Business Context and Reporting Period
Telephone and Data Systems, Inc. (TDS) filed this unaudited Form 10-Q for the three and nine months ended September 30, 2019, compared with the corresponding 2018 periods. TDS is a U.S.-only telecommunications company serving approximately 6 million connections through its 82%-owned U.S. Cellular wireless subsidiary and wholly owned TDS Telecom Wireline and Cable businesses.
Key Financial Metrics
| Metric | Q3 2019 | Q3 2018 | YTD 2019 | YTD 2018 |
|---|---|---|---|---|
| Operating revenues | $1,321 million | $1,297 million | $3,840 million | $3,777 million |
| Operating income | $29 million | $51 million | $171 million | $192 million |
| Net income | $23 million | $53 million | $132 million | $155 million |
| Net income attributable to TDS shareholders | $18 million | $46 million | $110 million | $119 million |
| Diluted EPS | $0.15 | $0.41 | $0.93 | $1.04 |
| Adjusted EBITDA | $325 million | $321 million | $1,025 million | $979 million |
| Capital expenditures | $253 million | $177 million | $664 million | $430 million |
Calculated consolidated operating margin was approximately 2.2% in Q3 2019 and 4.5% year to date, versus approximately 3.9% and 5.1% in the comparable 2018 periods. Net margin was approximately 1.7% in Q3 2019 and 3.4% year to date.
- Cash flow: Nine-month operating cash flow was $874 million, up from $812 million. Capital spending was $631 million, producing reported free cash flow of $243 million versus $365 million in 2018.
- Liquidity: Cash and cash equivalents were $853 million at September 30, 2019, compared with $921 million at December 31, 2018. Including restricted cash, cash, cash equivalents and restricted cash totaled $861 million.
- Debt: Current debt was $21 million and long-term debt, net, was $2.405 billion. There were no borrowings under TDS or U.S. Cellular revolving credit agreements, with unused capacity of $400 million and $298 million, respectively. U.S. Cellular also had $200 million of unused receivables securitization capacity, subject to collateral availability.
- Debt service: Long-term debt payments due for the remainder of 2019 and the next four years totaled $195 million, or 8% of total gross long-term debt obligations.
Segment Performance
- U.S. Cellular: Q3 revenue increased 3% to $1.031 billion and nine-month revenue increased 2% to $2.970 billion. Operating income declined 40% in Q3 to $20 million and 26% year to date to $115 million, primarily reflecting higher depreciation, technology-related accelerated depreciation and operating expenses. Adjusted EBITDA increased 5% in Q3 and 6% year to date. Retail connections declined to 4.905 million from 4.994 million, while postpaid churn rose to 1.38% from 1.29%.
- TDS Telecom: Q3 revenue declined 1% to $231 million, while nine-month revenue was flat at $695 million. Q3 operating income declined 29% to $20 million, but nine-month operating income increased 21% to $86 million. Cable growth and broadband and video expansion partly offset Wireline commercial and wholesale declines.
- Wireline: Nine-month revenue declined 3% to $512 million. Broadband and video growth was offset by declining voice, commercial and wholesale connections. Video connections increased 8%, while voice connections declined 4%.
- Cable: Revenue increased 8% in both Q3 and the first nine months, reaching $62 million and $184 million, respectively. Broadband connections increased 7%, and operating income improved to $3 million in Q3 and $8 million year to date.
Material Changes Versus the Prior Comparable Period
- Revenue increased modestly, but consolidated operating income and TDS-attributable net income declined because of higher depreciation, operating expenses and income taxes.
- The effective tax rate increased to 39.1% in Q3 2019 from 7.3% in Q3 2018 and to 32.8% year to date from 23.9%. The change primarily reflected a 2018 discrete tax benefit and higher projected unrecognized tax benefits in 2019.
- Capital expenditures increased 43% in Q3 and 54% year to date, driven primarily by U.S. Cellular network investments, 5G deployment and TDS Telecom fiber investment.
- U.S. Cellular’s 2019 operating performance reflected aggressive industry competition, lower gross additions and higher churn. Higher ARPU partly offset customer losses.
- TDS adopted ASC 842 lease accounting on January 1, 2019. At September 30, 2019, it reported $970 million of operating lease right-of-use assets and $1.046 billion of operating lease liabilities.
- Free cash flow declined by $122 million year to date, despite higher operating cash flow, because capital spending increased by $184 million.
Guidance, Outlook, Risks and Unusual Items
- 2019 capital expenditure outlook: U.S. Cellular expects $625 million to $725 million; TDS Telecom expects $300 million to $350 million. Planned investments include network modernization, VoLTE, 5G, fiber, broadband capacity and TDS TV+.
- U.S. Cellular expects to launch commercial 5G services in selected markets in 2020. VoLTE was available to 67% of subscribers as of the filing.
- U.S. Cellular was the provisional winning bidder for 690 spectrum licenses in FCC Auctions 101 and 102 for an aggregate purchase price of $256 million. Auction 101 licenses were granted October 2, 2019; Auction 102 licenses were expected in the fourth quarter of 2019. U.S. Cellular also applied to participate in Auction 103.
- TDS agreed to acquire substantially all assets of Continuum for $80 million in cash, subject to working capital adjustments. The transaction, serving approximately 36,500 North Carolina households, was expected to close in the fourth quarter of 2019, subject to approvals and other conditions.
- TDS Telecom accepted an additional $198 million of A-CAM funding, increasing annual support under the program to $82 million, excluding transitional amounts, through 2028. The funding carries additional broadband buildout obligations.
- An out-of-period adjustment increased U.S. Cellular operating lease income by $5 million in Q3 and year to date for errors in the timing of certain tower lease revenue. Management determined the adjustment was not material to any affected period.
- U.S. Cellular entered into five-year Amdocs agreements with committed, non-cancellable payments of $241 million beginning October 1, 2019.
- The Department of Justice is investigating U.S. Cellular and TDS participation in certain FCC spectrum auctions under the False Claims Act. TDS states that it is cooperating and believes the arrangements complied with applicable law and FCC rules; the outcome cannot currently be predicted.
- Principal risks include intense competition, customer churn, spectrum availability and auction costs, technology deployment, regulatory support uncertainty, significant indebtedness, access to capital, acquisitions, cyberattacks, litigation and potential impairment of licenses or other assets. Management reported no material changes to previously disclosed risk factors.
Facts Investors Should Verify
- Whether U.S. Cellular can stabilize retail connections and churn while converting 5G and network investments into revenue and profitability.
- Actual full-year 2019 capital expenditures versus the $925 million to $1.075 billion combined segment outlook and the resulting effect on free cash flow.
- Completion, purchase price adjustments and integration results for the Continuum acquisition.
- Timing and final cost of the Auction 102 spectrum licenses and any participation or spending in Auction 103.
- Debt maturities, covenant compliance, sub-investment-grade credit ratings and continued availability of revolving and securitization capacity.
- Potential consequences of the DOJ False Claims Act inquiry and any related contingencies.
- The effect of higher taxes, accelerated depreciation, lease accounting and the $5 million tower lease revenue adjustment on future reported results.