Analysis of a Security Valuation Derek Webb, Darryl Kraemer Arch Communications Analysis of a Security Valuation Derek Webb, Darryl Kraemer

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

Background

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

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

Strategy

Strategy Return on Capital  Business Strategy + Corporate Strategy Business Strategy  Industry Choice + Competitive Position

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

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

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

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

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

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

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

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

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

Class Discussion

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

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

Accounting Analysis

Accounting Analysis No unusual accounting measurement issues are evident

Ratio Analysis

DuPont Analysis Net Profit Margin (NI/Rev) Asset Turnover (Rev/Assets) Financial Leverage (Assets/SE) ROE (NI/SE) 1995 -0.246ò 0.207ò 3.18ò -0.162% 1994 -0.075ñ 0.571 12.58 -0.539% 1993 -0.126 N/A

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

Common Sized Statements 1995 - $ thou 1995 - % of rev 1994 - $ thou 1994 - % of rev 1993 - $ thou 1993 - % of rev Rev 162,598 100% 67,247 45,308 COGS 20,789 16.7%ñ 10,124 15.1%ñ 4,031 8.9% SG&A 94,623 58.2%ñ 16,591 24.7%ò 29,962 66.1% Interest Exp 22,560 13.9%ñ 4,221 6.3% ò 3,036 6.7% Margin (36,602) -22.5% ò (5,069) -7.5% ñ (5,725) -12.6%

Class Discussion

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

Common Sized Conclusions SG&A 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

Cash Flow Analysis

Cash Flow Analysis (000’s) 1995 1994 1993 From Ops 14,749ò 14,781ñ 8,721 Used to Invest 192,549ñ 28,982ò 30,998 From Financing 179,092ñ 14,636ñ 11,268 Net Inc/Dec 1,292ñ 435ñ (11,009) Cash end of period 3,643ñ 1,927ñ 1,492

Class Discussion

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

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 can’t 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?

Forecasting

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

Forecasting Millions 1995 1996E 1997E 1998E 1999E 2000E Subs 2.006 3.121 3.826 4.668 5.508 6.334 Avg. Rev/Unit/Mo $11.00 $8.95 $8.29 $7.88 $7.48 $7.19 Net Rev $141.8 $283.2 $355.6 $444.5 $502.7 $557.7 EBITDA $47.2 $102.4 $135.9 $171.4 $198.0 $225.5 Cap Ex $446.8 $428.8 $111.7 $114.9 $113.7 $114.3 Net Income ($34.9) ($131.0) ($155.6) ($184.2) ($177.3) ($161.2) Price/ Share $37.60 $47.60 $57.33 $65.65

Class Discussion

Class Discussion Which assumptions in the analyst’s forecasts would you question and why based on the previous analysis and implications we discovered?

Add/Beginning Subscribers (000’s) Forecasting Issues Subscriber estimates Year Add/Beginning Subscribers (000’s) Growth Rate 1996E 1115/2006 0.55 1997E 705/3121 0.22 1998E 841/3826 1999E 840/4667 0.18 2000E 826/5507 0.15 2001E 823/6334 0.13 2002E 787/7157 0.11 2003E 715/7944 0.09 2004E 606/8659 0.07 2005E 463/9266 0.05

Forecasting Issues Compound annual growth rate = 380% # of households with pager if industry grows at Arch’s 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 Arch’s rate still unrealistic: 82,635,258 / 2 = 41,312,304 or 43%

Forecasting Issues No use of balance sheet (DuPont) in analysts forecast, unrealistic ROE and Asset Turnover Didn’t account for increase in cap ex (assets) in relation to revenue forecasts, which distorts valuation

Forecasting Issues

Forecasting Issues

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

Forecasting Issues

Forecasting Issues

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

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 what’s left after paying all debt and taxes EBITDA good for short-term credit risk analysis

Valuation Conclusion

Valuation Conclusion We don’t agree with analysts price Subscriber growth rates unrealistic NOPAT estimates unrealistic Didn’t 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

Post Script

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)

Post Script Arch’s 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 Arch’s value at 0.11 times revenue, or ~$75M FCC approved merger, as did Arch shareholders