Telephone and Data Systems, Inc. (TDS) — 2014 Q3 Form 10-Q
Business context and reporting period
Unaudited results cover the three and nine months ended September 30, 2014, compared with the same periods in 2013. TDS operates primarily through 84%-owned U.S. Cellular and wholly owned TDS Telecom, which includes Wireline, Cable, and Hosted and Managed Services (HMS). At quarter-end, TDS served approximately 4.7 million wireless customers and 1.2 million wireline and cable connections.
Key financial metrics
| Metric | Three months ended September 30, 2014 | Nine months ended September 30, 2014 | Comparable change |
|---|---|---|---|
| Operating revenues | $1.280 billion | $3.712 billion | Q3 +8%; nine months essentially flat |
| Operating income (loss) | $(125.4) million | $(153.8) million | Compared with $(33.1) million and $256.3 million, respectively |
| Net income (loss) | $(121.2) million | $(126.6) million | Compared with $(11.1) million and $174.3 million, respectively |
| Net loss attributable to TDS shareholders | $(116.0) million | $(119.8) million | Compared with $(9.5) million and $148.0 million, respectively |
| Diluted EPS | $(1.07) | $(1.10) | Compared with $(0.09) and $1.35 |
| Operating margin | Approximately (9.8)% | Approximately (4.1)% | Significantly lower year over year |
| Cash flow from operating activities | Not separately provided | $496.2 million | Up from $437.9 million |
| Capital expenditures | Not separately provided | $508.5 million on an accrual basis | Down from $637.4 million |
| Adjusted free cash flow | Not separately provided | $(5.5) million | Improved from $(192.3) million |
| Cash and cash equivalents | $573.1 million at September 30, 2014 | Down from $830.0 million at December 31, 2013 | |
| Long-term debt | $1.719 billion, plus $0.9 million current portion | Broadly unchanged from year-end |
Interest expense was $27.2 million in the third quarter and $83.8 million for the first nine months. TDS paid $43.6 million of dividends to TDS shareholders during the first nine months and reported dividends per share of $0.1340 for the quarter and $0.4020 year to date.
Material changes versus the prior comparable period
- U.S. Cellular nine-month revenue declined 4% to $2.884 billion and operating income fell to a $93.8 million loss from $177.4 million of income. Service revenue declined 8%, primarily because of a smaller customer base following the Divestiture Transaction and NY1/NY2 deconsolidation. Equipment revenue increased 36%, but equipment costs increased 30%, producing a $514.5 million equipment loss.
- U.S. Cellular operating trends improved in the third quarter: retail net additions were 50,000 versus a 71,000 loss in the prior-year quarter, postpaid net additions were 52,000 versus a 60,000 loss, and postpaid churn improved to 1.6% from 1.7%. Billed ARPU rose to $53.24 from $50.92, while smartphone penetration increased to 57.9% from 47.1%.
- TDS Telecom nine-month revenue increased 19% to $806.4 million, primarily from the Baja, BendBroadband, and MSN acquisitions. However, operating expenses increased 30% to $832.6 million and the segment posted a $26.1 million operating loss versus $32.5 million of income.
- Wireline revenue declined 2% to $536.3 million, while Wireline operating income increased 63% to $75.6 million due to lower expenses. Wireline connections declined by 17,300 year over year to 954,900.
- Cable revenue increased to $73.5 million from $14.4 million, primarily due to acquisitions, but the segment remained approximately breakeven. Cable connections increased to 257,300 from 146,800.
- HMS revenue increased 72% to $198.6 million, largely due to MSN and Bend, but the segment recorded a $101.5 million operating loss versus a $13.6 million loss, including an $84.0 million goodwill impairment.
- Operating cash flow increased despite the consolidated net loss, reflecting substantial noncash depreciation, impairment, and other adjustments and more normalized accounts-receivable activity following the prior-year billing-system conversion.
Guidance, outlook, commentary, risks, and unusual items
- Management expected 2014 capital expenditures of approximately $600 million for U.S. Cellular and $210 million for TDS Telecom, primarily for network capacity, 4G LTE deployment, fiber, data centers, and infrastructure improvements.
- U.S. Cellular expanded equipment installment plans. These plans increase equipment revenue and receivables but may reduce service revenue and ARPU and expose the company to higher churn, bad debts, consumer-credit risk, and device replacement obligations. At September 30, related unbilled receivables totaled $128.6 million and related short- and long-term liabilities totaled approximately $44.6 million.
- The $84.0 million HMS goodwill impairment resulted from lower projected revenue and earnings. The impairment test used a 6.1% projected revenue growth rate, 2.5% terminal growth rate, and 11.5% discount rate, making future impairment risk sensitive to changes in these assumptions.
- Airadigm substantially completed its consumer wireless shutdown. TDS recognized $20.8 million of related exit and disposal expenses during the first nine months and received a $10.8 million tax benefit from reduced valuation allowances.
- TDS acquired BendBroadband for approximately $261 million in cash in September 2014. The acquisition added cable, broadband, fiber, advertising, broadcast, and data-center operations and contributed to increased TDS Telecom revenue and expenses.
- U.S. Cellular entered agreements to exchange approximately 148 million MHz/pops of non-operating licenses for approximately 46 million MHz/pops in operating markets plus $145 million of cash. The transactions require regulatory approval and were expected to close in 2015; TDS expected to record a gain.
- U.S. Cellular participated indirectly in the scheduled FCC AWS-3 Auction 97 through Advantage Spectrum. Additional funding could be substantial, although the amount was not known at filing.
- TDS and U.S. Cellular had no revolver borrowings at quarter-end and had $399.4 million and $282.5 million, respectively, available under their revolving credit facilities. Credit-rating downgrades increased borrowing rates and commitment fees and could restrict future access to financing.
- The amended leverage covenant permitted a maximum consolidated leverage ratio of 3.75 to 1.00 beginning July 1, 2014; the actual ratio for the twelve months ended September 30, 2014 was 2.53 to 1.00. Management stated that debt covenants were satisfied.
- Key risks include intense wireless and broadband competition, pricing and equipment subsidies, spectrum availability and auction funding, regulatory and Universal Service Fund changes, B/OSS system performance, acquisition integration, goodwill and license impairment, credit-market access, and potential increases in churn or bad debts from installment plans.
Most important facts for investors to verify
- Whether U.S. Cellular can sustain improved postpaid additions and churn while offsetting declining service revenue with higher ARPU and installment-plan equipment sales.
- The cash-flow and credit effects of equipment installment plans, including receivable collectability, upgrade obligations, bad-debt expense, and customer churn.
- Whether HMS performance recovers sufficiently to avoid further goodwill impairment after the $84.0 million charge.
- The operating contribution and integration costs of BendBroadband, MSN, and Baja.
- The timing, regulatory approval, and economics of the planned license exchange and expected gain.
- Funding requirements and potential financial exposure from Auction 97 and other variable-interest entities.
- Compliance with progressively tighter leverage covenants and the effect of sub-investment-grade ratings on refinancing costs and liquidity.
- Whether projected 2014 capital expenditures of approximately $810 million in aggregate remain consistent with operating cash generation and the company’s liquidity resources.