Business Context and Reporting Period
Telephone and Data Systems, Inc. (TDS) filed an unaudited Form 10-Q for the three months ended March 31, 2013, compared with the three months ended March 31, 2012. TDS operates primarily through 85%-owned U.S. Cellular, serving approximately 5.7 million wireless customers, and wholly owned TDS Telecom, serving approximately 1.0 million wireline customer connections.
Financial Performance and Position
| Metric | Q1 2013 | Q1 2012 | Change |
|---|---|---|---|
| Operating revenues | $1,308.6 million | $1,305.8 million | Up $2.8 million |
| Operating income | $7.2 million | $93.6 million | Down $86.5 million |
| Income before taxes | $11.2 million | $95.0 million | Down $83.8 million |
| Net income | $7.0 million | $67.6 million | Down $60.6 million |
| Net income available to common shareholders | $1.4 million | $52.2 million | Down 97% |
| Diluted EPS | $0.01 | $0.48 | Down $0.47 |
| Cash flow from operations | $246.4 million | $282.2 million | Down $35.9 million |
| Capital expenditures | $150.1 million | $228.5 million | Down $78.3 million |
| Free cash flow | $70.0 million | $39.6 million | Up $30.4 million |
Consolidated operating margin declined to approximately 0.5% from 7.2%. The effective tax rate increased to 37.4% from 28.9%, primarily because Q1 2012 included tax benefits from expiring tax statutes and deferred-tax adjustments.
- U.S. Cellular revenue was $1,081.7 million, down 1%; operating income was $1.5 million versus $85.2 million.
- U.S. Cellular service revenue declined 3% to $996.3 million, while equipment sales revenue increased 25% to $85.4 million. Equipment losses increased to $156.3 million from $118.7 million.
- TDS Telecom revenue increased 6% to $217.1 million, but operating income declined 40% to $7.9 million. HMS revenue benefited from the 2012 Vital Support Systems acquisition.
- Cash and cash equivalents were $766.7 million at March 31, 2013, versus $740.5 million at December 31, 2012. Short-term and long-term investments totaled approximately $165.7 million.
- Total debt was approximately $1.723 billion, consisting of $1.3 million of current debt and $1.721 billion of long-term debt. TDS and U.S. Cellular had no borrowings outstanding under their revolving facilities; approximately $399.8 million and $299.8 million, respectively, remained available.
- Quarterly dividends were $0.1275 per share, compared with $0.1225 in the prior-year quarter.
Material Changes Versus the Prior Comparable Period
- Operating expenses increased 7% to $1.301 billion despite essentially flat revenue. Cost of services and products rose 10%, and depreciation, amortization and accretion rose 23% to $242.1 million.
- U.S. Cellular operating income was reduced by the pending Divestiture Transaction, including approximately $38.0 million of accelerated depreciation and $6.9 million of net sale and exit costs. Management reported a net $45.1 million reduction to TDS operating income from the transaction in Q1.
- U.S. Cellular total customers declined to 5.736 million from 5.837 million. Retail customer net losses increased to 51,000 from 34,000, and postpaid churn increased to 1.7% from 1.6%.
- Smartphone penetration among postpaid customers increased to 43.5% from 34.4%, while smartphones represented 61.7% of devices sold versus 54.1%.
- TDS Telecom wireline connections declined by 12,700 to 975,000. ILEC and CLEC revenue declined, but HMS revenue more than doubled due primarily to the Vital acquisition.
- Operating cash flow decreased primarily because Q1 2012 included a $59.9 million federal tax refund. Lower capital expenditures increased reported free cash flow.
- U.S. Cellular repurchased 496,000 common shares for $18.4 million; there were no comparable repurchases in Q1 2012.
Guidance, Outlook, Risks and Unusual Items
- Current 2013 estimates assume the Sprint divestiture closes in Q2 2013. TDS estimates adjusted operating revenue of $4.515 billion to $4.685 billion, adjusted income before taxes of $810 million to $960 million, and capital expenditures of approximately $900 million.
- U.S. Cellular’s current estimates are adjusted operating revenue of $3.620 billion to $3.740 billion, adjusted income before taxes of $595 million to $715 million, and capital expenditures of approximately $735 million. TDS Telecom’s estimates remain unchanged at $850 million to $900 million of revenue, $220 million to $250 million of adjusted income before taxes, and approximately $155 million of capital expenditures.
- U.S. Cellular agreed to transfer customers and certain spectrum in Chicago, central Illinois, St. Louis and certain Indiana, Michigan and Ohio markets to Sprint for $480 million in cash, subject to adjustments. Sprint may reimburse up to $200 million of specified costs. The transaction was FCC-approved in March 2013 and was expected to close in Q2.
- TDS agreed to acquire substantially all of Baja Broadband’s assets for $267.5 million in cash, subject to adjustment and regulatory approvals. Closing was expected in Q3 2013; the acquisition was excluded from the stated 2013 estimates.
- Effective April 3, 2013, U.S. Cellular agreed to amend partnership arrangements with Verizon Wireless, requiring deconsolidation of NY1 and NY2 and equity-method accounting. TDS expected a non-cash pretax gain of $12 million to $28 million in Q2 2013.
- U.S. Cellular entered into a three-year agreement beginning later in 2013 to purchase an estimated $1.2 billion of Apple iPhone products. This may increase equipment subsidies, inventory requirements and network investment.
- The Amdocs B/OSS implementation was expected to continue through the end of 2013, with total payments estimated at approximately $179 million; $114 million had been paid by March 31, 2013.
- Key risks include intense wireless and wireline competition, customer losses and pricing pressure, declining roaming and regulatory-support revenues, smartphone subsidy costs, technology deployment and systems execution, FCC and Universal Service Fund changes, transaction execution and integration, litigation, spectrum availability, and access to financing.
- Legal proceedings and unasserted claims accrued totaled $1.7 million. Management stated that potential losses in excess of accrued amounts were not expected to be material, although outcomes could differ.
Important Facts for Investors to Verify
- Confirm the closing, accounting treatment and cash proceeds of the Sprint divestiture, including actual transition, severance, contract termination and decommissioning costs.
- Assess whether U.S. Cellular can reverse customer losses and stabilize churn while absorbing higher smartphone equipment subsidies and supporting iPhone distribution.
- Reconcile the effect of the April 2013 NY1 and NY2 deconsolidation, including the recognized gain and future equity-method earnings.
- Monitor approval, closing, financing and integration of the $267.5 million Baja Broadband acquisition.
- Compare actual 2013 revenue, adjusted pretax income and capital expenditures with management’s revised guidance.
- Review liquidity after capital spending, the Apple purchase commitment, acquisitions, dividends and U.S. Cellular share repurchases, together with compliance with debt covenants.