A May 15, 2009 WSJ article stated the following: “Activists to TDS: You are breaking up.  Shareholders are pressuring Telephone & Data Systems to put itself on the market or split up.  TDS assets include 80.8% of U.S. Cellular, an independent regional wireless carrier. Southeastern Asset Management set a shareholder forum in New York on Thursday to let investors vent.  Friday, Southeastern plans a call with Glass Lewis “to discuss governance implications.”  No word on whether TDS gets the message.”

So it may not be new news, but it’s definitely back in the news.  Chicago-based Telephone & Data Systems (TDS) is reportedly under substantial pressure by institutional investors to put itself on the block.  Mario Gabelli’s Gamco Investors and Southeastern Asset Management, each of which control approximately 15% of TDS shares, are apparently prepared to go head-to-head with the controlling Carlson family, following its rejection just over one year ago of a $100 per share offer by an unnamed party…the stock has subsequently declined to just $25 per share, from around $165 in late 2007.

In a press release from Southeastern Asset Management dated Aug 11, 2009 and entitled “Shareholders Demand Change at Telephone and Data Systems, Inc.”, I believe TDS may start getting the message.

Of course, although we hate to rub salt in wounds, many stocks have lost 50% or more of their value in the past year.  But very few investors had the opportunity to avoid that morass thanks to an unsolicited offer to buy at a healthy premium.  Unfortunately, TDS investors didn’t either, because the Board apparently refused to entertain the bid.

The Carlsons, which own just 10% of the company’s outstanding equity but control 52% of the voting power, have famously (infamously?) refused to sell for eons, and as a result both TDS and the shares of its 81%-owned subsidiary United States Cellular (USM) have historically traded at large discounts relative to their publicly traded peers as well as relative to the companies’ intrinsic value.  No matter how many times Mario has pounded the table and urged CNBC viewers to consider TDS and USM, investors have snubbed their noses. No exit strategy? No big upside.

But given recent press reports, we thought a close look at the situation was warranted.  At the end of the day, the Carlsons may never submit to the pressure, and their voting control protects their position, but there have been precedents where uncooperative boards have caved to the wills of large shareholders, and Mario Gabelli has long been a proactive investor.  

Back in the late 90s Mario Gabelli and Lynch Interactive began a “friendly” letter writing campaign to convince Hector ceo Curtis Sampson, that Lynch acquiring 51% of Hector, at a minimum of $10 per share, was in Hector shareholders’ best interests.  Unable to court Sampson into accepting proposal after proposal, Gabelli continued to buy up stock and took his case to shareholders.  In 2004, he was successful in at least convincing Hector shareholders to eliminate the company’s poison pill policy.  After that, it wasn’t too long before Hector received an unsolicited offer.

More important than the hopes and dreams of America’s investing elite, however, are the long-term ROI prospects of TDS shareholders, including the Carlsons.  What’s it worth today, and what will the value trend be over the next few years?  Given the rocky economy and competitive environment, the answer to the latter question is murky at best, but we can tell you with a high degree of confidence that TDS is worth more—probably a lot more—than the $25 per share that it currently trades for.

We’ve run a rudimentary breakup analysis on the company, and we think that even after last year’s economic collapse, and based on what we consider to be conservative valuation multiples, the equity in TDS should be worth upwards of $10b—yet public market investors are valuing the company at less than $3b.

 Here’s how we get there:

First, we looked at the company’s guidance for 2009 results, and used the midpoint for revenue and OIBDA.  The TDS’ filed 10-K for year-end 2008 reveals that it expects to generate $275m in OIBDA in its ILEC and CLEC operations, on $800m in sales.  In order to select valuation multiples, we examined three recent deals: CenturyTel’s (CTL) pending acquisition of EMBARQ (EQ), Consolidated Communications’ (CNSL) 2007 buy of North Pittsburgh Systems (another investor inspired transaction) and Windstream’s (WIN) 2007 acquisition of CT Communications.  The average of the three implied valuation multiples in the 3x revenue and 8x trailing cash flow range, but given the events of the past year, and the lower level implied in the most recent EMBARQ sale, we went with a more conservative 2x revenue and 6x cash flow.   The indicated value for the telephone operations is about $1.6b.

Next we considered USM.  The company has historically posted lower-than average cash flow margins despite a healthy 13% penetration rate across its majority-owned markets, and guidance for 2009 indicates that about $900m in OIBDA is anticipated, on $4b in revenue.  Comparable sales examined, including AT&T’s (T) announced buy of Centennial Communications (CYCL), Alltel’s, SureWest Wireless’ and Rural Cellular’s sales to Verizon Wireless (VZ) as well as T-Mobile’s buy of SunCom Wireless, implied that valuation multiples for wireless service providers are in the 3x+ revenue and 9x cash flow range—even for the most recent transaction.  On a per subscriber basis, the value range indicated by the selected transactions was in the $2,100-$2,400 range.

Here again, we opted for a conservative approach, despite the fact that the Carlson’s reluctance to sell might indicate a more aggressive offer would be required.  At 2.5x revenue, 81% of USM would be worth $8.1b, which was our selected value, although the range indicated by $2,000 per sub and/ or 7.5x OIBDA is wide.

Combined, the ILEC/CLEC ops and wireless ops are thus worth somewhere north of $9.7b.  Additionally, TDS, via USM, is a partner in a Los Angeles cellular partnership, which generates $65m-$70m annually for TDS.  We capitalized the income stream at 10x, implying a value of $660m.

The company has a small printing and distribution division, which we valued at 1x the $25m in annual revenue it generates, and TDS was sitting on $777m in cash at end of last year.

Finally, TDS also owns substantial spectrum licenses which it acquired via its interests in four “Variable Interest Entities”, or limited partnerships. King Street Wireless, LP, Barat Wireless, LP, Aquinas Wireless, LP and Carroll Wireless LP have each purchased (or are pending grant of) spectrum licenses at auctions conducted by the FCC.  Each LP, which are substantially funded by TDS, received an entrepreneur’s discount of 25%, and combined, acquired a total of $560m worth of licenses in Auctions 73, 66 and 58.

The validity of the LPs’ bidding discounts are presently under investigation by the Department of Justice, and return of the $165m bidding credit along with treble damages has been requested in a complaint, but we have nevertheless included TDS’ net holdings at book value.  Should the ruling go against the company, we would have to reduce our breakup value by $489m, or about just more than $4 per share.

Net net, we value TDS’ asset base at more than $11.6b.  Reduce that by the $1.6b in long-term debt on the books (whose fair value is lower by the way), and around $10b in equity value—or $87 per share—is implied.

So what does it mean for investors wondering why TDS trades for less than 30% of that?  A few things. First, Mario Gabelli is no slouch when it comes to finding undervalued companies to invest in, and we have to agree with him that TDS is attractive at these levels.

But will there be a value unleashing event?  The sale of USM has long been predicted and there’s no doubt that any of the top- 4 wireless carriers would be happy to blend the company’s 6.2m subscribers into their base. And obviously there was interest in TDS just over a year ago, and reportedly at an even higher level than our analysis indicates.

But the Carlson family has stubbornly refused to entertain outside offers for more than a decade.  What might prompt it to change its mind now?  Noisy proclamations on the part of Gabelli and Southeastern could get shareholders stirred up, but there’s still that whole voting control problem.

More likely, the Carlsons are looking at the annual earnings of their companies and saying to themselves that while times may be difficult, that’s true for all industries right now.  Where will they do better?  Tough question to answer.

TDS’ dividend is just $0.41 per share, yielding less than 2% at current prices, surely – yet another reason that investors have shied away from the stock.  But the company has plenty of cash and has also been purchasing its own stock. Over the long run, a smaller share base will lead to higher prices.  Furthermore, TDS has relatively low debt, which means its ability to service debt and generate free cash flow are likely secure—and that means something these days.

The bottom line is that while it may yet be a long time coming, TDS shares are likely to climb eventually—and a little noise on the part of Gabelli and Co. might just provide something of an impetus, sooner rather than later.

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