Quick Pitch: Consolidated Communications Holdings (CNSL)

Merger Arbitrage – Upside TBD

 

This idea was shared by Povilas.

This setup is an intriguing non-binding stage merger arb in the telecom space. CNSL shares have declined sharply this week due to industry concerns about potential environmental liabilities. However, I believe the sell-off may have been exaggerated, presenting a better entry point.

CNSL is a $384m market cap wireline and fiber telecommunications provider in the US. In mid-April, the company received a non-binding $4/share acquisition offer from a consortium led by its major shareholder, PE firm Searchlight Capital Partners. Searchlight holds a 34% stake and controls 2 out of 8 board seats. The proposal is currently being evaluated by the special committee. Recently, two minority shareholders of CNSL, Charles Frischer (owns 1%) and Wildcat Capital Management (3%), have publicly opposed the offer, claiming that it significantly undervalues the company and falls well below their intrinsic value estimates. It is not clear if the special committee will accept Searchlight’s offer or if there is potential for a price bump. However, the 23% spread to the current bid appears to provide a sufficient margin of safety while waiting for further developments.

Let’s address the key risk upfront. CNSL shares were trading with a minimal spread to the offer price for almost three months. The spread widened this week due to concerns about potential environmental remediation costs faced by US telecommunications providers, including CNSL. The catalyst for this sell-off was an article published by WSJ indicating that the existing network of copper cables encased in lead, built by telecom companies in the 1950-1960s, could release dangerous levels of lead into the environment. Last week, New Street Research released a report estimating the total industry-wide remediation costs at around $60bn, with CNSL’s share projected to be $544m. Upon New Street’s publication, shares of CNSL and its telecom peers plummeted.

I think the market’s reaction might have been exaggerated. AT&T, which is estimated to bear the majority of the potential costs at $34bn, has since countered the claims. AT&T highlighted that there is limited scientific evidence supporting the idea that lead-encased cables could pose a public health issue. the company also stated that the water sample testing information reported in the WSJ article differs significantly “from the expert testing commissioned by AT&T”. Following the rebuttal, share prices of telecom providers have already recovered close to pre-publication levels. AT&T is down only 4% (vs. 12% peak decline), FYBR is down 8% (vs. 33% peak decline), and LUMN is down 8% (vs. 22% peak decline). This compares to CNSL shares still being down 18% from the July 13 levels.

The potential remediation costs are still a risk and could require additional debt/equity financing from CNSL down the line. This could have an impact on the acquisition talks with Searchlight, which might be the reason why shares continue to trade at a wide spread. However, at this point, New Street’s estimates are only preliminary and highly uncertain. AT&T rebuttal makes sense and its shares have almost fully recovered. Even if CNSL eventually incurs remediation costs, these expenses are likely to be spread over an extended period of time, thereby not straining CNSL’s liquidity. Overall, I do not think this should have any impact on Searchlight’s decision.

Aside from this environmental risk, the likelihood of Searchlight walking away from the transaction appears to be minimal as the company has a pretty solid track record of acquisitions/investments in the communication space and has been involved with CNSL already for almost 3 years. Searchlight’s history with CNSL dates back to 2020 when the firm agreed to invest $425m into the company, in exchange for receiving a 35% ownership stake and a subordinated note. The financing allowed CNSL to fully fund its fiber network roll-out.

Searchlight is a large PE firm ($10bn in AUM) that has completed a number of transactions in the communications space, including Ziply (acquired in 2020), Mitel (acquired in 2018), GCI (debt investment performed in 2014) and Liberty Latin America (owns a 7% stake). The sample size of Searchlight’s public non-binding merger proposals is rather limited, however, in Feb’19 the PE firm made a non-binding offer for a controlling stake in Bezeq’s parent B Communications before proceeding to a definitive agreement several months later.

The activists, Charles Frischer and Wildcat Capital Management have raised concerns about Searchlight’s offer, considering it a highly opportunistic move amidst CNSL’s ongoing transformation from a wireline business to a higher-margin fiber broadband business. The current offer falls well below their share price targets:

  • Wildcat Capital has stated that CNSL’s value could be at least $14/share based on Apollo’s acquisition of LUMN’s assets in 20 states to create Brightspeed, which was completed in October 2022. The activists arrive at this target valuation by attributing the same value per fiber home passed as Brightspeed, while also giving credit to CNSL for lower build costs and its existing fiber spend in comparison to Brightspeed’s uninvested footprint.
  • Charles Frischer has hinted at a potential value for CNSL in the range of $30-$40/share in the next 3-4 years. He has proposed Searchlight to launch a partial tender offer at a price of $5+/share.

It is hard to assess if Searchlight will cave to activist pressure. The above-discussed environmental liabilities certainly do not help in this respect. Looking at historical precedents, Searchlight has previously opportunistically acquired Hemisphere Media Group at $7/share despite opposition from activists and competing bids at $8-$9/share. However, the offers for B Communications and Opus Group (Sweden-listed vehicle inspection and testing provider) have been raised. At B Communications, Searchlight initially proposed to pay $133m for the controlling stake in the company back in Feb’19 (described as the lowest bid received by the target) before eventually bumping it to $183m. At Opus Group, Searchlight launched a tender to acquire the controlling stake at SEK 7.75/share in Dec’19 only to up the bid to SEK 8.50/share several weeks later.

In terms of valuation, activists’ targets seem to partially/fully rely on CNSL management’s long-term business projections. Comparable industry transactions suggest there might be some headroom for an improved bid. The $4/share offer values CNSL at 7.1x 2023 adjusted EBITDA and at $2100 per fiber home passed. Here’s how this stacks up against industry transactions involving wireline/fiber providers:

  • Cable One’s acquisition of Hargray Communications – $2.2bn, 12.8x EBITDA in Feb’21.
  • Stonepeak’s acquisition of Astound Broadband – $8.1bn, 12.5x EBITDA in Aug’21.
  • Cable One’s merger with Mega Broadbands Investments – $1.3bn, 12.5x EBITDA in Sep’20.
  • Atlantic Broadband acquiring WideOpenWest’s Ohio assets – $1.1bn, 11.5x EBITDA in Sep’21.

Transactions involving exclusively fiber broadband providers have been performed at valuations above 20x EBITDA:

  • KKR and Oak Hill Capital’s investment in MetroNet – $3bn, 22x EBITDA in Apr’21.
  • EQT’s acquisition of Inexio – $1.1bn, 23x EBITDA in Sep’19.

CNSL’s publicly-listed peer FYBR ($3.7bn market cap) trades at 5.4x 2023E adjusted EBITDA and an equivalent $2100 per fiber home passed. While the valuation on per fiber home passed basis is identical, CNSL has boasted better fiber build economics than FYBR (i.e. lower build costs) and a more favorable competitive positioning (larger share of footprint located in monopolistic or duopolistic markets). This suggests CNSL should warrant a premium to FYBR, especially in a take-out scenario.

A bit of company background. CNSL provides telecommunication services in 22 US states. Since 2020, the company has been transitioning from copper wireline to fiber, with fiber coverage (as % of its footprint) expanding from 10% in 2002 to 38% in 2022. Management has guided for fiber coverage to reach 70% by 2026. The company expects revenues and EBITDA to inflect meaningfully from 2024 onward as the fiber roll-out continues to progress. CNSL’s management has previously set out to reach $1.5bn in revenue by 2026 on 45-50% EBITDA margins, implying $675m+ in 2026 EBITDA vs $320m guided for 2023. As detailed by the activist Wildcat, CNSL might also be eligible to between $200m-$450m in incremental subsidies as part of the current administration’s recently announced Broadband Equity, Access, and Deployment (BEAD) Program.

11 Comments

11 thoughts on “Quick Pitch: Consolidated Communications Holdings (CNSL)”

  1. Interesting idea, but why have margins collapsed in 2022 and 2023 for fiber companies and what will reverse that?

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    • Could you please specify? I see that operating/gross margins of the largest fiber/wireline providers (T, VZ, FYBR, LUMN) have generally been stable in 2022-2023. Meanwhile, CNSL’s operating/AEBITDA margins have been admittedly impacted by pressures from the declining legacy copper wireline business (offsetting the growth in fiber subscribers) and sales of non-strategic assets. The management expects this to reverse given the expanding fiber coverage given high incremental margins on new subscribers. There’s also the potential tailwind of the recently announced BEAD program. However, I am not sure how reasonable/achievable is the management’s long-term margin guidance target given that the number of total homes passed (including wireline and fiber passings) has recently been flat or declining.

      As for pure-play fiber broadband providers, I haven’t found any US publicly-listed comps to assess their margin dynamics, however, McKinsey report from Dec’22 (see below) suggests their EBITDA margins have stood between 40-50% which would be in line with the long-term guidance and CNSL (and also FYBR).

      https://www.mckinsey.com/industries/technology-media-and-telecommunications/our-insights/fiber-opportunity-four-deal-types-for-investors-to-consider

      I am far from an expert in the telecom space, so those more well-versed feel free to chime in.

      Reply
      • At a glance, EBITDA margins collapsed from nearly 40% in 2021 to mid 20’s in latest quarter.

        Similar pattern for the other fiber companies.

        The forward consensus seems to be, large capex investments, but no revenue growth and a slow recovery in EBITDA margins by 2027. It kind of looks like the fundamentals are deteriorating and growth has gone negative in Q1. This was trading at just over $2/share before they reported their atrocious Q1 results.

        So I am curious what these funds see in this, given the large amount of debt, especially compared to other fiber and telco players.

        This is my first impression after digging into this for 10-15 minutes. And caused me to lose interest, but I am curious to hear from anyone more knowledgable why I am wrong.

  2. Q2 update:
    “Proposal by Searchlight Capital Partners

    Discussions continue between the Special Committee of the Board of Directors and Searchlight Capital Partners regarding the non-binding proposal announced on April 13, 2023.”

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  3. Has anyone looked at the debt here?

    $1bn in Term Loans
    ~ $1bn in Senior Notes

    Does Searchlight have to refinance this debt (change of control) if they buy the company?
    They have a 6.2% avg cost of debt. It’s an attractive cost of debt….if they don’t *have to* refinance.

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  4. As expected, the market’s concerns related to environmental liabilities have proven to be exaggerated and the shares have now rebounded closer to the levels of Searchlight’s offer. I think that easy money on this trade has been made and the risk/reward is no longer as favorable as before. I’ve exited my position.

    Reply
  5. I decided to hold onto this one because I missed the window to sell around $4.00/share. This morning CNSL agreed to be acquired for $4.70/share by Searchlight and another PE firm. It is currently trading at $4.10. Any reason the spread is so large? I guess the market is worried the minority shareholders will try to block the deal. Is that a risk?

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    • The long timeline might have something to do with it:
      “The proposed transaction will result in Consolidated Communications becoming a private company and is expected to close by the first quarter of 2025, subject to customary closing conditions, including receipt of regulatory approvals and approval of the holders of a majority of the voting power represented by the outstanding shares that are entitled to vote thereon and held by shareholders other than Searchlight and BCI, their investment fund affiliates and the directors and officers of the Company. The transaction is not subject to a financing condition. Following the closing of the transaction, shares of Consolidated Communications common stock will no longer be traded or listed on any public securities exchange.”

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    • My thoughts on the revised offer for CNSL.

      14% spread is mostly due to the prolonged timeline as the merger is expected to close only in Q1’25. The time value of money accounts for half of the spread. There is also some uncertainty around minority shareholder and regulatory approvals. The downside to pre-non-binding merger announcement levels stands at 33%.

      The extended timeline is connected to the regulatory approvals as the parties will need to secure approvals from FCC, antitrust, CFIUS and the Californian State Public Utility Commission. These appear to be customary closing conditions, which I think pose limited risk to the transaction. Searchlight owns another fiber provider, Ziply, however, antitrust issues seem unlikely, given the limited horizontal overlap. Ziply focuses on the Northwest (Washington, Oregon, Idaho, and Montana), while CNSL operates primarily in the Northeast, South, and Midwest, with presence in the Northwest limited only to Washington.

      The transaction will also need to be approved by the majority of CNSL’s unaffiliated shareholders. There is a chance that activists Wildcat Capital (owns 3%) and Charles Frischer (1%), who have pushed-back on the previous $4/share offer, will come back again pushing for an even higher price. The $4.7/share proposal is far below the activists’ (seemingly very aggressive) price targets of $14-$30/share.

      But I think CNSL’s minority shareholder approval will eventually be received at the offered $4.7/share:
      – The offer also comes at a significant 70% premium to pre-announcement levels.
      – The transaction values CNSL at a 9.6x TTM EBITDA pro-forma for the sales of non-core assets. This compares to a 6.2x multiple for publicly listed similar-margin peer FYBR and 5x-9.4x LTM EBITDA multiples at which several other local telecoms were acquired over the last 7 years (see merger presentation). The takeover offer also values CNSL at $2500 per fiber home passed, compared to $2200 for FYBR. While CNSL warrants a premium to its peer due to lower build costs and better competitive positions in end-markets, the higher multiple at the offer price seems to reflect that already.
      – The value of the offer is not far from the 11-13x EV/EBITDA range where acquisitions of primarily higher-quality fiber providers (as opposed to wireline) were completed in 2020-2021. Meanwhile, CNSL still has a long way to go in its transition from legacy wireline to fiber – 1.5m copper passings currently vs 1.1m fiber passings.
      – As a standalone entity, CNSL might face issues funding its ongoing fiber buildout. CNSL’s management has guided for $495m in capital expenditures in 2023 alone compared to $351m in EBITDA and $203m in gross cash. Leverage is already maxed out as indicated by the debt covenant relief that the company entered into concurrently with the merger. As part of the amendment, the leverage ratio covenant has been increased from 6.35x (until Jun’25) to 7.75x (until Dec’24 before quarterly step-downs begin). The covenant ratio will revert to the initial levels by Aug’25 if the company has not received at least $300m in additional equity contributions.

      The risk of Searchlight walking away seems to be minimal given its long involvement with the company and a solid track record of investments and acquisitions in the communications space.

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  6. CNSL’s takeover by Searchlight has received pushback from one activist investor – something I mentioned as a possibility in my comment above.

    Wildcat Capital (owns 3%) sent a letter to the company, opposing the ongoing merger and demanding a higher price. While the offer price seems rather full based on relative valuation and TTM earnings, the activist argues that current EBITDA generation does not adequately reflect the company’s investments in fiber upgrades made over recent years, as there is a significant lag between initial CAPEX and meaningful earnings generation from the investments. Based on the activist’s estimate of $520m normalized EBITDA (70% higher than Q2’23 run-rate), Searchlight’s offer values CNSL at a 6x normalized EBITDA multiple, which is substantially below comparable industry transactions (10-15x). Wildcat Capital also argues that valuing CNSL in line with recent peer FYBR ABS transaction value ($3400 per fiber passing) would imply a price target of $10.7/share vs Searchlight’s offer of $4.7/share.

    This pushback somewhat increases the odds of wider opposition from shareholders and another price bump from Searchlight, although the market doesn’t seem very optimistic as CNSL’s share price has barely budged on the activist’s letter and the stock trades at 12% spread to the offer price.

    https://www.prnewswire.com/news-releases/wildcat-capital-management-sends-letter-to-consolidated-communications-board-of-directors-opposing-take-private-transaction-at-4-70-per-share-301977077.html

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  7. Charles Frischer (owns 1.2%), is voicing concerns over the takeover of CNSL by Searchlight and is pushing shareholders to vote against the deal. Full letter here: https://www.sec.gov/Archives/edgar/data/1402258/000147793223009058/cnsl_px14a6g.htm

    As for the specifics of the letter, Frischer has expressed concerns about how the entire negotiation with Searchlight was handled. This includes the granting of a rather significant $16 million breakup fee, as well as the fact that CNSL did not even solicit any other potential buyers during the negotiation process. Additionally, CNSL provided Searchlight with an enormous advantage, by not treating their transaction as a change of control concerning the CNSL debt.

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