Business Context and Reporting Period
Telephone and Data Systems, Inc. (TDS) filed this unaudited Form 10-Q for the three and six months ended June 30, 2017, compared with the same periods in 2016. TDS is a diversified U.S. telecommunications company serving approximately 6 million connections through 83%-owned U.S. Cellular and wholly owned TDS Telecom, which includes Wireline, Cable and Hosted and Managed Services (HMS).
Financial Performance and Key Metrics
| Metric | Three months ended June 30, 2017 | Change | Six months ended June 30, 2017 | Change |
|---|---|---|---|---|
| Operating revenues | $1,247 million | Down 4% | $2,485 million | Down 3% |
| Operating income | $28 million | Down 47% | $110 million | Up 38% |
| Net income | $12 million | Down 62% | $55 million | Up 31% |
| Net income attributable to TDS shareholders | $10 million | Down 63% | $47 million | Up 32% |
| Diluted EPS | $0.09 | From $0.25 | $0.42 | From $0.32 |
| Adjusted EBITDA | $280 million | Down 6% | $597 million | Up 3% |
| Capital expenditures | $134 million | Down 5% | $230 million | Down 14% |
Operating margin was approximately 2.2% for the second quarter and 4.4% for the first six months, compared with approximately 4.1% and 3.2%, respectively, in the prior-year periods. The quarterly decline reflected lower U.S. Cellular operating income; the year-to-date improvement reflected cost savings and lower equipment losses.
- U.S. Cellular: Second-quarter revenue was $963 million, down 3%; six-month revenue was $1.899 billion, down 3%. Second-quarter operating income fell to $5 million from $30 million, while six-month operating income increased to $59 million from $41 million. Retail service revenue declined 5% in the quarter and 4% year to date because of industry-wide price competition.
- Wireless operating trends: U.S. Cellular had 4.478 million postpaid connections at June 30, 2017, down from 4.490 million a year earlier, and 4.962 million total retail connections, up from 4.903 million. Year-to-date postpaid net additions were a loss of 4,000 versus additions of 81,000 in 2016. Postpaid churn improved to 1.21% from 1.24%.
- TDS Telecom: Revenue was $281 million in the quarter, down 6%, and $580 million year to date, essentially flat. Operating income increased to $25 million in the quarter and $53 million year to date. Wireline and Cable growth was offset by a substantial decline in HMS hardware and product sales.
- Segment detail: Wireline revenue increased 3% in both periods and six-month operating income rose 28%. Cable revenue increased 12% in the quarter and 11% year to date. HMS revenue declined 37% in the quarter and 15% year to date, producing operating losses of $7 million and $9 million, respectively.
Cash Flow, Balance Sheet, Debt and Liquidity
- Six-month cash flow from operations was $358 million, down from $400 million. Free cash flow, a non-GAAP measure defined as operating cash flow less property, plant and equipment additions, was $116 million versus $119 million.
- Cash and cash equivalents were $791 million at June 30, 2017, compared with $900 million at December 31, 2016. Investing cash outflows were $424 million, including $242 million of capital expenditures and $200 million for acquisitions and licenses.
- Total debt was approximately $2.44 billion, consisting of $12 million of current debt and $2.428 billion of long-term debt. Interest expense was $43 million in the quarter and $85 million year to date.
- Unused revolving credit capacity was $399 million for TDS and $298 million for U.S. Cellular. Neither entity had borrowings outstanding under its revolving facilities at June 30, 2017, and management stated that financial covenants were satisfied.
- TDS expects negative free cash flow for full-year 2017 despite its current liquidity position. The company’s credit rating has been sub-investment grade since 2014.
- Management expects 2017 capital expenditures of approximately $500 million at U.S. Cellular and $225 million at TDS Telecom, or approximately $725 million in total. TDS Telecom capital spending is expected to increase as A-CAM broadband construction progresses.
Material Changes, Outlook and Unusual Items
- U.S. Cellular won 188 licenses in the FCC’s 600 MHz Auction 1002 for $329 million, paid the remaining $186 million during the second quarter and received the licenses. Licenses increased by $340 million during the first six months.
- U.S. Cellular recognized $19 million of gains from license exchanges during the first six months, including a $17 million gain in the first quarter. These gains benefited year-to-date results.
- U.S. Cellular commercially deployed VoLTE in one key market during the quarter and expects additional market launches in early 2018.
- TDS is exploring a potential securitized borrowing using equipment installment plan receivables, potentially later in 2017. Net equipment installment plan receivables increased to $602 million from $525 million at year-end, while the allowance for credit losses increased to $57 million from $50 million.
- Effective January 1, 2017, equipment installment plan interest income was reclassified from interest and dividend income to service revenue. Prior periods were recast; the change did not affect pretax income, net income or earnings per share.
- The company expects to adopt the new revenue recognition standard on January 1, 2018, using the modified retrospective method. Management expects contract assets, contract liabilities and deferred contract-cost balances, with the ultimate financial impact still under evaluation.
- Federal USF support remains subject to a potential phase-down following the FCC’s MF2 process. TDS expects legacy support to continue at current levels during 2017 but cannot predict the timing or outcome of the auction or future support levels.
Risks and Contingencies
Key disclosed risks include intense wireless and broadband competition, declining pricing and roaming revenue, customer churn, equipment installment-plan credit losses and cash-flow demands, spectrum and network investment requirements, sub-investment-grade credit ratings, dependence on regulatory support and distributions from unconsolidated entities, potential impairment of goodwill and other intangible assets, cybersecurity incidents, technology changes, financing availability, and litigation or regulatory changes. Management noted limited excess fair value over carrying value for certain reporting units, which could increase future impairment risk if market conditions or forecasted cash flows deteriorate.
Investor Verification Checklist
- Verify the sustainability of U.S. Cellular’s postpaid customer base, pricing, churn and retail service revenue trends.
- Assess whether cost reductions and lower equipment losses can offset continuing wireless price competition.
- Monitor HMS revenue and profitability recovery, particularly recurring service revenue versus lower-margin hardware sales.
- Confirm the timing, cost and returns from the 600 MHz spectrum deployment and VoLTE build-out.
- Evaluate liquidity under the company’s expected negative 2017 free cash flow, including capital expenditures, dividends and debt service.
- Track equipment installment-plan receivables, bad-debt expense, allowance coverage and any securitization financing.
- Review the potential effects of FCC USF reform and the 2018 revenue recognition adoption.
- Reconcile non-GAAP Adjusted EBITDA and free cash flow to GAAP results before relying on those measures.