tech

Investment thesis

• Hickory Tech (HTCO) only appears overvalued as significant network investments have temporarily depressed EBITDA.


• However, "standing still" is not an option given the erosion in traditional voice revenue for the telecom industry.


• The long term benefit in the form of higher revenue, margins and market share greatly exceeds the short term cost of lower free cash flow.

Company overview

HTCO provides voice, data and network communications services to business and residential customers in Minnesota, Iowa, North Dakota, South Dakota and Wisconsin. HTCO operates in the following three segments:

• The fiber and data segment serves wholesale, enterprise and commercial business customers with advanced data, internet, voice and VoIP services.


• The equipment segment provides equipment solutions and support for business customers including network plan, design and implementation.


• The telecom segment provides bundled residential and business services including high-speed internet, broadband services, digital TV as well as local voice and long distance.

In October 2013, Hickory Tech changed its name to Enventis to provide services under a unified brand name and will seek shareholder approval to change its corporate name to Enventis at its next shareholder meeting.

More than just the local phone company

HTCO has come a long way from its founding as a local phone company more than a hundred years ago. Organic growth (driven by significant network investments) and acquisitions provided increased diversification (e.g. by services offered, customer base, geography) and consistent revenue growth as shown in the charts below.

There are two factors that deserve a higher multiple. First, many of the services offered (e.g. fiber and data, broadband*, local voice, directory publishing) generate recurring, high margin revenue with multi-year contracts, which results in increased cash flow visibility and overall margin stability. Moreover, the broad service offerings provide the ability to generate incremental revenue growth from cross-selling and bundling.

Second, HTCO has effectively transitioned away from the "melting ice cube" of traditional voice service given that business and broadband services (comprised of fiber and data, equipment and broadband revenue from the telecom segment) now account for ~79% of total revenue. For example, in the mrq broadband revenue rose 8% driven by an increase in DSL and digital TV subscribers, which proves that the fear of cord cutting is much greater than the reality.

Expense control (e.g. three consecutive years of telecom segment operating cost reductions) and bundling (especially during periods of economic weakness) have offset weakness in the telecom segment, which experienced "only" a 1% revenue decline in the mrq compared to 9% last year. For example, management said on the 3Q13 conference call that 94% of bundled subscribers opted into two-year agreements, which reduced DSL and digital TV churn by 3% and 5.5%, respectively.

The steady cash flow provided the ability to buyback $1.275 million of stock in 1H13 and consistently raise the dividend with the most recent increase of 3% last month. Moreover, HTCO has paid a cash dividend for more than 65 years.

A hidden asset is the fiber to the tower initiative with its long term contracts that should benefit from increased capacity spending by carriers. HTCO increased the number of fiber served cell sites from 43 to 69 in the mrq and has contracts to build ~50 more over the next six months. The strong M&A activity (e.g. industry leader American Tower recently acquired assets of NII Holdings and Global Tower Partners) in this space highlights the value of these assets.

*The broadband category includes high-speed internet access, digital TV as well as business ethernet and data services.

The growth of business and broadband causes short term pain and long term gain

In 2009, HTCO began to devote a significant amount of resources to increasing its business and broadband services through internal growth and acquisitions.

The recently completed Greater Minnesota Broadband Collaborative Project was one of the single largest (and relatively low cost) investments. HTCO received a federal broadband stimulus grant, which funded 70% of the total $21 million cost. The acquisition of IdeaOne Telecom further expanded the fiber network.

HTCO is currently in the process of connecting directly to the customer (e.g. the "last mile") in targeted markets with attractive returns on investment. Moreover, service costs should be lower going forward due to the geographic focus.

The end result of years of elevated capex spending should be strong organic growth and market share gains driven by expanding service offerings and a larger potential customer base.

Valuation

There are two important factors that mitigate the higher valuation.

Lower debt. As shown in the chart above, the leverage ratio is ~0.7x turns lower than the peer group average. HTCO is even stronger financially after a recent refinancing and debt reduction of $6.3 million over the past 18 months. This provides a significant advantage given the continued industry-wide erosion of high margin voice revenue.

Lower capex spending. Investors should not grow impatient with the temporary lower EBITDA margin as it should rebound once capex spending eventually reaches a lower run rate and as SG&A expenses remain stable. Given the significant investments made since 2009, HTCO is much closer to the "end" than the beginning. For example, management projected 2013 capex spending to decline closer to the high end of the targeted range of 6-20%.

The focus should be on the long term benefits (e.g. higher revenue, margins, market share, reduced churn) rather than the short term cost in the form of lower free cash flow. Given the previously mentioned industry challenges, investors should actually be more worried about companies not investing in the future. Management said that only ~35% of the annual capex budget is dedicated to maintenance while the rest is dedicated to expansion.

Risks

Competition. There is intense and increasing industry competition, which has resulted in lower pricing power. The secular trend away from wireline (in favor of wireless) continues to drive lower traditional voice revenue.

Regulatory risk. New regulations (especially the National Broadband Plan and FCC order 11-161) resulted in lower network access revenue although this is offset to some extent by Connect America Fund support.

Rising programming costs. HTCO would be negatively affected if it is unable to pass on the rising cost of programming to video subscribers, especially as its small size provides little negotiating power.

Conclusion

HTCO should "grow into" a higher multiple as EBITDA increases due to growth initiatives and lower capex spending.

A stop loss should be placed below $13 or ~5% below the current price. The time frame is 12-24 months given the ongoing business transition is a longer term story. Investors may want to wait for a pullback given the ~10% gain in the past week.

Source: Significant Network Investments Should Drive Long-Term Growth At Hickory Tech

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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. (More...)

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