Arch Communications Group - Essay Example

Arch Communications Group, founded in 1986, was valued to be the third largest communications company in the United s in 1995 offering paging services and equipment to a subscriber base of 2,006,000 on local, regional, and nationwide levels. According to its annual report for the fiscal year 1995, it boasts of the highest growth rate in the industry growing by 162.6% based on its EBITDA, 124.7% in revenue, and almost tripling its subscriber base from 538,000 to 2,006,000. With its stock trading at $29.62 by November of 1995, it is undoubtedly a very profitable investment. However, in March of 1996, Arch stocks dropped almost 58% to only $12.50 following the fall of stock prices in the paging sector. Analysts, however, still consider Arch to be a sound buy. One of these analysts is John Adams, at Wessels, Arnold & Henderson, who believes that Arch’s stocks are undervalued. In his analysis, using EBITDA, Adams concludes that the company’s stocks are still a profitable investment because of its impressive historical growth. This implores investors to ask if Arch’s stocks were undervalued. In Adams’ valuation estimates, where he presents a ten-year horizon long estimate of Arch’s cash flow until the year 2005, this seems to be the case. John Adams forecasts Arch to have continuous growth in its subscriber base, which should reach more than 9 million subscribers, and in EBITDA from 47.2 in 1995 to 356.8 in 2005. According to Adams’ analysis, Arch will remain to be a profitable company in the paging industry in the long term. This analysis, based on EBITDA values, portrays continuous annual growth in cash flow margins from 33%, valued at $47.2 million in 1995 to 46.9% at $356.8 million in 2005. A strong point in this analysis lies in its ease to manipulate values for comparison with other companies within the industry. In Exhibit 3, EBITDA trends of the top paging companies highlights Arch as having one of the highest EBITDA margins in 1995 – a staggering 37% similar with Pagenet, the largest paging company in the country. Arch was also presented to have the highest growth rates in the industry at a 273% subscriber growth rate, 224% revenue growth rate, and 303% EBITDA growth rate, all of which are significantly higher than its competitors. Its Enterprise Value / EBITDA ratio is also the second highest at 18.9, second only to MobileComm, at 27.8 in 1995, and its Enterprise Value / Subscriber ratio is projected to be the highest in 1996 at $422, significantly higher than the average ratio, which is at $326. Based on these values, one can see a clear picture of Arch’s position vis-à-vis its competitors in the industry. This analysis, however, possesses a number of weak points – it does not account for the company’s capital expenditures and it is an inaccurate measure of cash flows. By using EBITDA margins to draw comparable conclusions regarding Arch’s value against competing companies in the industry, it failed to consider several factors. First, it failed to account for capital expenditures, as a result, Adams disregarded Arch’s soaring capital expenses at $446.8 million. This is a risky misrepresentation because it neglects the fact that the $47.2 million EBITDA value of the company has yet to be utilized to pay for capital expenses annually. This explains why despite positive EBITDA values, the company’s free cash flows remains to be negative in 1995 at –417.6. This leads to the second weakness – inaccurate cash flow margins. Based on EBITDA, Arch has a 33% cash flow margin in 1995, however, based on its free cash flow, this margin drops to an astounding –294 percent. Even though Adams’ analysis paints an accurate estimate of its competitive position within the paging industry, it failed to account for competitive position against substitutes outside the paging industry. Furthermore, Arch, is a capital-intensive company. It requires constant improvements in technology to keep up with its competitors within and outside the paging industry and it needs constant re-investment in its equipment. It must be constantly investing in Research and Development and be aggressive in developing new technologies and applying innovative improvements in service delivery. Arch, however, is not keen on this. It believes more on stability than innovativeness in its technology – it would rather be a “fast follower” than a leader. As a result, Arch’s capital expenditures were focused more on acquisitions and consolidation of the paging industry and not in the more important aspect of developing and innovating technology. An analysis of Arch’s capital expenditures would have shown this. As a result, Adams’ analysis of Arch’s performance falls short. --- Contrary to the analyst’s conclusion, Arch’s stocks were, therefore, not undervalued. First, Adams assumed that competition outside the industry could be generally ignored due to the continuing dominance of pagers in the communications industry despite predictions of its demise. This prompted Adams to disregard non-pager companies in his valuation of Arch and focus solely on other pager companies to determine Arch’s competitive position. Second, because the subscriber growth rate of the company continued to improve at a rate that is highest in the industry, the analyst, assumed that this will hold true at least until the terminal year of his analysis. As a result, revenue values were estimated at an increasing rate, such that, the declining ARPU was not given much emphasis because it could be offset by subscriber growth. And third, the analyst assumed that there is no need to account for debts in his valuation because of the nature of paging industries. Adams’ assumptions, however, are not necessarily accurate. First, by assuming that competition from other industries could be ignored, he failed to consider the possibility that other industries could eventually develop into strong competitors. Increased competition will undoubtedly affect the value of paging company’s stocks including Arch. This should have been considered in the analysis especially because Arch, as a company in a capital-intensive industry does not pay much attention to these substitutes nor do they invest in new technology. This lead him to assume that Arch’s subscriber base will continue to grow, which, again is a risky assumption. It significantly increased Arch’s revenue despite the fact that substitutes to pagers will eventually penetrate Arch’s market causing a continuous increase in subscriber growth for Arch uncertain. Last, by disregarding debt and simply using EBITDA values, the analyst failed to account for the company’s high debt and the effect that its aggressive acquisition strategy has on its free cash flows. --- Therefore, based on Arch’s performance, the company, at the time of the analysis was not undervalued. It had a free cash flow of –$417.6 due mainly to its high capital expenditures, it incurred high debts and its aggressive growth strategy focused more on acquisition of other paging companies and not on highly regarded capital, which should be the case for companies in the communications industry. Because of these reasons, its stocks dropped dramatically in price despite its promising performance in 1995. References: Bernard, V., Healy, P., Palepu, K. (2000). Business Analysis & Valuation – Using Financial Statements. Cincinnati, Ohio: South-Western College Publishing. Read More