Business Context and Reporting Period
Telephone and Data Systems, Inc. (TDS) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2018, compared with the corresponding 2017 periods. TDS is a diversified telecommunications company serving approximately 6 million connections through 83%-owned U.S. Cellular and wholly owned TDS Telecom, which comprises Wireline and Cable operations. Prior-period segment information was recast because hosted and managed services became non-reportable effective January 1, 2018.
Key Financial Metrics
| Metric | Q2 2018 | Q2 2017 | YTD 2018 | YTD 2017 |
|---|---|---|---|---|
| Operating revenues | $1,255 million | $1,247 million | $2,480 million | $2,485 million |
| Operating income | $61 million | $27 million | $141 million | $109 million |
| Net income | $44 million | $12 million | $101 million | $55 million |
| Net income attributable to TDS shareholders | $33 million | $10 million | $72 million | $47 million |
| Diluted EPS | $0.29 | $0.09 | $0.63 | $0.42 |
| Adjusted EBITDA | $319 million | $280 million | $659 million | $597 million |
| Adjusted OIBDA | $272 million | $242 million | $568 million | $522 million |
| Capital expenditures | $138 million | $134 million | $253 million | $230 million |
Q2 operating margin was approximately 4.9%, compared with 2.2% in the prior-year quarter. Q2 net margin attributable to TDS shareholders was approximately 2.6%, compared with 0.8% in Q2 2017. The six-month operating margin was approximately 5.7%, compared with 4.4% in 2017.
- Six-month cash flow from operating activities was $463 million, compared with $358 million in 2017.
- Six-month free cash flow, defined by TDS as operating cash flow less property, plant and equipment additions, was $188 million, compared with $116 million.
- Cash, cash equivalents and restricted cash totaled $877 million at June 30, 2018, compared with $622 million at December 31, 2017. Cash and cash equivalents alone totaled $873 million.
- Long-term debt, net, was $2.427 billion, with a current portion of $20 million. Total gross debt was approximately $2.447 billion based on reported current and long-term balances.
- TDS had $399 million of unused capacity under its new revolving credit agreement, while U.S. Cellular had $298 million available. The receivables securitization agreement had $200 million of unused capacity, subject to collateral availability.
- Interest expense was $43 million in Q2 and $86 million for the first six months, broadly consistent with the prior-year periods.
Material Changes Versus the Prior Comparable Period
- Consolidated operating income increased 126% in Q2 and 29% for the first six months, driven primarily by improved U.S. Cellular results, cost savings and lower equipment costs.
- U.S. Cellular operating income increased to $56 million from $5 million in Q2 and to $121 million from $59 million year to date. Adjusted EBITDA increased 25% in Q2 and 19% year to date.
- U.S. Cellular revenue increased 1% in both periods. Equipment sales increased 5% in Q2 and 9% year to date, while service revenue was flat in Q2 and down 1% year to date.
- U.S. Cellular postpaid retail connections declined to 4.468 million from 4.478 million year over year. Q2 postpaid net losses were 13,000, compared with net additions of 23,000 in 2017; churn increased to 1.19% from 1.13%.
- TDS Telecom revenue was essentially flat, but operating income declined 41% in Q2 and 29% year to date. Wireline revenue declined 4% in Q2 and 3% year to date, while Cable revenue increased 12% in both periods.
- Cable reported operating losses of $3 million in Q2 and $4 million year to date, compared with operating income of $3 million and $5 million, respectively. Higher programming costs and depreciation contributed to the decline.
- Income tax rates declined materially because the Tax Act reduced the federal corporate tax rate. The effective tax rate was 31.5% in Q2 and 30.5% year to date, versus 45.0% and 44.4% in the comparable 2017 periods.
- TDS adopted the new revenue recognition standard, ASU 2014-09, on January 1, 2018 using the modified retrospective method. The adoption increased beginning retained earnings by $163 million and affected revenue classification, contract assets, contract liabilities and operating results.
- TDS prospectively changed the estimated useful life of Cable video franchise rights from indefinite to 15 years. This increased depreciation, amortization and accretion by $4 million in Q2 and $9 million year to date, reducing net income by $3 million and $7 million, respectively.
Guidance, Outlook, Commentary, Risks and Unusual Items
- U.S. Cellular expects 2018 capital expenditures of $500 million to $550 million. TDS Telecom expects approximately $270 million. Management expects to fund spending primarily with operating cash flow, existing cash and, if needed, revolving or receivables-backed facilities.
- Strategic priorities include U.S. Cellular network enhancement, VoLTE deployment, evaluation of 5G opportunities, fixed wireless broadband and business solutions, along with Wireline fiber expansion, A-CAM buildout, broadband capacity investments and Cloud TV deployment.
- TDS expects U.S. Cellular’s legacy Federal USF support to continue at the 2017 level through 2018, but cannot predict the timing or outcome of the Mobility Fund Phase II auction or the resulting support phase-down.
- TDS Telecom accepted an additional $3 million per year for 10 years under the A-CAM program, with related broadband buildout obligations.
- The company states that its credit rating is currently sub-investment grade and warns that reduced operating cash flow, lower regulatory support, acquisition or spectrum spending, weaker capital markets, covenant issues or reduced distributions from the Los Angeles SMSA Partnership could impair liquidity.
- The Department of Justice is investigating U.S. Cellular and TDS under the False Claims Act concerning participation in certain FCC spectrum auctions. TDS and U.S. Cellular believe their arrangements complied with applicable law and FCC rules, but the outcome cannot currently be predicted.
- TDS recorded a $6 million out-of-period adjustment in the first quarter related to noncontrolling interests with redemption features. Management determined the adjustment was not material to the affected periods.
- The filing identifies competition, technology changes, spectrum availability, regulatory support, customer churn, cybersecurity, potential impairment of licenses and franchise rights, indebtedness, litigation and access to financing as material risks. No material changes to previously disclosed risk factors were identified.
Important Facts for Investors to Verify
- Reconcile reported 2018 results with 2017 results in light of the modified-retrospective adoption of ASU 2014-09 and its effect on revenue timing and classification.
- Monitor U.S. Cellular postpaid net additions, churn, equipment installment receivables and the sustainability of cost reductions.
- Assess whether Wireline declines and Cable losses reverse as broadband, fiber, A-CAM and Cloud TV investments mature.
- Verify the timing and financial impact of the Mobility Fund Phase II auction and any reduction in legacy Federal USF support.
- Review total debt maturities, sub-investment-grade credit status, covenant compliance and available revolving and securitization capacity.
- Track the DOJ False Claims Act inquiry and any related contingency, settlement or compliance developments.
- Confirm the final Tax Act adjustments expected by the third quarter of 2018, which the filing states could be material.
- Distinguish GAAP results from Adjusted EBITDA, Adjusted OIBDA and free cash flow, which TDS identifies as non-GAAP measures.