Business Context and Reporting Period
Telephone and Data Systems, Inc. (TDS) filed this unaudited Form 10-Q for the three months ended March 31, 2012, filed May 4, 2012. TDS operates primarily through 84%-owned U.S. Cellular, wholly owned TDS Telecom, and smaller printing and wireless subsidiaries. At March 31, 2012, TDS served approximately 5.8 million wireless customers and 1.0 million wireline customer connections.
TDS revised its reportable segment presentation to separately report U.S. Cellular, ILEC, CLEC, Hosted and Managed Services, and a non-reportable segment. Prior-period segment data was re-presented accordingly.
Key Financial Metrics
| Metric | Q1 2012 | Q1 2011 | Change |
|---|---|---|---|
| Operating revenues | $1.306 billion | $1.259 billion | Up 4% |
| Operating income | $93.6 million | $88.9 million | Up 5% |
| Operating margin | 7.2% | 7.1% | Up approximately 0.1 point |
| Income before taxes | $95.0 million | $84.5 million | Up 12% |
| Net income | $67.6 million | $54.3 million | Up 24% |
| Net income attributable to TDS shareholders | $52.3 million | $43.5 million | Up 20% |
| Net income available to common shareholders | $52.2 million | $43.5 million | Up 20% |
| Basic diluted EPS | $0.48 / $0.48 | $0.40 / $0.39 | Increased |
| Adjusted OIBDA | $289.0 million | $280.8 million | Up 3% |
| Cash flow from operating activities | $282.2 million | $333.0 million | Down 15% |
| Capital expenditures | $228.5 million | $127.5 million | Up 79% |
| Free cash flow | $39.6 million | $175.1 million | Down 77% |
Net margin was approximately 5.2% in Q1 2012 versus 4.3% in Q1 2011. The effective tax rate declined to 28.9% from 35.7%, substantially benefiting from discrete tax items. Excluding those items, the 2012 effective tax rate would have been approximately 9.3 percentage points higher.
Segment Performance
- U.S. Cellular: Revenue increased 3% to $1.092 billion and operating income increased 45% to $85.2 million. Service revenue rose 4% to $1.024 billion, supported by data and inbound roaming revenue. Adjusted OIBDA was $229.7 million versus $203.1 million.
- TDS Telecom: Revenue increased 3% to $204.1 million, but operating income declined 59% to $13.1 million. Higher Hosted and Managed Services revenue from the OneNeck acquisition was more than offset by increased expenses and declines in ILEC and CLEC revenues.
- ILEC and CLEC: Wireline customer connections declined to 987,700 from 1,011,200. ILEC revenue declined 3% to $145.1 million, while CLEC revenue declined 3% to $44.0 million.
- Hosted and Managed Services: Revenue increased to $17.6 million from $6.2 million, primarily due to the July 2011 OneNeck acquisition, but the segment remained unprofitable with a $3.1 million operating loss.
Liquidity, Cash Flow and Debt
- Cash and cash equivalents were $639.1 million at March 31, 2012, compared with $563.3 million at December 31, 2011.
- Short-term investments were $230.0 million and long-term investments were $50.3 million.
- Total debt consisted of approximately $1.531 billion of long-term debt and $1.4 million of current debt. Principal debt outstanding included TDS senior notes of $641.3 million and U.S. Cellular senior notes of $886.0 million.
- TDS and U.S. Cellular had no borrowings outstanding under their revolving credit facilities. Available capacity was $399.8 million for TDS and $299.8 million for U.S. Cellular, or approximately $699.6 million combined.
- Operating cash flow declined primarily because of unfavorable accounts payable and working-capital changes, despite higher adjusted OIBDA and a $59.9 million federal tax refund.
- Cash used for property, plant and equipment was $242.6 million. U.S. Cellular accounted for $201.3 million of capital expenditures, including network expansion and 4G LTE deployment.
- Management stated that cash, investments, operating cash flow and available financing were sufficient to meet anticipated obligations and expenditures for the foreseeable future.
Material Changes, Guidance and Outlook
- U.S. Cellular had 5.837 million total customers, including 5.570 million retail customers. Retail customers declined by 34,000 during the quarter, postpaid churn increased to 1.6% from 1.4%, and smartphone penetration increased to 34% from 20%.
- U.S. Cellular launched 4G LTE in late March 2012; coverage reached approximately 25% of customers at quarter-end, with a plan to cover more than 50% of customers by year-end.
- U.S. Cellular’s full-year 2012 estimates were unchanged: service revenue of $4.050-$4.150 billion, operating income of $200-$300 million, adjusted OIBDA of $800-$900 million and capital expenditures of approximately $850 million.
- TDS Telecom’s unchanged 2012 estimates were operating revenue of $810-$840 million, operating income of $55-$85 million, adjusted OIBDA of $245-$275 million and capital expenditures of $150-$180 million.
- U.S. Cellular sold most assets and liabilities of a wireless market for $49.8 million in cash and recorded a $4.2 million gain.
- On April 17, 2012, U.S. Cellular agreed to acquire four 700 MHz licenses for $34.0 million, subject to FCC approval and expected closing in the third quarter of 2012.
- TDS Telecom expects to receive $105.1 million of federal broadband grants and contribute $30.9 million for 44 projects required to be completed by June 2015.
- TDS expects federal income tax payments to increase substantially beginning in 2013 as accelerated tax depreciation benefits decline.
Risks, Contingencies and Unusual Items
- U.S. Cellular faces customer losses, higher churn, intense wireless competition, device subsidies, increasing data-network costs, and uncertainty over roaming and spectrum access.
- FCC reforms to the Universal Service Fund and intercarrier compensation are expected to reduce existing support; U.S. Cellular’s support is scheduled to decline 20% beginning in July 2012, with uncertain replacement funding.
- TDS Telecom faces declining physical access lines, competition from wireless, cable and VoIP providers, regulatory uncertainty and continued pressure on network access revenue.
- TDS disclosed possible future impairment risk for licenses and goodwill. Weak macroeconomic or financial-market conditions, or a decline in the stock price, could require an interim impairment test and potentially a material charge.
- Legal proceedings and unasserted claims accrued were $1.9 million. Management stated that additional contingent losses were not expected to be material, although outcomes could differ from recorded amounts.
- TDS revised prior-period amounts for immaterial errors involving cash-flow classifications and asset-retirement obligations. The revised Q1 2011 figures are used for comparison.
- The Q1 2012 tax rate benefited from $7.2 million of discrete tax items, including statute-of-limitations expirations and correction of deferred tax balances.
- TDS completed a January 2012 share consolidation and reclassification; comparative share counts and EPS were retroactively adjusted.
- No material changes were reported to contractual obligations or risk factors from the 2011 Form 10-K, other than $161.3 million of increased future operating-lease commitments from lease extensions.
Important Facts for Investors to Verify
- Whether U.S. Cellular can reverse retail customer losses and higher postpaid churn while expanding LTE and smartphone adoption.
- The effect of FCC Universal Service Fund and intercarrier-compensation reforms on wireless and wireline revenues.
- Whether the substantial increase in capital spending, particularly U.S. Cellular’s LTE deployment, produces sufficient revenue and cash-flow returns.
- The sustainability of Q1 earnings growth given the $7.2 million of discrete tax benefits and the $4.2 million asset-disposal gain.
- Progress toward TDS Telecom’s operating-income guidance despite declining ILEC and CLEC connections and the continuing losses in Hosted and Managed Services.
- Future federal tax payments beginning in 2013 as bonus depreciation benefits reverse.
- Potential license or goodwill impairment charges if market conditions or operating performance deteriorate.
- FCC approval and closing of the announced $34.0 million 700 MHz license acquisition.