SATELLITE, CABLE & BROADCASTING David B. Kestenbaum 212-218-3851 dkestenbaum@morganjoseph.com James Leahy 212-218-3784 jleahy@morganjoseph.com Company Update September 7, 2007 Key Metrics RCNI - NASDAQ $13.39 Pricing Date 09/06/2007 Price Target $20.00 52-Week Range $30.74-$12.16 Shares Outstanding (mm) 37.9 Market Capitalization ($mm) $507.5 3-Mo Average Daily Volume 518,426 Institutional Ownership 92% Debt/Total Capital 73.3% ROE NM Book Value/Share $5.10 Price/Book 2.6x Dividend Yield NM LTM EBITDA Margin NM EPS($) FY: December Prior Curr. Prior Curr. 2006A 2007E 2007E 2008E 2008E 1Q-Mar 1.68 -- (0.59)A -- -- 2Q-Jun (0.69) -- (2.15)A -- -- 3Q-Sep (0.60) -- (0.35)E -- -- 4Q-Dec (0.65) -- (0.25)E -- -- FY (0.25) -- (3.32)E -- (2.96)E P/E NM NM NM Revenue($mm) Prior Curr. Prior Curr. 2006A 2007E 2007E 2008E 2008E 1Q-Mar 143.6 -- 153.3A -- -- 2Q-Jun 157.3 -- 159.2A -- -- 3Q-Sep 157.6 -- 157.9E -- -- 4Q-Dec 158.3 -- 161.2E -- -- FY 616.8 -- 631.5E -- 654.0E 1 Year Price History for RCNI Q3 Q1 Q2 2007 Created by BlueMatrix Company Description: RCN Corporation (www.rcn.com) is a provider of bundled telecommunication services in the US. These include analog cable TV, digital cable TV, high-speed Internet, and voice service. The company also provides a variety of commercial products and services to voice carriers, Internet Service Providers, data providers, and other enterprise customers. These services include SONET and Ethernet-based transport services, dark fiber leases, high-speed Internet access, managed servers and Webhosting, bulk and retail video service, and voice services. 21 18 15 12 9 RCN Corporation Rating: Buy Despite the Tape; Things Look Good; Reiterate Buy Investment Highlights: We remain confident in RCN's flexible financial structure, LT growth initiatives, and consistent operating performance. In our view, the company continues to take the appropriate steps to grow the business, maintain balance sheet flexibility, and increase shareholder value. Given RCN's strong operating fundamentals, consistent financial performance, and current valuation, we reiterate our Buy and $20PT. We believe RCN can reach 30% EBITDA margins within 2 years. EBITDA margins were 23.6% in 2Q07, representing a 380bp improvement off 19.8% margins in 2Q06 as RCN continued to focus on streamlining targeted marketing initiatives and improving field operations. While the company's SG&A remains above its competitors, we believe its cost cutting initiatives are working and that they will continue in 2008 and beyond. Further, we note that the Commercial side is already generating EBITDA margins of nearly 30%, which we believe can grow to the mid-30% range in the next two years. Ultimately, the combination of accelerated SG&A containment and continued Commercial margin upside leads us to believe our 2008 EBITDA margin estimate of 25.8% could prove conservative. Telephone drags but negative impact should diminish. Telephone revenue declined 8.2% in 2Q07, which dragged overall Core Residential growth downwards to 3.3% growth from 7.0% ex-voice. However, the other two businesses continue to perform well and offset Telephone declines related to both microwave and fixed-to-mobile substitution. Additionally, few microwave customers are left. Going forward, we believe that while Telephone revenues will continue to fall, the rate of decline will moderate around 2%-3% Y/Y. FiOS threat is overdone. FiOS is only in 50% of RCN's markets and does not target MDU's (multi-dwelling units). Given that RCN's New York MDU penetration is approximately 97% and Verizon is not located in Chicago, Boston is the only RCN market that could potentially feel some FiOS impact (MDU's make up 41% of total penetration). However, pricing for both services is relatively consistent; accordingly, we do not believe there is much incentive for customers to switch. Neon bank financing secure; we believe deal multiple will be favorable. RCN expects the transaction to close around November 1. We ultimately believe the acquisition price will be favorable. Annualizing Neon's 1H07 EBITDA generates a 13.7x multiple, which excludes potential margin improvement or synergy impact. Our $15mm synergy expectation generates a 7.6x EV/EBITDA in 2008, which we believe is more than acceptable. The Disclosure section may be found on pages 5-6 of this report. The Valuation section may be found on page 5 of this report.
We remain confident in RCN's flexible financial structure, long term growth initiatives, and consistent operating performance. In our view, the company continues to take the appropriate steps to grow the business, maintain balance sheet flexibility, and increase shareholder value. More specifically, we remain confident that RCN can generate EBITDA margins of 30% over the next two years via continued revenue growth, SG&A cost containment, and additional Commercial upside, which will soon include the Neon acquisition. Given the company's strong operating fundamentals, consistent financial performance, and current valuation, we reiterate our Buy rating and $20PT. Still confident the company can reach 30% EBITDA margins within 2 years. EBITDA margins were 23.6% in 2Q07, and represented a 380bp improvement Y/Y as RCN continued to focus on streamlining targeted marketing initiatives and improving field operations. While the company's SG&A remains above that of its competitor's, RCNI has vastly improved this metric from 2006 levels in the year to date. Overall, we believe the company's cost cutting initiatives are taking hold and will accelerate in 2008 and beyond. Accordingly, we believe our 2008 SG&A expectations could prove conservative, which could boost EBITDA margins higher than currently expected levels. Further, we note that the Commercial side of RCN's business is already generating EBITDA margins of nearly 30%, which could contribute additional upside to overall company margins. More specifically, given the high revenue-growth, fixed-cost nature of the business (as well as continued cuts in SG&A expenses), we believe the Commercial side could easily grow to the mid-30% range in the next two years. Ultimately, the combination of accelerated SG&A containment as well as continued Commercial margin upside (our current estimates do not include Neon) leads us to believe our 2008 EBITDA margin estimate of 25.8% could prove very conservative. Telephone remains somewhat of a drag but negative impact should diminish; other businesses are strong. Telephone revenue declined 8.2% in 2Q07, which dragged overall Core Residential growth downwards to 3.3% growth from 7.0% ex-voice during the quarter. However, the other two businesses continue to perform well and offset Telephone declines related to both microwave and fixed-to-mobile substitution. Video and Data revenues rose 6.7% and 8.7%, respectively, Y/Y in 2Q07, while RGU additions were also strong, particularly on the Data side. Further, we believe the segment's rate of decline will moderate as microwave customers are now almost completely churned (we estimate that less than 5,000 subscribers currently remain). Overall, we believe that while Telephone revenues will continue to fall, the rate of decline will moderate around 2-3% per quarter going forward. In our view, the FiOS threat is overdone. Despite noise from Verizon (VZ - $ - NYSE) about its FiOS deployment and speculation that FiOS competition has hit RCN, we believe RCN has seen little competitive impact and that most of its markets will be relatively well insulated going forward. More specifically, FiOS is only in 50% of RCN's markets and does not target MDU's (multi-dwelling units), a core component of RCN's New York, Boston, and Chicago markets. Given that RCN's New York MDU penetration is approximately 97% and Verizon is not located in Chicago, Boston is the only RCN market that could potentially feel some FiOS impact (MDU's make up 41% of total penetration). However, pricing for both services is relatively consistent, and accordingly, we do not believe there is a huge incentive for customers to switch from RCN's network over to FiOS. Overall, given that FiOS only overlaps with approximately 25% of RCN's total network base, we believe the threat from FiOS is largely overexaggerated. Bank financing for Neon is secure; we believe the deal multiple will be favorable. The company expects the transaction to close around November 1. It will pay for the transaction with a $250mm bank facility and $10mm in cash. Once the financing closes, Neon must hit agreed-upon financial metrics in 3Q07 to complete the acquisition. Given the company's performance(revenues grew 12% in 1H07 while EBITDA grew 166%), 2 MORGAN JOSEPH & CO. INC.
we believe Neon will meet the requirements. In addition, we believe the acquisition price will be very favorable for RCN once the deal closes (estimated 4Q07) and synergies come into play. More specifically, annualizing 1H07 EBITDA generates an EV/EBITDA multiple of approximately 13.7x, which is inline with Neon's peers; however, this does not include potential margin improvement or synergy impact. While RCN expects to see approximately 10mm in synergies (implies an 8.9x multiple), we believe this view is conservative and expect synergies of approximately $15mm. This generates a multiple to 7.6x in 2008, which is more than acceptable, in our view. We continue to expect long-term upside from RCN's footprint expansion. RCN continues to expand its footprint, having built out 20,000 homes of the 50,000-75,000 it targets for the year. To that end, the company has already announced that it will build out four new Lehigh Valley communities and four Boston neighborhoods over the balance of the year. Going forward, we believe RCN's move to build out new areas and target "cold pockets" within current service areas will drive both RGUs and long-term revenue growth. Valuation. The company's currently trade at x 2008E TEV/EBITDA, below our 6.8x target multiple and well below the current 6.9x and 7.0x multiples for Comcast (CMCSA - $ - NASDAQ) and Cablevision (CVC - $ - NYSE). This comes as RCN continues to demonstrate its ability to deliver consistent performance and in the midst of several long-term growth initiatives. 3 MORGAN JOSEPH & CO. INC.
RCN Corporation - Quarterly and Annual Income Statements 2005-2008E ($ in millions) December 2005 1Q06 1Q06PF 2Q06 3Q06 3Q06PF 4Q06 4Q06PF 2006 1Q07 2Q07 3Q07E 4Q07E 2007E 2008E Total Revenues $561.0 $143.6 $135.8 $157.3 $157.6 $149.7 $158.3 $150.6 $616.8 $153.3 $159.2 $157.9 $161.2 $631.5 $654.0 Yr/Yr Change in Revenue ($) 19.2% 2.0% NE 11.2% 13.5% 7.8% 13.2% 7.6% 10.0% 12.9% 1.2% 5.5% 7.0% NE 3.6% Qtr/Qtr Change in Revenue ($) NE 2.6% NE 9.5% 0.2% -4.8% 5.8% 0.6% NE 1.8% 3.8% -0.8% 2.1% NE NE Costs and expenses Direct expenses $196.8 $49.9 $47.5 $50.3 $51.9 $49.3 $54.8 $52.4 $206.8 $53.1 $54.3 $52.9 $51.6 $211.8 $209.3 % of Revenues 35.1% 34.8% 34.9% 32.0% 32.9% 32.9% 34.6% 34.8% 33.5% 34.6% 34.1% 33.5% 32.0% 33.5% 32.0% Operating and selling, general and administrative $276.0 $66.5 $62.8 $70.7 $71.2 $67.0 $69.8 $66.0 $278.2 $64.1 $63.3 $67.2 $71.1 $265.7 $276.2 Total Costs $472.8 $116.5 $110.2 $120.9 $123.0 $116.3 $124.6 $118.4 $485.0 $117.2 $117.6 $120.1 $122.7 $477.6 $485.5 EBITDA $88.1 $27.1 $25.6 $36.4 $34.6 $33.4 $33.7 $32.3 $131.9 $36.1 $41.6 $37.8 $38.5 $154.0 $168.5 % of Revenues 15.7% 18.9% 18.9% 23.1% 22.0% 22.3% 21.3% 21.4% 21.4% 23.6% 26.1% 23.9% 23.9% 24.4% 25.8% EBITDA Growth NE 17.2% NE 83.9% 48.6% 43.5% 53.9% 47.1% 49.6% 41.0% NE 9.2% 19.3% 16.8% 9.4% Depreciation & Amortization 190.3 50.8 49.3 48.6 47.8 47.8 48.8 48.8 196.1 47.1 47.5 43.0 40.0 177.6 220.0 Other Charges/Asset Impairments 14.2 1.2 1.2 1.4 1.3 1.3 2.1 2.1 6.0 4.3 (2.2) 0.0 0.0 2.1 0.0 Stock Compensation Expenses 5.2 5.2 4.5 4.3 4.3 4.2 4.2 18.2 5.3 6.5 5.3 5.3 22.4 20.0 Operating Income (expense) ($116.3) ($30.1) ($30.1) ($18.1) ($18.8) ($20.0) ($21.4) ($22.9) ($88.4) ($20.5) ($10.2) ($10.5) ($6.8) ($48.0) ($71.5) Operating Margin NE NE NE NE NE NE NE NE NM NE NE NE NE NM NM Interest Income (Expense) (42.3) (9.3) (9.3) (4.9) (2.9) (2.9) (2.8) (2.8) (20.0) (2.3) (4.0) (2.3) (2.3) (11.0) (40.0) Other Income (expense) 20.9 107.9 107.9 (2.2) (0.0) (0.0) (0.2) 1.1 105.4 (0.1) (65.2) 0.0 0.0 (65.4) 0.0 Pretax Income ($137.8) $68.4 $68.4 ($25.3) ($21.8) ($23.0) ($24.4) ($24.5) ($3.0) ($23.0) ($79.5) ($12.8) ($9.1) ($124.4) ($111.5) Pretax Income Margin NE 47.6% 50.4% NE NE NE NE NE NE NE NE NE NE NE NE Income Tax (0.8) (7.5) (7.5) 0.0 0.0 0.0 (0.1) (0.1) (7.6) 0.5 0.0 (0.1) (0.1) 0.3 (0.4) Net Income ($138.6) $61.0 $60.9 ($25.3) ($21.8) ($23.0) ($24.5) ($24.7) ($10.6) ($22.4) ($79.5) ($12.9) ($9.2) ($124.1) ($111.9) EPS (weighted average) ($3.85) $1.68 $1.68 ($0.69) ($0.60) ($0.63) ($0.65) ($0.65) ($0.25) ($0.59) ($2.15) ($0.35) ($0.25) ($3.32) ($2.96) EPS Growth NE NE NE NE NE NE NE NE NE NE NE NE NE NE NE Shares (weighted average) 36.0 36.2 36.2 36.6 36.4 36.4 37.9 37.9 36.8 37.7 37.0 37.2 37.4 37.3 37.8 Source: Company reports and Morgan Joseph & Co. Inc. estimates 4 MORGAN JOSEPH & CO. INC.
Required Disclosures Rating and Price Target History for: RCN Corporation (RCNI) as of 09-06-2007 06/07/06 I:Hold:NA 08/10/07 Buy:$20 21 18 15 12 Q3 Q1 Q2 Q3 Q1 Q2 Q3 Q1 Q2 2005 2006 2007 9 Created by BlueMatrix Price Target Our price target is $20.00 per share. Valuation Methodology Our Buy rating and $20.00 price target are based on TEV/EBITDA multiple analysis. On a TEV/EBITDA basis, RCN today trades at a 5.8x our 2007E estimate and 5.3x our 2008E estimate. On a comparative basis, Comcast (CMCSA - $25.05 - NASDAQ) and Cablevision (CVC - $32.66 - NYSE) each trade at 7.9x 2007E Street consensus estimates and at 6.9x and 7.1x 2008 Street consensus, respectively. Our target 2008E TEV/EBITDA estimate is 6.8x, still at a discount to the current trading levels for Comcast and Cablevision, a discount we believe is prudent given the level of growth RCN should deliver compared to the growth that Comcast and Cablevision are set to deliver. Risk Factors RCN operates in a highly competitive market. RCN's network buildout strategy is relatively expensive and may not generate sufficient RGU additions. The telecommunications industry is subject to an ever changing regulatory environment. As programming costs rise, RCN has less bargaining power compared to its larger competitors. The company recently took on significant additional debt. I, David Kestenbaum, the author of this research report, certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers, and no part of my compensation was, is, or will be directly or indirectly tied to the specific recommendations or views contained in this research report. I, James Leahy, the author of this research report, certify that the views expressed in this report accurately reflect my personal views about the subject securities and issuers, and no part of my compensation was, is, or will be directly or indirectly tied to the specific recommendations or views contained in this research report. Research analyst compensation is dependent, in part, upon investment banking revenues received by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. intends to seek or expects to receive compensation for investment banking services from the subject company within the next three months. 5 MORGAN JOSEPH & CO. INC.
Investment Banking Services/Past 12 Mos. Rating Percent Percent BUY [B] 67.33 32.35 HOLD [H] 30.69 9.68 SELL [S] 1.98 0.00 Meaning of Ratings A) Buy means reasonable outperformance relative to the market over 12-18 months. B) Hold means market-type risk adjusted performance; potential source of funds. C) Sell means expected to underperform the market. Other Disclosures The information contained herein is based upon sources believed to be reliable but is not guaranteed by us and is not considered to be all inclusive. It is not to be construed as an offer or the solicitation of an offer to sell or buy the securities mentioned herein. Morgan Joseph & Co. Inc., its affiliates, shareholders, officers, staff, and/or members of their families, may have a position in the securities mentioned herein, and, before or after your receipt of this report, may make or recommend purchases and/or sales for their own accounts or for the accounts of other customers of the Firm from time to time in the open market or otherwise. Opinions expressed are our present opinions only and are subject to change without notice. Morgan Joseph & Co. Inc. is under no obligation to provide updates to the opinions or information provided herein. Additional information is available upon request. Copyright 2007 by Morgan Joseph & Co. Inc. Morgan Joseph & Co. Inc. 600 Fifth Avenue, 19th Fl New York, NY 10020 Tel. 212.218.3700 Fax. 212.218.3789 Sales and Trading New York Tel. 212.218.3767 Fax. 212.218.3705 Pittsford Tel. 877.237.6542 Fax. 585.899.6029 6 MORGAN JOSEPH & CO. INC.