Arch Communications

1
Arch Communications

• Analysis of a Security Valuation
• Derek Webb, Darryl Kraemer

2
Agenda

• Background
• Strategy Analysis
• Accounting Review
• Ratio Analysis
• Cash Flow Analysis
• Forecasting Review
• Valuation
• Post Script

3
Background
4
Background

• Arch Communications Group Inc. founded in 1986
• 3rd largest paging company in USA in 1996
• 3 million subscribers in 1996
• Local, regional and nationwide basis
• 180 of 200 major metro cities

5
Background

• Current competitive positioning
• Low cost provider
• Economies of scale for ops, size of subscriber
  base
• Standard, reliable technology
• Fast follower, proven and somewhat dated tech
• Prompt and efficient delivery
• Resellers, retailers and direct sales
• Invested in expanded networks, and capacity
• Integrate acquisitions successfully

6
Strategy
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Strategy

• Return on Capital ? Business Strategy Corporate
  Strategy
• Business Strategy ? Industry Choice Competitive
  Position

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Corporate Strategy

• Goals
• To become dominate player in wireless paging
  segment
• Aggressive growth through strategic acquisitions
  and internal additions
• Strengthen distribution channels and increase
  capacity
• Invest in select technologies
• Geographic expansion

9
Competitive Positioning

• Product Market Focus
• Local, regional and nationwide
• Major metro areas
• Every pager type - 87 digital
• Direct, retailer and resellers for distribution
  channels

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Competitive Positioning

• Core Activities
• Build networks
• Distribute through reseller and retailers
• Sell via direct channel
• Support and service
• Backend billing operations
• Marketing through direct channels

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Competitive Positioning

• Value Proposition
• Proven, reliable service at a low cost
• Fast delivery of messages
• Limited to no network downtime
• Large geographical coverage

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Industry Choice

• Degree of Rivalry HIGH
• Limited product differentiation
• Oligopoly market structure
• Rapid consolidation
• Fragmented markets
• Low switching costs

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Industry Choice

• Ease of Entry - MED
• Capital intense
• Can acquire license, or company
• No strong barriers to entry other than capital
  expenditure

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Industry Choice

• Threat of Substitute Products HIGH
• Cellular technology improving
• Battery life extending
• Improved feature set
• Advancements in voice networks (PCS)
• Mobile satellite communications

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Industry Choice

• Power of Suppliers MED
• Manufacturers are supplying same product to all
  competitors
• Duopoly market structure (Motorola, NEC)
• Strong brand equity

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Industry Choice

• Power of Customers HIGH
• Low switching costs
• Growth driven by consumers, not business
• Fickle group
• Price sensitive

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Class Discussion
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Class Discussion

• What are the implications of our strategy
  analysis on the forecasting and valuation of Arch
  over the next 5yrs?

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Implications of Strategy Analysis

• Industry unlikely to have abnormal growth and
  profits in long range
• High cap expenditures required
• To continue growth through expanded coverage and
  acquisitions
• To upgrade existing networks
• Debt or equity?
• Product is commoditizing with consumers
• High threat of cellular and competitive tech
  replacing the paging market

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Accounting Analysis
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Accounting Analysis

• No unusual accounting measurement issues are
  evident

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Ratio Analysis
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DuPont Analysis
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DuPont Conclusions

• ROE improving because of reduced financial
  leverage
• Net profit margin declining
• Asset utilization declining because of large
  investment in plants, higher inventories and
  higher AR

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Common Sized Statements
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Class Discussion
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Class Discussion

• What conclusions can be drawn from a review of
  the Common Sized Statement?

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Common Sized Conclusions

• SGA increasing due to acquisitions, and increase
  of 100M of revenue
• Margins decline because of increased debt to fund
  acquisitions, inventory and operating expenses
• COGS showed insignificant increase from 1994-1995
  

29
Cash Flow Analysis
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Cash Flow Analysis
31
Class Discussion
32
Class Discussion

• What are the implications of our cash flow
  analysis on the forecasting and valuation of Arch
  over the next 5yrs?

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Cash Flow Implications

• 1995 showed a decrease in cash from ops
• Took on huge debt financing to acquire companies
  for growth, fund operations and to increase
  inventory
• Cash from ops cant cover the 154M operating
  expenses
• Going forward, will they be able to grow cash
  from ops to meet debt covenants post-acquisition,
  and fund operating expenses?

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Forecasting
35
Forecasting

• Very detailed forecast ? down to the subscriber
  growth level
• Revenue growth rates used were inline for a
  maturing industry
• In this era, a lot of positive analysis for
  technology companies

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Forecasting
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Class Discussion
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Class Discussion

• Which assumptions in the analysts forecasts
  would you question and why based on the previous
  analysis and implications we discovered?

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Forecasting Issues

• Subscriber estimates

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Forecasting Issues

• Compound annual growth rate 380
• of households with pager if industry grows at
  Archs rate unrealistic
• 14,226,000 x 3.808 14,226,000 82,635,258
• of household ? 82,635 / 95,000 86
• of households with pager if industry grows at ½
  Archs rate still unrealistic
• 82,635,258 / 2 41,312,304 or 43

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Forecasting Issues

• No use of balance sheet (DuPont) in analysts
  forecast, unrealistic ROE and Asset Turnover
• Didnt account for increase in cap ex (assets) in
  relation to revenue forecasts, which distorts
  valuation

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Forecasting Issues
43
Forecasting Issues
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Forecasting Issues

• Backing into Analysts forecast of 37.60
• Avg. of subscribers in 1995 ? 538,000
  1,468,000 / 2 1,272,000
• Net revenue 141,800,000
• Rev/sub ? 141,800,000 / 1,272,000 111.48 / 12
  9.29/month

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Forecasting Issues
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Forecasting Issues
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Forecasting Issues

• Based on backing into analysts predication
• Arch would have 109M customers in 2004 (rev/avg.
  rev per customer)
• Arch is 14 of market ? 489M customers if
  industry grows ½ as fast as Arch
• Population in 2004 at 3 growth/yr (1.03)9
  255M 332M
• 489M / 332M 1.47 pagers / person!!
• Unrealistic

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Forecasting Issues

• EBITDA not an accurate measure of firm
• Interest expense for growth
• Depreciation on fixed assets in tech industry
  with rapid change
• Shareholders only get whats left after paying
  all debt and taxes
• EBITDA good for short-term credit risk analysis

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Valuation Conclusion
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Valuation Conclusion

• We dont agree with analysts price
• Subscriber growth rates unrealistic
• NOPAT estimates unrealistic
• Didnt account for increase in capital
  expenditures no DuPont or balance sheet
• 10yr forecast is a long period to forecast out
• We came to a stock price of 3.61
• Market may be using Option pricing model based on
  future expectation of growth

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Post Script
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Post Script

• Industry continued its decline based competition
  from cell phones
• Trend towards consolidation continued
• 1998 Arch acquired MobileMedia, who earlier filed
  for bankruptcy
• From 1997-1999, Arch report revenue increases
  from 397M to 642M
• Significant losses over the same period from
  (182M) to (288M)

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Post Script

• Archs stock continued to decline
• They announced a 1 for 3 reverse stock split in
  June 1999
• In Nov. 1999, Arch and PageNET agreed to merge,
  with combined 16M subscribers
• Merged placed Archs value at 0.11 times revenue,
  or 75M
• FCC approved merger, as did Arch shareholders