Shenandoah Telecommunications Company (SHEN) Earnings Call Transcript & Summary

Thank you all for coming out. I'm Mike Funk from Bank of America. I lead the North American telecom, data center and tower research team here at the bank. Really grateful to have Ed McKay from Shenandoah here again with us. So thank you, Ed, for coming out.

Thanks, Mike. Glad to be here. Always good to be in the city, certainly a little bit of a change of pace from the Shenandoah Valley of Virginia, but glad to be here. Thanks for the invitation.

Yes. We love to have you. So thank you again for that. I wanted to start really high level and something that's, I think, of interest and topical for the entire telecom ecosystem, and that's SpaceX and Starlink -- and Starlink has already been in the market with broadband for a while. They've been relatively successful. But with plans to launch the V3 satellites, I think internally, we're projecting something like 20,000 V3 by 2030. Their capacity is obviously going to expand materially, potentially allowing them to address a much larger market. Our research, we show in the United States is about 20% rural, right, depending on the definition. And I believe that is the most natural addressable market for Starlink broadband given that it's a shared service. Now I realize not all your markets are rural or fit that definition, but where you operate and where you build is more kind of semi-suburban rural relative to, say, in New York City or Los Angeles. So a very long intro to get to a short question, which is, how do you think about the competitive threat? And how, if any way, does it change your plans or your strategy?

So to date, we've seen minimal impact from Starlink. The only place where we've really seen any impact at all is in our very rural markets. When we look at our fiber-to-the-home markets, virtually no impact from Starlink, even in our incumbent cable markets that are more dense, very little impact. It's only these very rural areas where we've seen an impact. We believe we have a superior product. We can offer higher speeds, better latency, and we think customer service differentiates us as well. So we're certainly keeping an eye on that. In some of our rural markets, we have changed our pricing plans to make them more competitive. Right now, in our rural markets, customers can get twice the speed for a lower price than they can get with Starlink. So we have reacted, we've seen churn come down. Really, the peak churn we saw in these rural areas was in the first quarter. At that point in time, they were giving away free equipment, had heavily discounted promotional rates. Since then, we've seen the churn levels come down. Part of that is they stopped the free equipment promotion, but also, I think our new rate plans have helped to decrease churn as well.

Okay. And what do you find most compelling to customers? Is it price? Is it the speed difference? Is it emphasizing reliability? What resonates most with your customers if you're doing your internal market research?

In the rural areas, we have some challenging demographics. It's more about price there. When you look at our Glo Fiber markets, which is now the vast majority of our passings, it's more about speed, low latency, reliable service. So we think there will be less of an impact from satellite in those fiber-to-the-home markets.

And then as you, kind of, move towards the end or you progress in the Glo Fiber construction phase and I guess, presumably greater focus on customer growth and cash generation, how do your operating priorities or focus change?

Sure. Well, we think we've built a very unique network. We've invested over $600 million building out our fiber-to-the-prem network. We first launched in 2019. But now is the time to fill up that network. So we are focused on driving data penetration in those markets. Current penetration rate is about 21% on average. We're projecting 37% penetration sort of midterm 5 to 7 years after we launch a market. So we believe we have significant upside from organic growth in the Glo Fiber market. So driving penetration there is the biggest priority. We're also driving growth in our commercial fiber business. We now have almost 20,000 route miles of fiber stretching from Chicago all the way to the Washington, D.C. area. We're serving enterprise, mid-market customers. We're seeing growth in our wholesale and our carrier business as well. Also, we see an additional opportunity for data center connectivity in our markets. And then I'd say the third priority would be keeping our expenses under control and operate efficiently. As we're driving top line revenue from the growth in Glo Fiber and our commercial fiber business, our focus is on keeping our operating expenses constant so we can see some EBITDA margin expansion. So that those are what I keep emphasizing with the team in the coming year.

And I want to come back to the expense side and even the data center connectivity market opportunity, but I thought want to stay focused on Glo Fiber here for a second. So if you think about the return on investment, right, for fiber. And I think generally, ballpark people said kind of greater than 20% penetration is when you want to get to, to get to an adequate return. You're targeting 37%. But the other factors are obviously going to be price and then churn. So based on what you know now in your projections, where do you expect your return to go over time on the investment you've made? And I guess, what are the levers or variables that you're watching most closely for any risk to that return target?

So when we build our business case for a Glo Fiber market, we have a 15% IRR threshold, that's an unlevered IRR. So we're well on our way to hitting that target with our penetration curve. So we monitor our growth curve carefully since we launched in 2019, we had a predictable growth curve that our cohorts typically follow. That's been very predictable. From an ARPU standpoint, our ARPU has been very resilient. We've averaged between $76 and $77. The key there is we've had customers going upstream as far as speeds. 80% of our customers now are taking speeds of 1 gig or higher, and that includes about 19% at 2 gig and another 5% at 5 gig. So some customers are going upstream. We've had tremendous success at the middle to high end of that market. And because of that, we believe that ARPU will continue to be resilient.

And on the disconnect that you see, you mentioned Starlink earlier and some of the discount of the free equipment. But what are you seeing from fixed wireless in terms of percentage of disconnects?

I would say minimal impact from fixed wireless. In our markets, there are some terrain challenges. We used to be a wireless operator in our market. I can tell you from experience, it is tough to operate fixed wireless, particularly with mid-band spectrum when you have large trees, heavy foliage, rolling terrain with hills and mountains. So I think we've been impacted less by fixed wireless than some of our larger peers that may be more in the Midwest with flat ground or in larger cities with MDUs where you can send a fixed wireless signal directly into a large building.

Okay. So you feel good about trajectory for the rest of the year then with your net additions given the competitive pullback you saw from Starlink, some of your own planned pricing changes in end market.

We do. We feel very good as far as our net addition trajectory. We had a record quarter for net additions in Glo Fiber last quarter. So we're feeling very good about our ability to hit our penetration targets.

And maybe you're better positioned than some of your peers that have been doing overbuilds or greenfield builds with fiber. But there has been a lot of talk about consolidation amongst fiber operators. What is your view on the need for consolidation among some of the emerging fiber operators? Do you think that happens -- and if not, what do you think the path is for the industry?

Yes. I think we're going to see more and more consolidation. I think that has already started, and we see that as a potential opportunity for us. There are some fiber-to-the-home providers within our region that we think maybe have not had the success that we've had with Glo Fiber. There could be an opportunity for an acquisition down the road for us to possibly roll up some of these other providers.

And then how do you evaluate valuation? I know some evaluate just in a simple cost to pass, right? They'll do a cost per home passed and if that's less than their cost to build, then that's an attractive valuation for them. How do you think about valuation of targets?

Well, some of it depends on -- when you look at the additional opportunity, it depends on the density of the market and that cost to pass, and this is important to demographics. We've noticed in the lower income areas, it's a challenge getting as high a penetration rate. But when we build our models, we assume different penetration rates depending on the market. For example, a higher income market, we may have a target penetration rate in the low 40% range. Lower income markets, it may be in the low 30% range. And those higher-end markets, it costs more to pass. We have larger lots, primarily underground utilities. In the lower income areas, smaller lots, primarily aerial facilities, and the cost to put the drop into the customer's house is typically lower because it's a shorter drop. So we can get the same returns in a higher income area with higher cost to pass as compared to a lower income area with lower cost to pass.

Because of higher penetration in the higher income area, you can presume and maybe even lower churn rates as well or lower moves or...

Lower churn, higher penetration and likelihood to go up to...

A higher speed.

Absolutely.

Higher speed. And I always wonder about that, you see a lot of marketing for higher-speed fiber tiers. And I know my own fiber usage, I know kind of the average fiber usage, I know what an HD stream takes. And it all comes in well below those multi-gig type of services that you're talking about. So what is the use case that is being sold to consumers for the higher-end tiers? And what are you seeing from the consumers that do trade up in terms of trading back down after having that service for a while?

We see very few trade back down once they've had the high-end service. A lot of Internet traffic is bursty. These higher speeds get you the data more quickly, especially with the upstream data now, remote work. We do think there is advantage. But to your point, if you're just streaming video, you don't need all that speed. But we -- some of it even the customers in these high-end areas, they want to have the fastest speeds. Bit of bragging rights for the gigabit plus speeds.

Kind of a Ferrari in the garage, right? Can only drive 60. I want to go back to the OpEx comment that you made earlier. So I hear from a lot of my companies about the, kind of, challenge of keeping costs under control. Right? Whether it's on the building side, it's hard to find skilled labor or even the white collar workers as well, we're seeing wage inflation -- so how are you controlling costs? And how do you plan to continue to control cost to drive higher operating leverage?

So a couple of things -- earlier in the year, we announced a reduction in force, about a 10% reduction in our workforce. Part of that was due to winding down our Glo Fiber construction at the end of this year. So we're going to start to see the benefits of that starting in 2027 -- we're also -- we also have several AI initiatives to improve our customer service and tech support call handle times. We're seeing positive results with those initiatives. We have another AI-powered initiative to reduce our truck rolls to proactively detect problems in the network so we can solve that problem before we have to send a truck out to the customer's home.

And can you remind me, have you said publicly what your margin expansion target is for the next 12 months or 24 months?

So 300, 400 basis points annually. We believe we have significant upside on our margin expansion.

And then you also mentioned, I want to come back to the data center connectivity business. And you're not the only one. Other operators, including Verizon, now have leaned in the data center connectivity. So what are you -- how large is the market opportunity? And then I have also heard from some people that the bidding process is, kind of, a lot more competitive for data center connectivity, meaning people are underwriting lower returns, right? Let me just address those two things, size of the market and then returns you're underwriting?

So we're in a bit of a unique position with our fiber assets in Ohio, our fiber assets in Virginia. There's significant hyperscaler data activity from Columbus down into Southern Ohio. We already have fiber network in place. There's significant activity in Virginia, where we already have fiber network in place. So we think the sweet spot for us is providing that fiber access quickly, and we can do that with a capital-light approach, taking advantage of our existing fiber and conduit, building fiber to the endpoints of the data center as opposed to having to build the entire route from scratch. I don't want to give the specifics on the potential dollar amount, but we have signed a master service agreement with one of the large hyperscalers. Next step with that would be service orders. Now from the time we signed that service order to the time we see revenue and EBITDA, still probably about 12 to 18 months because we do need to build the fiber to the data center, the endpoints and also the data centers are still under construction in most cases. So we expect -- we can start to see an impact in the 2020 -- early 2028 time frame from a revenue standpoint. But you'll see that the impact closer as far as our new sales bookings. We report that on a quarterly basis. I would say there's an opportunity for a material increase in those new sales bookings with some of the opportunities we have in the pipeline.

And the structure of the contract, so some companies are structuring them where they receive cash upfront for the build and then obviously recognize that deferred revenue over time, right, flows through, but it's not a cash impact as it flows through a life of contract. Others obviously would pay for the build themselves and then you charge more on a recurring basis for the service. How are you structuring your contracts with the hyperscalers?

We would see a mix of that. We would likely see a nonrecurring charge upfront to cover, for example, our connection from our existing fiber to the data center and then an ongoing revenue stream as well.

Okay. And you mentioned Ohio earlier, headlines recently about SB Energy, planning to build a large multi-gigawatt facility in Southwestern Ohio, the Pike facility. Is that -- would that be an opportunity for you or something you'd be in discussions with thinking geographically, I think, pretty close to some of your Ohio assets.

Yes. Southern Ohio, we have existing fiber assets in place. So I think the data center opportunity there is certainly somewhere where we believe we can play.

And then just going back to the Glo Fiber markets, how should we think about the ramp from the 21% to 37% penetration? I know you mentioned, kind of, a record net add quarter in the most recent quarter. But is that going to be relatively linear? Or should we think about that being a lumpier trajectory from the 21% to the 37%?

So when we launch a cohort, we typically have 15% penetration after the first year. After 3 years, that jumps to 25% plus. And then after that, it's a gradual increase to that 37%. Some of our older cohorts launched back in 2019, '20, they're now at 40-plus percent penetration. And some of it depends on the mix of residential versus commercial passings in these cohorts. The business passings tend to ramp more slowly. Sometimes they're under contract, so it takes a little while to get that. But from a return standpoint, in a business area, we can actually get to similar returns with a lower penetration because our ARPU for the business customers is double the ARPU for our residential customers.

And can we just talk some metrics here for a minute? We've, kind of, talked about some of the pieces here, the net adds you talked about trading up to higher speed tiers. So can we talk about the components of revenue growth and how you're thinking about revenue growth, whether it's net adds, ARPU expansion from higher tiers or other factors like expanded markets and data center connectivity. And then maybe take us from that growth rate, kind of, how you're thinking about EBITDA growth and even growth in free cash flow?

So in Glo Fiber, we're a share taker right now. So the primary growth there is coming from net adds. As far as ARPU and pricing, we haven't increased our price for Glo Fiber since we launched service. Now we have given customers higher speed and more value for the same price. But as long as we're taking share, we're likely to keep that pricing consistent with what we have today. I think over time, we have additional pricing power. I think we have a superior product from a speed standpoint, from a latency standpoint, I think we also have a superior product from a customer service standpoint. And then on the commercial side, most of our growth there is success-based growth. And when we sign a new contract, we're building to the customers, we believe we have significant opportunity there. We have over 90,000 locations that are near net within 0.25 mile of our fiber. We only serve about 6,000 of those locations today. So we think there's significant upside of taking advantage of our existing fiber network in those near network opportunities. So I think those are the big drivers of the revenue growth, as I mentioned earlier, focused -- we're focused on keeping our operating expenses constant, and that's going to drive the higher EBITDA and EBITDA margin expansion.

And then I guess beyond the EBITDA, how are you thinking about CapEx?

So as we wind down our build at the end of this year, we're going to substantially complete our Glo Fiber builds, substantially complete the government grant projects we've been working on. Our cash -- our CapEx is going to decline significantly. So with the CapEx declining with our revenue increasing with our operating expenses remaining constant, the goal is free cash flow positive starting in 2027. Another area that's helped us there, we have -- we completed a refinancing last year. We have ABS in place for our fiber networks now. So that helped us significantly from a cost of capital standpoint, and that's going to contribute to the free cash flow as well.

Okay. And of the enterprise locations and things in that category, I think, right? What is the cost to connect each of those locations?

It varies a little bit. Typically, in those near-net opportunities, $5,000 to connect them. If it's on our Glo Fiber network, it's much less. It's maybe $1,000 to connect them. Now we do success-based builds as well that are outside of those near net opportunities. And we do -- we build a model there with a target IRR. And again, we're targeting 15%-plus unlevered IRR. We don't typically do speculative builds. So we typically need to get an anchor customer before we will build. Sometimes we'll take a lower return on that initial customer and there's additional opportunity along the routes.

Okay. I asked earlier about the competitive threat from LEO for residential, yesterday, I think it was, just that AT&T announced an agreement with Amazon Leo -- for commercial or business broadband, right? So how do you think about LEO as the competitive threat or even affecting your builds given, say, $5,000 worth of connection affecting your business data connectivity.

I think in many cases, these businesses are still going to want fiber. Now they may have an alternate for a wireless connection but I think with the speed, reliability, I think there's still going to be a demand for fiber for these enterprise customers.

Okay. And then we talked a little bit about consolidation earlier. And you have expanded your footprint over the years. I mean, Ohio was an expansion market, correct? So how should we and investors think about the qualities of markets as you think about potential expansion? I mean, is it, kind of, that Midwest area? Is that the right geographic region? Or you wouldn't look more broadly? How should we think about the criteria?

Well, we're operating in 8 states now. We've launched the Glo Fiber service in 6 states. If we were to expand further, we would want to be geographically adjacent. We've built our network so that we can connect it together. So we do have some operating efficiencies within the region. I think other fiber-to-the-home providers have just built wherever they could get an agreement with the municipality to scatter it all over the place. We made a conscious effort to keep things more dense where we could have efficiencies with our field operations and we could connect these markets to our own fiber backbone for efficiencies as well.