NPSI ($23.40) <North Pittsburgh Systems > by dman976

**Value-Investing-Forum** Tue May 30, 2006 10:32 am

NPSI ($23.40) <North Pittsburgh Systems > by dman976
4/11/2006 9:38:00 AM NPSI ($23.40) <North Pittsburgh Systems > by dman976 (from Value Investor Club)

Description:

North Pittsburgh Systems is an undervalued RLEC with hidden assets and a catalyst
to realize value. NPSI has investments in very valuable wireless partnerships that in
my opinion are being given no value by the market; additionally, the recent
liquidation of the Rural Telephone Finance Bank (in which NPSI owns an interest) will add
to the Company’s already strong balance sheet. NPSI has very little following on Wall
Street and is covered by just one analyst. Recently, a couple of activist
shareholders who have had success investing in the industry took a position in NPSI and there
presence is likely to unlock the value inherent in the Company’s balance sheet and
cash flows, to the benefit of all shareholders.

NPSI is the incumbent local exchange carrier for multiple rural areas north of
Pittsburgh (285 square mile territory, including Alleghany, Armstrong, Butler and
Westmoreland Counties) where it services approximately 70,000 access lines and
approximately 12,000 DSL lines. Over the past decade, the ILEC territory has experienced, and
continues to experience, robust population growth due to the continued expansion of
new housing territories as these territories are one of the last remaining areas of
rural land within driving distance (southernmost territory is 12 miles away) of
Pittsburgh. The Company also operates a very successful CLEC in neighboring cities and
the Pittsburgh metro area, focusing on small business customers. The CLEC now has
approximately 60,000 access lines and 2,500 DSL lines. Finally, the Company owns
interests in 3 wireless partnerships, stakes which date back to the early 1980’s when
cellular licenses were issued. The three partnerships are 1.) the Pittsburgh metro
region in which the company holds a 3.6% stake; 2.) a rural license encompassing Clarion
and Lawrence counties and the northern portions of Armstrong and Butler counties in
which the company holds a 14.3% stake and 3.) a rural license covering the southern
portions of Armstrong and Butler counties in which the company holds a 23.7% stake.
The Partnership’s are run by Verizon Wireless, which act as the General
Partner.

The Company has done a good job of using its strengths to edge out into the more
densely populated Pittsburgh and suburban Pittsburgh markets. The competitors in the
CLEC markets, MCI, Sprint and Verizon (depending on the area) all are massive
companies and do not offer the personalized service and “high touch” of the CLEC that has
been taking share. Additionally, the Company recently unveiled its own VOIP
solution, and the Company is likely to roll out a video product shortly as they are
completing a fiber to the node project, which will allow them to compete with local cable
companies (to be discussed in “risk factors”) in offering a triple play of services.
It is notable that the Company has not yet rolled out a video offering, which is the
industry trend. This is a result of a cozy relationship that existed for years
between NPSI and the local cable company, Armstrong. Armstrong for years owned
approximately 10% of the stock in NPSI and had a board seat. Armstrong’s representative was
recently kicked off the board in 2005 after the cable company announced its own voice
product, a trend throughout the industry. My guess is that Armstrong was feeling
pressure from satellite providers and therefore felt it needed to expand into new
offerings. This opens up competitive issues as well as opportunities for NPSI as they
receive competition from Armstrong while eventually going after Armstrong’s (near)
monopoly on video in the market. A larger acquirer with a wireless presence could
purchase NPSI, add the video offering and a wireless offering and offer a quadruple play
in a growth market.

The wireless assets have been well managed and operating profit in the owned
service areas have more than doubled in just two years. The market seems to assign little
value to these assets. In fact, the only analyst covering the stock states, “at the
end of the day, while these properties benefit the Company’s cash flow position, we
think they are unlikely to be accorded much value in terms of NPSI stock.” I think
the market is mistaken in this assumption. The results of the wireless businesses
for the past few years are as follows (all 3 markets,
combined):

2003 2004 2005
Revenues 304.6 402.2 485.0
Op Income 46.2 81.7 90.5
Net Income 47.6 82.9 91.6

These partnerships carry no net debt and in fact carry a small net cash position.
From publicly available documents it is difficult to determine exactly the amount of
the overall pie that NPSI owns, although equity income on NPSI’s books was $3.1
million in ’03 $5.6 million in ’04 and $6.0 million in ’05, implying NPSI ownership of
about 6.7% of the overall pie.

The Way the Market Looks At Valuation

The market simply looks at NPSI and sees a boring LEC trading at about 6x EBITDA
with no catalyst. I think this is mistaken. Current valuation per the
numbers:
Market Cap @ $23: $345 million
Net Cash: $30 Million
TEV: $315 Million
EBITDA: $50 Million (6.3x)
EBITDA-Capex: $40 Million (7.8x)

Here is how I look at it:
Market Cap @ $23: $345 million
Net Cash: $45 Million (includes RTFC cash proceeds & Q1 cash flow)
Wireless Assets: $55-$65 Million
TEV: $235-$245 Million
EBITDA: $50 Million (4.7x-4.9x)
EBITDA-Capex: $40 Million (5.9-6.1x)

Combine this with the fact that this company may receive a premium as an
attractively sized buyout candidate for the CTL’s and CZN’s of the world while a group of
activists might be able to force something in this regard (see below), and it makes no
sense for this company to trade at a 36-37% multiple discount to the comparables
(see below).

Sum of the Parts Valuation

RLEC’s are still afforded reasonable multiples due to their ability to generate
high margins and sizable cash flows. Additionally, RLEC’s are typically in less
desirable markets for direct competition as new entrants cannot justify the cost to
directly compete in the local telephone business. While revenues from long distance access
and other phone related services are falling gradually due to the regulatory
environment, wireless substitution and voice over Internet competition, the provision of
video, DSL and Internet-related services have helped to cushion the fall.

Given that a transaction appears to be possible given the presence of activists, I
believe a look at comparable company valuations is
appropriate:

EV/EBITDA EV/Sub/Line
ALSK 7.7x $2,262
CBB 6.9x $2,969
CTL 6.0x $3,327
CZN 7.9x $3,713
CTCO 6.1x $2,151
IWA 8.4x $4,088
FRP 9.1x $4,182
VCG 7.4x $3,747
Average 7.4x $3,304
Source: Baseline

Based on these valuations, it is reasonable (and conservative), I believe to
assign a range of values on a takeout of $3,000 to $3,500 per line for the RLEC as a low
and high bound on the valuation with the thought in the back of the mind that it
could be higher. I discount the CLEC and DSL lines by 50% as the CLEC markets are more
competitive and carry lower margins, while the DSL relationship is typically lower
revenue per sub. I then spot-check these numbers against an EBITDA
multiple:

Total RLEC Access Lines: 70,000
Value/Line (Low) $3,000
Value/Line (High) $3,500
Total RLEC Value (Low) $210 Million
Total RLEC Value (High) $245 Million
Total CLEC Access Lines: 60,000
Value/Line (Low) $1,500
Value/Line (High) $1,750
Total CLEC Value (Low) $90 Million
Total CLEC Value (High) $105 Million
Total DSL Lines 15,000
Value/Line (Low) $1,500
Value/Line (High) $1,750
Total DSL Value (Low) $22.5 Million
Total DSL Value (High) $26.3 Million
Total Line Value (Low) $322.5 Million
Total Line Value (High) $376.3
LTM EBITDA $50 Million
LTM EBITDA Multiple (Low) 6.4x
LTM EBITDA Multiple (High) 7.5x

I think a 6.5-7.5x EBITDA take-out multiple is a conservative assumption and the
numbers could certainly end up higher, but I think it serves as a reasonable place to
begin valuing NPSI. With some comps in excess of 7x EBITDA, this is particularly
low if the company enters into a value maximizing process, which has been the MO of
the activists to force. Please note that the Value/Line estimates are discounted
substantially for the CLEC, which has lower margins and a more difficult competitive
environment.

Wireless Value

These businesses all generated $6 million of equity income to NPSI (equivalent to
Operating Income). These assets should have D&A of a total of about $55 million
based on its PP&E, the equivalent of about $4 million allocable to NPSI. As previously
noted, these assets have seen strong growth and growing profitability over the past
two years. The following comparable companies are relevant in analyzing this
asset:

Comparable Company
EV/’05E EBITDA EV/Sub*
Dobson 9.0x $1,934
Leap 11.0x $1,137
Ubiquetel 11.5x $2,503
Average 10.5x $2,036
* Modestly dated information

Comparable Transactions

Date Acquirer Acquiree EV/LQA EBITDA EV/Sub
11/18/05ALLTEL Midwest Wireless 10.5x
8/30/05 Sprint/Nextel Gulf Coast Wireless 8.6x
8/30/05 Sprint/Nextel IWO Holding 9.3x
1/10/05 ALLTEL Western Wireless 8.7x $2,042
12/15/04Sprint Nextel 8.3x $3,045
12/8/04 Alamosa Airgate PCS 9.3x $1,640
2/17/04 Cingular AT&T Wireless 10.5x $2,151
3/19/02 ALLTEL CenturyTel Wireless 10.1x $2,400
Average 9.5x $2,256

Based on these valuations, I think it is conservative to take a sizable haircut on
the average EBITDA multiple of approximately 9.5x, using 8x on the low end and 9.5x
on the high end. Additionally, it is necessary to make an adjustment for the tax
effect if these assets were to be sold (basis is approximately $13
million):

Wireless EBITDA Allocable to NPSI: $10 Million
Low Multiple: 8x
High Multiple: 10x
Low Value: $80 Million
High Value: $100 Million
After-Tax Proceeds (Low): $52.2 Million
After-Tax Proceeds (High): $65.2 Million

Balance Sheet

NPSI has the cleanest balance sheet in the entire industry (as far as I can tell).
As of 3/31/05, the company should have approximately $35 million in net cash.
Additionally, the Company will be receiving approximately $12 million in cash (post-tax)
from the liquidation of the Rural Telephone Finance Company. This will leave the
company with $45-$50 million in net cash, while most of the comps are highly leveraged.

Sum of The Parts
RLEC/CLEC (Low) $322.5
RLEC/CLEC (High) $376.3
Wireless Assets (Low) $50.0
Wireless Assets (High) $60.0
Net Cash $46.0
Total Value (Low) $428.5
Total Value (High) $492.3
Value/Share (Low) $27.91
Value/Share (High) $32.16

As previously mentioned, another way to think about this is to adjust the
valuation for a sale of the wireless assets and the cash. If we were to do this, it would
leave us with a TEV of around $235 million, leaving the core LEC trading at around
4.7x EBITDA, too cheap if you believe the activists can force NPSI into a shareholder
value enhancing transaction (please see below discussion on
this).

Financial Engineering Potential

While the potential for a sale of the Company is the most attractive outcome,
management may have the ability to placate the activists by taking a more aggressive
approach toward managing its balance sheet.

As I have stated, NPSI is extremely underleveraged and has the most conservative
balance sheet in the sector (to shareholders detriment, IMHO - note they are
generating a 25% ROE despite this fact). This strategy makes no sense when one considers
that the RLEC’s have access to cheap financing via CoBank, a co-op financing source,
which drives down financing costs for the sector. With the hidden assets, conservative
balance sheet, and low valuation of the RLEC, the potential for financial
engineering is attractive. Most players in the sector have levered up and a number of them
(FRP, IWA) are paying out virtually all free cash flow as dividends (these companies
have received premium valuations):

Net Debt/EBITDA
ALSK 3.5x
CBB 4.7x
CTL 2.1x
CZN 3.7x
CTCO 1.5x
IWA 3.9x
FRP 5.1x
VCG 4.3x
Average 3.6x
NPSI 0.0x

The potential to leverage the balance sheet, sell off non-core assets and retain
significant value in the stub is real:

Net Cash $46 Million
Sale of Wireless $55 Million
EBITDA $50 Million
Cash @ 4x EBITDA $200 Million
Cash @ 5x EBITDA $250 Million
Cash Availabe (Low) $312 Million
Cash Available (High)$361 Million

Under a dividend scenario (vs a stock repurchase scenario – the ultimate value is
the same if all cash available is used to repurchase shares or pay out a
dividend):

Leverage Leverage
4x EBITDA 5x EBITDA
1-Time
Dividend $302 Million $351 Million
Dividend/Share $20.14 $23.46
Operating Inc $30 Million $30 Million
Int Expense@ $16 Million $20 Million
8%
Pre Tax Inc $14 Million $10 Million
Net Inc $8.4 Million $6.0 Million
EPS $0.56 $0.40
P/E 16x 16x
Free Cash Flow $15.4 Million $13 Million
FCF/Share $1.03 $0.87
FCF Multiple 8.7x 7.4x
Stub Price/Sh $8.96 $6.40
TEV/EBITDA 6.7x 6.9x
Val. To $29.06 $29.86
Shareholders

In an aggressive scenario, the Company could potentially pay out a dividend in
excess of the current market cap! The Price/FCF multiples in this scenario are
conservative, I believe, and the resulting TEV/EBITDA valuations are certainly not
aggressive. Additionally, if NPSI were to adopt a “payout” strategy whereby it paid out free
cash flow as dividends, the valuation could certainly exceed 6.9x EBITDA (as many of
the comps reflect), so I view this as a modestly conservative scenario that leaves
you with significant upside from current
levels.

Industry Consolidation

I found the following article very interesting and a worth while read. It appears
that the players in the industry are looking for consolidation to occur and NPSI
would be a natural beneficiary of this trend, as larger companies could afford to
invest in video services, and fiber to the premises as well as offer wireless services to
help “own the home” and own the customer relationship as it relates to media
distribution and communications:

Citizens, CenturyTel mull rural consolidation
Wed Mar 29, 2006 8:03 PM ET
By Sinead Carew
NEW YORK, March 29 (Reuters) - Citizens Communications Co. and CenturyTel Inc. may
take part in the consolidation of the U.S. telecommunications industry, according
to top executives who laid out criteria for potential deals on
Wednesday.
As Alltel Corp. and Sprint Nextel Corp. spin off their local phone units, and AT&T
Inc. plans to buy BellSouth Corp., some investors are expecting another spate of
deals in the local telephone service market.
Citizens' President Jerry Elliott said mergers should help local providers operate
more efficiently by pooling costs for information technology, accounting and human
resources.
"There's no reason to have a bunch of stand alone companies. As many of them as
possible should be combined," Elliott said on the sidelines of the Bank of America's
Media, Telecommunications and Entertainment
conference.
A banker familiar with the industry believes CenturyTel and Citizens are ripe for
consolidation because they need more phone lines and services to compete against
larger rivals.
Elliott said Citizens was "agnostic" as to whether it would be a buyer or a
seller, but if it was to buy another company, it would ideally be in another rural market,
where there is less competition and customers are more
loyal.
The U.S. south-west and mid-west would be Citizens preferred geographic location
for potential mergers and any deal would have to allow the company to maintain its
dividend to free cash flow ratio of around 60 percent, Elliott
said.
Stamford, Connecticut-based Citizens, which operates in 24 states, plans to pay a
25 cent dividend on March 31.
Elliott did not name any potential acquisition targets and said he did not "know
of any today."
CenturyTel's Chief Financial Officer Stewart Ewing said his company would be most
interested in deals for phone lines close to its operating region, unless they were
big enough deals, with 50 to 100 thousand lines, to be worth going further
afield.
"There's certainly properties we'd look at if they were to come on the market," he
said at the same conference. CenturyTel operates in 26 states in rural areas and
small- to mid-size cities.
He would not comment on specifics but said any deal would have to look more
attractive to shareholders than CenturyTel's repurchases of its own shares. CenturyTel
said last month its board authorized a stock repurchase of up to $1
billion.
Asked if CenturyTel would entertain any acquisition offers, Ewing told the
audience: "I'm convinced our board would do the right thing if we were approached with an
attractive offer."
But he said a sale would not be a requirement.
"We think we're large enough to have the scale ... to manage the access lines we
have," he said.
He said CenturyTel may consider raising its dividend if it does not find other
suitable investment opportunities. Monroe, Louisiana-based CenturyTel's dividend is
just over 6 cents per share. (Additional reporting by Jessica Hall in Philadelphia)
This trend ties in nicely with activist investors getting involved in NPSI.

Activist Probability of Success

In terms of credentials, the activists in the name are solid, particularly as it
relates to this industry.

One of the activists, Opportunity Partners, invested in HCT at around $20 and has
been integral in convincing HCT to pursue a strategic alternatives process. The
stock has run to almost $30. They also identified and bought into NULM prior to its
sizable run last year, but have not needed to be active given the performance of the
stock. Another of the activists, Santa Monica Partners, has been battling with WWVY for
years and his efforts have resulted in the company hiring an investment banker to
pursue strategic alternatives.

The most interesting piece of this part of the story is that the board ALREADY
seems to have lost the support of some of its shareholder base (prior to the activists
getting involved). In the 10-Q filed 8/9/2005, a sizable portion of the shareholder
base WITHHELD votes from the incumbent
directors:

Name Shares in Favor Shares Withheld % Withheld
Brown 9,899,602 2,956,699 23.0%
Cole 12,108,471 747,830 5.8%
Crowley 12,085,081 771,240 6.0%
Kimble 9,960,774 2,895,527 22.5%
Kraskin 11,150,192 1,706,109 13.3%
Nelsen 12,127,838 728,463 5.7%
Thomas Jr 9,873,210 2,983,091 23.2%

It should be noted that these shares were with held from management with no active
stance taken by a shareholder opposing them. Prior to the activists filing, about
25% of the shares were held by institutional investors who likely voted for
management without much thought. These types of investors would, at a minimum, give
considerable thought to an activist agenda. This bodes well as shares now should continue to
trade with buyers representing institutions who believe the company should be sold,
resulting in a favorable change in the shareholder base. Finally, the board of
directors is unclassified, meaning the activists could run an entire slate in opposition
to the current board. Undoubtedly, management realizes this as well. With these
issues, I view it as very likely they will cave to either a sale of the company or a
large distribution of cash to shareholders via a large dividend or large share
repurchase.

Risk Factor

The most significant risk I see is that Armstrong Cable has recently launched a
competitive voice service in the company’s less rural markets. NPSI has noted that
access line losses have picked up a bit, but not significantly. The lone analyst that
covers NPSI reduced his EBITDA estimate slightly as a result of the competition. It
should be noted that NPSI has not yet rolled out a competitive video product, which
is ineveitable and will result in NPSI taking share right back from Armstrong on the
video side of the business. There are some mitigating factors that suggest NPSI will
retain significant profitability in its
LEC:
- Cost Differential: For those who don’t use a great deal of long distance, NPSI’s
pricing is at a significant discount to
Armstrong
- Growing Market: The Company’s core markets are growing, so while market share
will slip, the overall pie is growing.
- Up-take of DSL lines (17% penetration rate vs. 12% for comps) suggests customers
have some loyalty to NPSI.
- Future roll-out of video will allow NPSI to offer triple play, making customers
more sticky.
- Satellite Penetration is already high in Armstrong’s markets, suggesting a
number of households do not have a relationship with Armstrong and are therefore less
likely to switch.
- NPSI has refused to cooperate with number portability under the argument that
VOIP offering is different from fixed line products. While competitors fight this, it
will likely provide a barrier as subs would need to switch phone
numbers.
- There will undoubtedly be quality issues with Armstrong’s product at least in
the short-term. Most individuals I have spoken with that utilize a cable/VOIP offering
have had quality/connection issues.

Conclusion

I view NPSI as an undervalued, non-followed situation which is not correctly
valued by the marketplace in the current context. I view a purchase of NPSI as an
interesting event driven situation through either continued telecom consolidation or a
large return of capital to shareholders.

Catalyst:

Large shareholder repurchase (Dutch Auction) at a premium
Large dividend
Sale of the Company

**blast_investor** Tue May 30, 2006 10:44 am

This stock pick NPSI is excellent. NPSI is clearly under-priced compared to its peers.

On the weak side, NPSI free cash flow yield is on the low teen side. The business is declining and the preferred free cash flow yield would be 15% or higher.

**goog** Tue May 30, 2006 2:24 pm

The absolute value of this stock doesn't look very cheap. Could it be the whole sector overvalued?

**blast_investor** Tue May 30, 2006 3:32 pm

It is sector issue. It is pretty rare to find a free cash flow yield to be > 10% in these days.

Most stocks are not that great value in the market right now.

goog wrote: The absolute value of this stock doesn't look very cheap. Could it be the whole sector overvalued?