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.