1. Analysis of a Security Valuation Derek Webb, Darryl Kraemer
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

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

8. 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

10. 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

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

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

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

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

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

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

17. Class Discussion

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

19. 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

20. Accounting Analysis

21. Accounting Analysis
No unusual accounting measurement issues are evident

22. Ratio Analysis

23. 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

24. 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

25. Common Sized Statements
$ thou
% of rev
$ thou
% of rev
$ thou
% 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%

26. Class Discussion

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

28. 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

29. Cash Flow Analysis

30. 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

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?

33. 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?

34. 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

36. 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

37. Class Discussion

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

39. 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

40. Forecasting Issues Compound annual growth rate = 380%
# of households with pager if industry grows at Arch’s rate unrealistic:
14,226,000 x ,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%

41. 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

42. Forecasting Issues

43. Forecasting Issues

44. Forecasting Issues Backing into Analysts forecast of $37.60
Avg. # of subscribers in 1995  538, ,468,000 / 2 = 1,272,000
Net revenue = $141,800,000
Rev/sub  $141,800,000 / 1,272,000 = $ / 12 = $9.29/month

45. Forecasting Issues

46. Forecasting Issues

47. 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

48. 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

49. Valuation Conclusion

50. 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

51. Post Script

52. 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 , Arch report revenue increases from $397M to $642M
Significant losses over the same period from ($182M) to ($288M)

53. 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