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— Deals —
The deals have continued in the past year, despite the credit crisis and the recession, with Windstream Corp. and Frontier Communications Corp. announcing buyouts in recent weeks. CenturyTel Inc. and Embarq Corp. are close to completing a merger announced in October. Rural carriers, some dating to the 1890s, when Alexander Graham Bell's telephone patents expired, operate in slow-growing markets with low population densities. They have looked to buyouts to improve revenues and the benefits of scale to boost profitability. Dividends are the allure for many investors in the sector. Long buffered by a lack of competition, however, many rural carriers are losing customers to cable operators and wireless companies.
"We'll continue to see consolidation," Windstream CEO Jeff Gardner says. "It is very hard these days being a small rural telecom." While some midsized rural players can continue to operate independently, savings and other benefits from combining with larger companies will continue to drive them to seek deals that allow them to invest in broadband technologies and cover dividends. "This isn't a business that's going to show large revenue growth," Gardner says. "Working on your cost structure is very important. It's hard in this type of environment, with the type of competition we're facing, to do that without scale." The most recent batch of deals illustrate differing strategies about how rural telecoms should grow. Windstream is buying Ephrata, Pa., phone, broadband and television provider D&E Communications Inc. for $330 million. The deal is modest in scope, but Windstream expects it to add to profitability in the first year. Frontier will combine with a unit that Verizon Communications Inc. is spinning off. The tax-free, $8.6 billion deal will transform Frontier, more than doubling its phone lines, to 7 million, and pushing its top line from $2.2 billion to $6.5 billion. The deal will be dilutive in the first year and require $3.2 billion in financing. Other telecoms that have purchased large parcels of lines from Verizon have stumbled, but Frontier's management is adamant it will succeed. Meanwhile, CenturyTel and Embarq are close to completing a $11.6 billion stock-and-debt merger, unveiled in October. The new company, CenturyLink, will operate 8.6 million landlines. Because it is a merger of two corporations and not an asset purchase, the companies can eliminate overhead and other costs and can benefit from savings by operating at a large scale. Windstream, Frontier and CenturyLink look to be major forces in the consolidation of rural telecom. While Frontier and CenturyLink will greatly increase their size, they also have the most integration ahead, which could keep them from big buys in the near term. Acquiring D&E will give Windstream 165,000 more landlines, a relatively small gain for its portfolio of 3 million lines. Windstream says the deal will be accretive to free cash flow in the first year and will reduce its dividend payout ratio. "We'd rather do a deal like that than some of these transformative deals that are out there," Gardner says. Windstream, of Little Rock, Ark., was formed through a complex deal in 2006. The company was the landline unit of Alltel Corp., which Verizon Wireless has since acquired. Alltel spun off rural lines and merged the business with Valor Communications Group Inc. in a $9.1 billion deal. Gardner says the company looks for systems that have been the focus of management and that are not secondary assets that might not have received attention and investment. Other criteria are that targets compete well against cable operators, have limited losses of landlines and will be free-cash-flow-positive in the first year. In 2007, Windstream purchased CT Communications Inc., which had more than 130,000 lines, for roughly $600 million. "It's never been about just getting bigger for us," Gardner says. "I would like us to be a bigger company, if we could do it with the type of assets we are targeting." Gardner cites a 2002 transaction in which Alltel purchased nearly 600,000 lines in Kentucky from Verizon for $1.9 billion. "We did have to fix it up. We did have to invest capital right away," he says. "Because these markets weren't a big focus of the company we purchased them from, they needed a lot of attention and they lost market share." Windstream is paying 5.2 times Ebitda, or 3.7 times after expected synergies, according to Stifel, Nicolaus & Co. Frontier is paying 4.5 times Ebitda, Stifel says, and 3.6 times after expected benefits from the deal. Frontier is combining with a Verizon spinoff that operates 4.8 million landlines. The company expects sales to increase to $6.5 billion, from $2.2 billion, while its debt falls to 2.6 times Ebitda, from 3.8 times Ebitda. "It is transformational," says Frontier CFO Don Shassian. "It is very accretive. It really changes the nature of the balance sheet. It lowers our payout ratio, giving greater sustainability to the dividend." Frontier will pay $5.3 billion in stock to Verizon shareholders. It will deliver $3.3 billion in cash and debt securities to Verizon and assume some debt. The Stamford, Conn., buyer will need $3.2 billion in financing at closing. "Their synergy targets are very achievable. They are right in the range in what we would have forecast," Chris King, an analyst at Stifel Nicolaus, says. "On the flip side, there is some risk at the state regulatory level if regulators want to extract a pound of flesh." The telecom projects that the deal will be cash-flow-accretive in the second year. Frontier is also cutting its annual dividend to 75 cents, from $1, and aims to become investment grade. Two recent Verizon rural phone line sales have not worked out as planned. Hawaiian Telcom Communications Inc., which Carlyle Group bought from Verizon for $1.6 billion in 2005, went bankrupt in December 2008. FairPoint Communications Inc. bought Verizon landline units in Maine, New Hampshire and Vermont for $2.4 billion in 2008. The price was originally higher, but state regulators required Verizon to leave more cash at the units and put other financial limits on FairPoint. Hawaiian Telcom and FairPoint had similar problems. One was debt. FairPoint initially projected that its deal with Verizon would deleverage its balance sheet. As Ebitda fell, however, its debt ratios actually increased. Another problem: the switchover from Verizon's billing, customer care, human resources and other back-office systems. Frontier says comparisons with Hawaiian Telcom and FairPoint are off target. "Our view is there are four things distinctly different between those transactions and this one," Shassian says. First, Frontier's management is experienced at running a large-scale operation, with more than 2 million land-lines and $2 billion in revenue. It has integrated large acquisitions, such as its $1.2 billion buyout of Commonwealth Telephone Enterprises Inc. in 2006. Second is the nature of the markets, which are more remote than Hawaiian's properties and less competitive. "These properties are very rural," Shassian says, with only 37 landlines per square mile. They have less seasonal variance than FairPoint's New England markets. Leverage is another difference. Hawaiian Telcom and FairPoint were "well north of 4 times" Ebitda, Shassian says, while Frontier's leverage will come down to the "mid-2s" after the deal. Lastly, Frontier is buying operations in 14 states, 13 of which will have their own systems that they will still use after the deal. Frontier has to switch from Verizon's systems in only one market at closing. It will not have to undergo the same systems overhaul that sank Hawaiian Telcom and FairPoint. Meanwhile, CenturyTel and Embarq have received the final approvals, from Pennsylvania and Washington, that they need to close their merger. The deal still requires Federal Communications Commission clearance. CenturyTel, with 2 million lines, is buying Embarq, which has nearly 5.9 million lines and was spun out from Sprint Nextel Corp. The deal values Embarq's equity at $5.76 billion. CenturyTel will also assume $5.8 billion in debt. The new company will be called CenturyLink and will operate in CenturyTel's hometown of Monroe, La. Management projects $4.2 billion in Ebitda, on revenue of $8.8 billion. The company expects its ratio of debt to Ebitda to fall from 2.5 to 2.3. "The synergy numbers they laid out are very achievable and our guess will probably be exceeded over the next several years," Stifel Nicolaus' King says. In addition to Windstream, Frontier and CenturyLink, there are other mid-sized, publicly traded carriers providing landline service in rural markets with market caps in the tens of millions of dollars. The list includes Consolidated Communications Holdings Inc., Alaska Communications Systems Group Inc., Iowa Telecommunications Services Inc., Otelco Inc., Hickory Tech Corp., New Ulm Telecom Inc. and Warwick Valley Telephone Co. Consolidated CEO Bob Currey proclaimed, "We see ourselves as acquirers" during a late May investor call. As its name implies, Consolidated has history in M&A. McLeodUSA Inc. bought the company in the 1990s. McLeod later went bankrupt and sold the business to Providence Equity Partners Inc., Spectrum Equity Investors and management in 2002. Consolidated bought operations outside of Houston from TXU Corp. in 2004, went public in 2005, and bought North Pittsburgh Systems Inc. in late 2007. Consolidated's director of investor relations, Matt Smith, says the company seeks rural markets with affluent demographics, network quality, the capability to provide broadband services such as Internet protocol television without major investments, ease of integration and savings and other synergies. Consolidated wants cash flow to be accretive in the first year, although the company might consider a longer period if other factors make it attractive. Outside its territory, Consolidated targets companies with at least 50,000 landlines or $100 million in revenue. If a company is contiguous to its network, or within a state where it operates, it might consider smaller units, which are easier to integrate. Several factors could make life difficult for smaller rural phone and Internet companies. One is competition from cable operators. Last year, former FCC Chairman Kevin Martin advocated rules about how carriers compensate each other that favored larger telecoms. For now, intercarrier-compensation rules do not seem to be the top priority for the new FCC. As Martin's proposals demonstrated, changes in the rules could effect the economics of rural telecoms and change the way some companies view their prospects. Debt maturities could force sales. Some carriers may have net operating losses that reduce their tax payouts. When the NOLs expire, some companies may find it harder to support their dividends. As it has struggled, FairPoint stopped paying its dividend in 2008. "There are some very good companies out there that are much smaller than us, and I'll think they'll do very well," says Frontier's Shassian. "Others might not feel very comfortable in their skin, and they'll want to get larger." In a slow-growth industry such as rural telecom, dividends are a key part of the value proposition. In 2004, Frontier, which was then called Citizens Communications Corp., supercharged its dividend with a one-time, $2 payout on top of a regular $1 annual dividend after a closely watched strategic review. Other carriers followed suit, and high-dividend, high-yield strategies became popular in rural telecom. When it announced the deal with Verizon, Consolidated also disclosed that it would scale back its dividend to 75 cents per share, from $1. "We do have a change in philosophy," Shassian says. The company did not plan to reduce the dividend before the Verizon deal. Frontier was influenced to scale back the dividend because of the size of the transaction, which requires investments to upgrade networks and will face regulatory scrutiny. "It's a little bit heavier investment than we would have made otherwise, and than Verizon has been making," Shassian says. Rural telecoms must balance supporting their dividends, potentially acquiring other telecoms and investing in networks so they can offer broadband services. While rural carriers have traditionally been buffered from competition, wireless and other services have leached away business. Cablers have introduced Internet-phone and high-speed Internet services. The slow erosion of the customer base is a fact of life. In the first quarter, Frontier lost 7% of its lines, CenturyTel shed 6.7%, Windstream, 5.3% and Embarq, 2.5%. The decline in customers can be offset by more services, such as high-speed broadband or video. "If your payout ratio is 90% and you're losing 10% of your access lines per year, that's very difficult to maintain," Gardner says. The next stage of expansion may be challenging, because there are fewer potential partners. Verizon has said it's done with its rural divestitures. AT&T Inc. chairman and CEO Randall Stephenson said at an investor conference in late May that while the Dallas telecom regularly considers carving out rural assets, such a divestiture would be difficult and is not a current priority. Qwest Communications International Inc. is a wild card. The telecom pulled an auction of its long-distance fiber network in June. Had it been able to unload the asset and reduce its debt, the Denver telecom could have been a player in the rural market. There are midsized carriers, such as Consolidated, which views itself as a buyer, and Iowa Telecom. Hawaiian Telcom's reorganization would leave its lenders, led by Lehman Commercial Paper Inc., with most of the equity in the company. The lenders presumably would not want to be long-term telecom operators. With fewer options for "transformational" deals, scale and synergies may become more elusive. Though they are coveted, synergies are by their nature fuzzy. The value of savings and other benefits is based on comparisons with assumptions of how companies would have performed if they remained independent. "I haven't seen a telecom acquisition yet when companies didn't
decide that they hit their synergy targets," says Stifel Nicolas
analyst King.
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In rural telecommunications, M&A has long been part of the competitive landscape. 
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