Telephone and Data Systems, Inc. — 2016 Q2 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016, compared with the corresponding 2015 periods. TDS is a diversified U.S. telecommunications company operating 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 | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Operating revenues | $1,283 million | $1,276 million | $2,526 million | $2,528 million |
| Operating income | $41 million | $32 million | $57 million | $315 million |
| Income before taxes | $50 million | $44 million | $73 million | $336 million |
| Net income | $32 million | $26 million | $42 million | $202 million |
| Net income attributable to TDS shareholders | $28 million | $23 million | $36 million | $169 million |
| Diluted EPS | $0.25 | $0.21 | $0.32 | $1.53 |
| Cash flow from operating activities | Source text does not provide a quarterly GAAP value | Source text does not provide a quarterly GAAP value | $400 million | $538 million |
| Capital expenditures | $142 million | $189 million | $267 million | $293 million |
Q2 operating margin was approximately 3.2%, compared with 2.5% in Q2 2015. Six-month operating margin was approximately 2.3%, compared with 12.5% in the prior-year period. Six-month net margin attributable to TDS shareholders was approximately 1.4%, compared with 6.7% in 2015.
- Six-month free cash flow, defined by TDS as operating cash flow less property, plant and equipment additions, was $119 million, compared with $179 million in 2015. Adjusted free cash flow was $123 million versus $202 million.
- Cash and cash equivalents were $899 million at June 30, 2016, down from $985 million at December 31, 2015.
- Total debt was approximately $2.45 billion, consisting of $14 million of current debt and $2.436 billion of long-term debt. Debt fair value was approximately $2.552 billion excluding current debt and capital lease obligations.
- TDS and U.S. Cellular had no borrowings under their revolving facilities, other than letters of credit. Available capacity was $399 million for TDS and $283 million for U.S. Cellular.
- Six-month interest expense increased to $85 million from $68 million, primarily because of U.S. Cellular debt issued in late 2015 and its senior term loan borrowing.
- Six-month adjusted EBITDA was $583 million, compared with $580 million in 2015. Adjusted EBITDA is a non-GAAP measure.
Segment developments
- U.S. Cellular: Q2 revenue was $980 million, essentially flat year over year; six-month revenue was $1.938 billion, also flat. Q2 operating income increased to $18 million from $8 million, while six-month operating income fell to $17 million from $259 million because 2015 included substantial tower and license-related gains. Retail service revenue declined 8% in both periods, partly offset by equipment sales growth of 44% in Q2 and 45% year to date.
- U.S. Cellular had approximately 5.0 million connections at period end, including 4.5 million postpaid connections. Year-to-date postpaid net additions increased to 81,000 from 26,000, and postpaid churn declined to 1.24% from 1.41%. Smartphone penetration reached 77%, compared with 69% a year earlier.
- Postpaid ARPU declined to $47.37 in Q2 from $53.62, while postpaid ABPU, a non-GAAP measure including equipment installment billings, declined to $56.09 from $58.06. Equipment installment plan connections represented 37% of postpaid connections, compared with 20% a year earlier.
- TDS Telecom: Q2 revenue increased 2% to $300 million and six-month revenue increased 1% to $581 million. Six-month operating income declined 12% to $41 million, with adjusted EBITDA down 2% to $156 million.
- Wireline: Six-month revenue declined 1% to $348 million and operating income declined 9% to $45 million. IPTV connections grew nearly 50%, but voice connections declined 4%.
- Cable: Six-month revenue increased 2% to $90 million, but operating income declined 90% to $1 million as service costs increased. Cable connections grew 5% year over year.
- HMS: Six-month revenue increased 6% to $144 million, and adjusted EBITDA increased to $11 million from $5 million. HMS remained at an operating loss of $4 million, improved from an $8 million loss.
Material changes and unusual items
- The sharp six-month earnings decline was principally due to the reduction in gains from sales and exchanges of businesses and licenses: $252 million in 2015 versus $9 million in 2016.
- U.S. Cellular recorded a $9 million gain on the first closing of a spectrum exchange and received $13 million in cash. Additional spectrum transactions were expected to close in the second half of 2016 and could generate additional gains.
- U.S. Cellular paid a $143 million FCC deposit for participation in the 600 MHz Auction 1002. Additional payments could be substantial if it wins licenses; some or all of the deposit could be refunded if it does not win qualifying licenses.
- Six-month operating cash flow was reduced by a $94 million increase in equipment installment plan receivables. Management expected these receivables to continue consuming working capital in the near term.
- TDS recorded a $4 million out-of-period reduction in Wireline depreciation expense related to prior-period over-depreciation. Management determined the adjustment was not material to prior or current periods.
- No material changes to previously disclosed legal proceedings or risk factors were reported. Disclosure controls were effective as of June 30, 2016.
Outlook, liquidity and risks
- Management expected 2016 capital expenditures of approximately $500 million for U.S. Cellular and $180 million for TDS Telecom, or approximately $680 million in total.
- TDS expected negative free cash flow in 2016 because of equipment installment plan receivable growth and significant capital expenditures.
- Management believed cash, available credit facilities and expected operating and investing cash flows were sufficient for normal operating needs and debt service for the coming year, while noting that liquidity could be pressured by spectrum purchases, acquisitions, lower regulatory support, reduced distributions from the LA Partnership or limited access to financing.
- TDS noted that its credit rating had declined to sub-investment grade and that it does not have direct access to U.S. Cellular cash unless U.S. Cellular pays a dividend; U.S. Cellular had no current intention to pay one.
- Key risks include intense wireless and broadband competition, pricing pressure and churn, spectrum availability and auction costs, equipment installment-plan credit and cash-flow exposure, regulatory support uncertainty, technology and network investment requirements, leverage and refinancing risk, cybersecurity, impairments, litigation and access to capital.
- U.S. Cellular’s 4G LTE network reached 99% of postpaid connections and 98% of cell sites. A multi-year VoLTE rollout was planned to begin with one market in 2017.
Investor verification checklist
- Verify the composition, maturities, interest rates and covenant headroom of the approximately $2.45 billion debt balance.
- Track equipment installment plan receivables, allowance levels, upgrade guarantees and their effect on operating cash flow and free cash flow.
- Confirm the outcome and cash cost of FCC Auction 1002 and the closing and gains associated with pending spectrum exchanges.
- Assess whether U.S. Cellular can sustain connection growth and churn improvements despite declining ARPU and industry pricing pressure.
- Reconcile reported GAAP results with non-GAAP adjusted EBITDA, operating cash flow and free cash flow measures.
- Monitor 2016 capital spending against the approximately $680 million plan and the effect on liquidity, dividends and share repurchases.
- Review subsequent filings for regulatory changes affecting Federal USF and Connect America Fund support, net neutrality proceedings and any material legal or contingency developments.