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Valuation of AirThread Connections - Brief Cases ________________________________________________________________________________________________________________ HBS Professor Erik Stafford and Joel L. Heilprin, Illinois Institute of Technology Finance Professor and Managing Director of 59th Street Partners prepared this case solely as a basis for class discussion and not as an endorsement, a source of primary data, or an illustration of effective or ineffective management. This case, though based on real events, is fictionalized, and any resemblance to actual persons or entities is coincidental. There are occasional references to actual companies in the narration. Copyright © 2011 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School. E R I K S T A F F O R D J O E L L . H E I L P R I N Valuation of AirThread Connections In early December 2007, Robert Zimmerman, senior vice president of business development for American Cable Communications (ACC), was in his office sifting through a number of investment banking proposals related to potential acquisition targets when he paused to consider the recent presentation made by Rubinstein & Ross (R&R). Rubinstein & Ross was a boutique investment bank with a strong reputation for doing deals in the media and telecommunications sector. During that meeting, Elliot Bianco pitched the idea of American Cable buying out AirThread Connections, a large regional cellular provider. The basic premise of the AirThread acquisition was threefold. First, American Cable and AirThread could help each other compete in an industry that was moving more and more toward bundled service offerings. American Cable currently offered video, internet, and landline telephony, but did not have any kind of wireless offerings. This gap in product offerings had so far been exploited only modestly by competitors—primarily incumbent local exchange carriers (ILEC’s) with wireless networks—but as those firms grow their video offerings the problem was expected to become more acute. Additionally, American Cable saw a looming competitive threat from advanced wireless networks based on the 802.16n standard for mobile WiMAX. Those networks are expected to be able to deliver not only wireless telephony but also internet service with throughput similar to that which is currently offered by cable providers. AirThread, for its part, faced similar pressures with respect to the same set of competitors because it didn’t offer landline or internet service. However, unlike ACC, AirThread was feeling the pressure more immediately in the form of higher customer acquisition and retention costs, plus slower growth. 4263 R E V : A P R I L 2 7 , 2 0 1 2 For the exclusive use of D. Ghosh, 2020. This document is authorized for use only by Devleena Ghosh in Behavioral Corporate Finance (Summer 2020) taught by DUCCIO MARTELLI, Universit?? degli Studi di Perugia from Jun 2020 to Aug 2020. 4263 | Valuation of AirThread Connections 2 BRIEFCASES | HARVARD BUSINESS SCHOOL Second, the acquisition could help both companies expand into the business market. Both firms had customer bases that were heavily reliant on retail/residential customers. In the case of American Cable, this had resulted in a lack of long-term service contracts, which could have increased the stability and reliability of the company’s revenues. In turn, this would also have had the beneficial effect of reducing the risk associated with ACC’s operations. Furthermore, expanding into the business segment would help each firm increase its network utilization and, as a result, increase its cost efficiency. Third, American Cable was in a unique position to add value to AirThread’s operations. AirThread had a cost disadvantage relative to its main wireless competitors owned by ILECs. A large portion of wireless network operating costs related to moving traffic from cell towers to central switching offices using either landlines leased from competitors or technically cumbersome microwave equipment. A preliminary study by Rubinstein & Ross estimated that use of American Cable’s fiber lines could have saved AirThread more than 20% in backhaul costs. In addition to the strategic fit, R&R believed that it could obtain a significant amount of debt financing for an AirThread acquisition. Bianco was confident that the high quality of AirThread’s network assets, its valuable wireless spectrum licenses, and its steady cash flow would merit a debt to value ratio as high as 45% to 50% based on EBITDA coverage ratios exceeding 5.0x.1 American Cable Communications In December of 2007, American Cable Communications (ACC) was one of the largest cable operators in the United States. The company’s cable systems passed roughly 48.5 million homes and served approximately 24.1 million video subscribers, 13.2 million high-speed internet subscribers, and 4.6 million landline telephony subscribers. Consolidated revenue for 2007 was expected to be $30.9 billion with net income of $2.6 billion. Overview of Cable Industry Dynamics The cable industry had been rapidly transforming over the last decade as a result of advances in technology, changes in regulation, and shifts in competitive dynamics. In turn, these forces had been driving large investments in network infrastructure that require commensurate increases in the customer base to effectively utilize the new capacity. It was this need to acquire economies of scale and scope that led American Cable’s executives to believe that only a handful of very large network providers would survive into the future. The smaller companies would eventually be weeded out through industry consolidation. As a result, American Cable became an aggressive acquirer. American Cable’s Business Development Group American Cable’s business development group has been tasked with the primary goal of increasing the company’s customer base as a means to fuel both top line growth and network utilization. From 1999 through 2005, ACC’s business development group spearheaded more than $15.0 billion of acquisitions and, as a result, the company believed it had developed a strong corporate finance team with significant acumen in identifying, valuing, structuring, and executing corporate control transactions. In addition, the company also believed that its experience as an acquirer had allowed it to develop unique operational know-how in the area of merger integration. 1 EBITDA coverage ratio is EBITDA/total interest expense. For the exclusive use of D. Ghosh, 2020. This document is authorized for use only by Devleena Ghosh in Behavioral Corporate Finance (Summer 2020) taught by DUCCIO MARTELLI, Universit?? degli Studi di Perugia from Jun 2020 to Aug 2020. Valuation of AirThread Connections | 4263 HARVARD BUSINESS SCHOOL | BRIEFCASES 3 Furthermore, the company believed that its core competency as an acquirer would continue to play a fundamental role in its future success. With the rapidly increasing costs of acquiring new customers and the high penetration rates in video and high speed internet, the group surmised that the only way to achieve meaningful customer growth would be through additional acquisitions. American Cable’s acquisition process began with the screening of potential communications service providers that operate in territories adjacent to, or within, the firm’s existing regions. Next, a basic investment thesis was developed that outlined the acquisition benefits in terms of the strategic fit of a target company’s assets and operations with those of American Cable, the potential synergies from a merger, the likely price of the target relative to an estimate of its intrinsic value, and the acquisition’s likely effect on the competitive dynamics within the industry. After the initial screening, a preliminary valuation was done to estimate the target’s underlying value irrespective of its current market price. The valuation techniques utilized include market multiple approaches as well as discounted cash flow methodologies, such as WACC-based DCF and APV. The capital structure assumptions employed were designed to mimic American Cable’s past investment policies, which were to purchase the target with a significant amount of debt and then pay down the debt to a sustainable long-term level that was in line with industry norms. The company’s use of acquisition leverage was modeled after the classic LBO approach used by many private equity firms. The goal was to use a tax-efficient structure that maximizes investor returns by minimizing the amount of up-front equity invested in the deal. AirThread Connections Business AirThread Connections (ATC) was one of the largest regional wireless companies in the United States, providing service in more than 200 markets in five geographic regions. The company’s 2007 revenue and operating incomes were expected to be approximately $3.9 billion and $400 million respectively. The firm’s networks covered a total population of more than 80 million people. In addition, AirThread had an extensive set of roaming agreements with other carriers to provide its customers with coverage in areas where the company did not operate a network. Table 1 depicts the company’s wireless ownership interests. Table 1 Wireless Licenses Operating Markets 209 Non-Operating Markets 9 Markets In Which ATC Has A Controlling Interest 218 Markets To Be Acquired Under Existing Purchase Agreements 25 Non-Controlling Investment Interests 17 Total Markets 260 For the exclusive use of D. Ghosh, 2020. This document is authorized for use only by Devleena Ghosh in Behavioral Corporate Finance (Summer 2020) taught by DUCCIO MARTELLI, Universit?? degli Studi di Perugia from Jun 2020 to Aug 2020. 4263 | Valuation of AirThread Connections 4 BRIEFCASES | HARVARD BUSINESS SCHOOL Exhibit 2 provides additional details on the company’s customers and penetration rates by region for its total consolidated markets and operating markets.2 AirThread also intended to continue to expand its network operating area by participating in FCC auctions for