Airthread Case Study

AirThread Case

Background

As the cable industry becomes increasingly competitive, the cost of acquiring new customers and market penetration rate have gone up. As organic growth gets more difficult, industry consolidation started, and American Cable Communications has resorted to acquiring smaller companies to increase its customer base and its economy of scale. One such company that ACC has considered to acquire was AirThread Connections. This potential acquisition makes sense for the following reasons:

1. After the acquisition, ACC can close the gap in product offerings - the company can offer bundled services with wireless offerings to compete more effectively with ILEC’s. By bundling they can also access business customers to diversify its revenue stream, and reduce risk as business customers sign longer contracts.
2. Similarly, AirThread could improve its competitive position by utilizing ACC’s fiber line to reduce backhaul costs. Bundling products also helps improve their competitive position.
3. The acquisition would also help solve AirThread’s problem of low operating margin due to customer acquisition cost (marketing), retention cost (customer service), and system operating cost. The resulting reduction in backhaul cost and increase in revenue would improve the profitability (margins) of the firm.

To value how much Air Thread is worth to ACC, we need to consider a variety of factors - apart from the DCF model and the APV approach, we also need to consider the tax savings due to debt incurred in 2008, the potential revenue and cost synergies, and the illiquidity discount as mentioned in the case. Also, “Equity in Earnings of Affiliates” on the income statement should also be factored into valuation as it’s valued separately in the case. Below we first value Air Thread on a stand-alone basis:

To value Air Thread using a DCF or APV approach, we first need to project FCF and then find the appropriate discount factor. Since we are first asked to find the enterprise value of the firm assuming a terminal leverage ratio of 28.1% (industry average), using a DCF approach with WACC is more appropriate as the percentage of debt in the capital structure is fixed. To calculate FCF:

Now we need to calculate the cost of capital for Air Thread’s industry using a list of comparable firms. Using a list of comparable firms in Exhibit 7, we find each firm’s asset beta below through unlevering and find the average:

Using the CAPM with an asset beta of 0.7967, a risk-free rate of 4.25% and a risk premium of 5% given in the case, we find the unlevered value of Air Thread to be 8.23%. In order to find WACC, we need to first find the return on equity, which can be derived from return on debt.

Using a debt beta of 0.25, the return on debt is 5.5%. Then using Return on equity = Ra+D/E(Ra-Rd) = 9.3%. Once we have both Re and Rd, we can find WACC = E/V*Re + D/V*(1-tax rate)*Rd = 7.62% (with 40% tax rate and a D/V of 28.1%).  
Now that we have WACC and FCF projections for 5 years, we can just use the NPV formula in Excel to find the PV of FCF in the first 5 years, which come up to be $1.368 billion.

Now we need to find the terminal value of the firm. We have two methods to solve this: perpetual growth method or exit multiple method. The perpetual method further breaks down into 2 scenarios: We can either use the macro economic growth rate of 3% or using (ROC*Reinvestment Rate) as mentioned in the case to find the terminal growth rate. The latter method gives as a terminal growth rate of approximately 1.88% (The reinvestment rate calculation is just plugging in the numbers; for return on capital, we assume shareholder’s equity grow at historical rates and debt remains at the 2007 amount). See below for details:

We recommend using the 1.88% growth rate instead of the 3% macro-economic growth rate because the latter number is just a commonly used economic metric, while the 1.88% growth rate is derived from financial data specific to the firm, and as long as the calculated growth rate is smaller than the 3% macro growth rate, the number would not be unreasonable.