SSB from last month:
RCNC: RAISING TARGET TO $75; REITERATE BUY RATING
Salomon Smith Barney
Tuesday, June 01, 1999
--SUMMARY:--RCN Corporation--Telecommunications Services
*We are raising our price target on RCN to $75 from $37 due to the improved
cost of capital and risk profile of RCN in light of its recent financings
that the company secured.
*Clearly, RCN's advanced fiber network is an asset that is becoming more
valuable as larger competitors, such as AT&T, are increasingly looking for
ways to access residential customers.
*With RCN's advanced fiber network, we would argue that RCN is ahead of the
game in being able to provide high-bandwidth consuming products such as
high-speed Internet access which is increasingly becoming more important at
the consumer level.
--EARNINGS PER SHARE--------------------------------------------------------
FYE 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year
Actual 12/98 EPS $(0.41)A $(0.72)A $(0.81)A $(1.05)A $(3.06)A
Previous 12/99 EPS $(1.11)E $(1.15)E $(1.24)E $(1.41)E $(4.91)E
Current 12/99 EPS $(1.03)A $(1.15)E $(1.07)E $(1.16)E $(4.44)E
Previous 12/00 EPS $N/A $N/A $N/A $N/A $(6.00)E
Current 12/00 EPS $N/A $N/A $N/A $N/A $(5.54)E
Previous 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Current 12/01 EPS $N/A $N/A $N/A $N/A $N/A
Footnotes:
--FUNDAMENTALS--------------------------------------------------------------
Current Rank........:1S Prior:No Change Price (5/28/99).....:$41.56
P/E Ratio 12/99.....:N/Ax Target Price..:$75.00 Prior:37.00
P/E Ratio 12/00.....:N/Ax Proj.5yr EPS Grth...:0.0%
Return on Eqty 98...:N/A% Book Value/Shr(99)..:5.12
LT Debt-to-Capital(a)75.7% Dividend............:$N/A
Revenue (99)........:340.0mil Yield...............:N/A%
Shares Outstanding..:85.1mil Convertible.........:Yes
Mkt. Capitalization.:3536.8mil Hedge Clause(s).....:#
Comments............:(a) Data as of the most recently reported quarter.
Comments............:
--OPINION-------------------------------------------------------------------
We are raising our price target on RCN to $75 from $37 due to the
improved cost of capital and risk profile of RCN in light of its recent
financings that the company secured. RCN recently secured a $1 billion
bank facility committed and underwritten by CMB at LIBOR + 3% or roughly
8.0% today, and $250 million of senior convertible preferred stock to
Hicks, Muse, Tate & Furst Inc at an annual dividend rate of 7%. The
company also completed an equity offering last week providing RCN with
net cash proceeds of $300 million. With these financings in addition to
its current cash position RCN is fully financed for its initial east and
west coast operations. In addition, we increased our penetration rates
for voice from 31% of marketable homes in 2008 to 34-35%, in line with
its video penetration. We believe there is upside to our target from
additional commercial opportunities from the excess capacity on RCN's
fiber optic network. RCN's New Business and Product Development Group
was established to identify these opportunities for its fiber optic
network.
We believe that the only way for the residential household to become a
scaleable user of broadband services via telephony, video or data is if
the household in fact has more revenue-generating services at their
disposal. The gating factor in having a scaleable consumer is bandwidth
to the home. Therefore we would argue that the future value of a
subscriber is directly correlated to the amount of bandwidth that can
come into that subscriber's household. As the table below indicates,
RCN, given that it is building a brand new network from scratch, has
multiples of the capacity of a traditional cable system. Most cable
systems are 20 years old and start out at a 220 MHz backbone, thus making
it almost impossible to fully upgrade to 750 MHz, much less 860 MHz. In
addition, old cable systems that have to be retrofitted must install
additional equipment for the upgrades which increases operating cost as
well as diminishing the bandwidth deliverability.
Since all cable plant is essentially shared Ethernet backbone, the amount
of capacity into the home is a function of the backbone capacity of the
cable plant and the number of homes hanging off the node. As the table
below indicates, RCN starting from scratch is building an 860 MHz
backbone systems with fiber either directly into a multiple dwelling unit
(MDU) or within 900 feet of the home. Furthermore, with only 150 homes
per node, RCN can deliver as much as 50 times the capacity of most
existing cable systems. In even a best case scenario of a cable system,
RCN still delivers at least 4 times the capacity of that cable system.
COMPARATIVE BANDWIDTH TO THE HOME TABLE
Distance from
Home/Node Node to Home Comparative Bandwidth
Typical HFC 5,000 >5,000 feet 2% of RCN bandwidth
Best HFC 500 <5,000 feet 25% of RCN bandwidth
RCN 150 <900 feet 45 Mbps
Thus, if one were to do an interesting exercise and look at the price
that AT&T paid for MediaOne and TCI on a per bandwidth per home basis,
RCN stock would be worth about $900 per share. Obviously, that is an
exercise just to prove a point and one needs customers and cash flow, and
must deliver services, but the point is still well taken. As RCN
constructs its network (and there is no management team that has a better
track record at constructing networks than RCN's) and as they market to
homes (early results show they can get penetration well into the 20%s
within 6 months of marketing to customers), it is clear that the value of
the future subscribers will far exceed the value for existing cable
customers today given the scaleability for current and new future
services that RCN can deliver in a much more cost-effective seamless way
than will ever be the case for retrofitted cable systems.
Our $75 price target is only predicated upon existing video, data and
telephony services and there is nothing in our model for incremental
revenue streams from new types of services developed or a concerted
effort to wholesaling RCN's network to other carriers or potentially
hooking up with carriers, such as WorldCom or Level 3, to deliver
capacity to businesses. However, within our model we have included the
full cost of the entire capacity in our capital expenditures estimates.
Thus, we are only reflecting revenue streams that are utilizing about 14%
of the existing capacity while reflecting in our cost of capital
assumptions the full 100% cost of the capacity. This leaves tremendous
incremental upside to return on investment and consequently the net pr
esent value, as RCN delivers more services over this plant. As we said,
the absolute gating factor in the ability to deliver more services and
thus generate more revenue per customer is bandwidth per customer. There
is no residential play in the US, whether it is a Bell or a soupped-up
cable system that can come close to matching RCN's ability to deliver
bandwidth to the residential user and that can come close to matching
RCN's cost structure.
We believe that RCN, with its advanced fiber network and bundled service
offering targeted at residential customers, will emerge as one of the
most attractive assets in the CLEC space. Increasingly, the value of
consumers and a network connection to these consumers are becoming more
evident, especially with AT&T and its attempt to gather cable assets and
thus provide a bundled service offering to its customers. We believe the
growth in Internet usage and for bandwidth consuming applications is
prevalent in the residential market as well as the business market. RCN,
as the 7th largest ISP and with a broadband connection into the home via
is advanced fiber network, is positioned to take advantage of this
trend. Furthermore, we believe RCN will be able to achieve a high return
on capital due to its strategy to target two key markets with huge
revenue potential--the Boston to Washington DC and the San Francisco to
San Diego corridors which account for 40% of the market in only 6% of the
nation's geography.
RCN's progress in its west coast markets extending from San Francisco to
San Diego is on track with customer service expected to begin by the end
of 1999. RCN received local approvals to offer services in South San
Francisco and San Mateo. RCN may look for a partner where it makes sense
on the west coast to accelerate its roll out, a similar strategy that
they followed on the east coast. To further enhance RCN's network, the
company entered into an agreement with Level 3 to purchase cross-country
fiber capacity supporting RCN's Internet operations recently. In
addition, the companies agreed to share cost of construction in several
markets including Boston and Manhattan.
Clearly, at the core of RCN's strategy is its advanced fiber network--a
network that is designed to support all of RCN's services--voice, video
and data. Obviously, RCN has the benefit of starting out with brand new
state of the art equipment which provides RCN with a low-cost and
scaleable network. RCN is bringing fiber closer to the home (in general
within 900 feet of the home) and reducing the amount of equipment between
the home and the network node, allowing for ease of upgrades if
necessary. Given that RCN's current voice, video and data services will
only utilize roughly 14% of its network capacity, RCN's advanced fiber
network also provides the company with excess capacity to handle future
services. In addition, the network provides RCN with commercial or
wholesale opportunities, especially given that RCN's network currently is
within 1,000 feet of 250,000 square feet of office space. We continue to
believe RCN is a unique asset which will increasingly become more
valuable to potential suitors and have confidence in management's ability
to execute.
The cash-on-cash returns for RCN is quite high. As shown in the table
below, the total network cost per single connection is $1,200 broken down
as follows: $900 for each homes passed and $300 per each service
connection (i.e., voice, video or data service). Assuming roughly
$35-$40 per service per month and EBITDA margins in the 40-45% range, the
annual cash flow for the service is roughly $200. Thus, the cash-on-cash
return for a home with a single connection is 17%. When an incremental
service is added, the total incremental cost is $300 which is the per
connection cost only since the fixed network cost has already been
invested in this particular home. Assuming annual cash flow for the
service of $200, the cash-on-cash return is 67% for each incremental
service provided to a subscriber. These cash on cash returns of a single
connection of about 17% and for an incremental service of 67% are on an
unleveraged basis. On a leveraged basis the return on equity is 2-3
times these amounts which is why the economics are so good. It all comes
down to the fact that RCN serves more homes per mile and serves
demographics where the spend per household is much higher and thirdly,
RCN offers multiple services over the same plant. Therefore, RCN has
three things driving large return on capital--clustered homes, high spend
per home and multiple services per plant.
CASH-ON-CASH RETURN TABLE
Network Connection Total Annual Cash-on-Cash
Cost Cost Cost Cash Flow Return
Single connection $900 $300 $1,200 $200 17%
Incremental $ 0 $300 $ 300 $200 67%
connection
HIGHLIGHTS OF Q1'99 RESULTS
We did not publish a call note when RCN reported Q1'99 results on 5/4/99
since we were in a quiet period due to the recent equity offering and we
would like to point out the highlights from the quarter at this time.
RCN reported strong Q1'99 results with revenues and EBITDA losses better
than our expectations. Q1'99 revenues were $79.7 million, slightly
better than our estimate of $78.7 million. EBITDA losses were $21.5
million versus our estimate of a loss of $25.6 million due to lower than
expected SG&A. Service connections continue to improve for a total of
885,742 at the end of the quarter, reflecting a 4% sequential increase.
The company continues to aggressively build its advanced fiber network in
order to provide services to the underserved residential market and ended
the quarter with 350,733 homes passed and 301,546 marketable homes.
Clearly, this asset is becoming more valuable as larger competitors, such
as AT&T, are increasingly looking for ways to access residential
customers. With RCN's advanced fiber network, we would argue that RCN is
ahead of the game in being able to provide high-bandwidth consuming
products such as high-speed Internet access which is increasingly
becoming more important at the consumer level.
DETAILS ON THE QUARTER
Total revenue for the quarter was $79.7 million with strong growth in all
lines of the business. RCN exited the quarter with an annual revenue run
rate of $320 million. Voice revenue for the quarter was $12.4 million,
growing 25.0% sequentially with voice lines of 100,219. Data revenues
were $27.1 million for the quarter with data subscribers of 516,102.
Video revenues were $30.5 million or 14.2% YOY growth with video
subscribers at the end of the quarter of 269,421 while other revenues
totaled $9.8 million. Average revenue per customer for voice is slightly
less than $60 including long distance for on-net customers and in the low
$30 range for off-net; video on-net is in the low $40s and in the low-mid
$30s for off-net; and dial up Internet access is in the high teens while
high-speed access on average is just under $40 per month.
RCN has been adding new on-net customers and migrating its off-net
customers onto its own network with on-net advanced service connections
growing to 149,235, improving 21% sequentially. By product category,
on-net voice connections grew to 40,215 (a 30% increase sequentially),
video connections increased 15% sequentially to end the quarter with
99,098, and data customers grew to 9,922 or 60% sequential growth. Of
the total 30,381 service connections added during the quarter 25,842 were
on-net service connections and 4,539 were off-net reflecting RCN's move
toward reducing resold voice service and the continued migration of
off-net customers onto RCN's own network. Total off-net service
connections at the end of the quarter were 736,507 with 60,004 voice,
170,323 video and 506,180 data connections. RCN has de-emphasized resale
of voice customers, a strategy which improves gross margins, and as a
result its net voice adds were only 4,300.
RCN is very aggressively building out its advanced fiber network to
increase its potential on-net customers and service connections--the
drivers of revenue growth and value. Total service connections were
885,742 with 16.9% on-net. Homes passed were 350,733 at the end of the
quarter while the number of marketable homes (i.e., homes to which the
full suite of on-net products are marketed) totaled 301,546 at the end of
the quarter, a 12% sequential increase. In general the first quarter is
the slowest in terms of additional homes passed due to local moratoriums
on builds. RCN is on track to reach 700,000 homes passed by the end of
1999 with roughly 550,000 marketable homes. Capital expenditures per
home passed remain less than the $900 budgeted amount due to the buildout
in more dense markets as well as a reduction in equipment costs. Capital
expenditures for the quarter were $82.9 million and is expected to total
roughly $650-$700 million in 1999.
NET/NET: We continue to believe that RCN's advanced fiber network is
becoming more valuable as larger competitors, such as AT&T, are
increasingly looking for ways to access residential customers. We
reiterate our Buy rating and raise our price target to $75 from $37.
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