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FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Investing in Rural US Telecom companies via Trusts and REITS

Companies / Investing Mar 15, 2007 - 12:39 AM GMT

By: Roger_Conrad


Where have all the high yields gone?

With top-quality utilities and real estate investment trusts (REITs) paying out 3 percent or even less, it's certainly become a lot more difficult to earn a decent income return in recent years--particularly if you stick to Wall Street's beaten path.

Of course, real bargains are hard to find, even if you're willing to buy something that's not a mainstream, NYSE-listed stock officially sanctioned by your broker. But your odds improve considerably if you go where others fear to tread, either because of complexity or simple bearishness.

Rural telecommunications companies carry the burden of both objections. And though they've thrown off some substantial gains over the past year or so, they're still one of the cheapest and highest-yielding sectors.

Since the late 1990s, telecommunications has been one of Wall Street's least-loved sectors. Rather than focus on rapidly growing broadband and wireless service--and the stabilizing of pricing power--the financial media has stuck to the negative year after year, focusing on telecoms' hefty capital spending, competitive threats and the steady erosion of the basic local and long distance telephone business. That's weighed on share prices across the board.

At the same time, investors have been hot and heavy for telecom upstarts attacking the franchises of incumbent telephone and cable television providers. During the '90s, competitive local exchange carriers (CLECs) garnered hundreds of billions of dollars on Wall Street.

That craze ended disastrously, as CLEC after CLEC went belly up and completely wiped out investors. But the aftermath didn't stop the Street from salivating anew over the same concept this decade with Voice over Internet Protocol (VoIP) companies, which provide phone service over computer lines in competition with incumbent providers.

The poster child for the frenzy was VONAGE (NYSE: VG) and its widely anticipated initial public offering. It turns out the IPO came about a year too late. Vonage popularized VoIP via lavish advertising campaigns and convinced a large number of people to drop their basic phone service. The cost to Vonage itself, however, has been staggering. With price as its primary and only appeal, the company's profit margins are non-existent, and they're likely to get a lot smaller thanks to a recent court ruling that it infringed on three patents owned by VERIZON COMMUNICATIONS (NYSE: VZ).

As for the stock, it came out as a high-priced IPO, enriching insiders. But it was a complete catastrophe for investors, including customers who were induced to buy shares and were later threatened with lawsuits if they failed to pay well above market for shares.

Investors' fascination with underdog telecoms and corresponding loathing of big telecoms is always just a bit below the surface. But that duality has receded a bit over the past year, at least for some of the larger incumbent players.

AT&T (NYSE: T), for example, has surged in the wake of its successful merger with Bell South. COMCAST (NSDQ: CMCSA) has had phenomenally good fortune selling a basket of entertainment, broadband and communications services. And wireless companies like ALLTEL (NYSE: AT) have soared on robust growth and takeover speculation.

Rural phone companies too have been strong performers, particularly since the second half of 2006. We've seen some decent returns from the likes of CITIZENS COMMUNICATIONS (NYSE: CZN) and WINDSTREAM (NYSE: WIN), and even some huge gains from takeovers like Commonwealth Telephone.

By and large, the group is still in Wall Street's doghouse, where it's been for the better part of a decade. In fact, the higher their prices have pushed during the past few months the deeper analysts' gloom. Most rural telecoms now rate very poorly in Street opinion. In fact, one major house recently asserted that “rural telco stocks may have run their course.”


Why are Wall Street and most investors so bearish on rural telecoms? The biggest reason is lingering doubt about the long-term viability of their primary asset: the same copper phone lines that have connected country and city for more than a century. 

We are moving toward a broadband and wireless world, away from the old phone line technology. But the actual process is going far slower than the hype would have us believe. As a result, there's still plenty of money to be made from the old network.

True, second phone lines once used for dial-up Internet are giving way to faster DSL, cable modem connections and state-of-the-art fiber optic networks like Verizon's. This week, Verizon won a statewide franchise to offer cable television service in California, which should accelerate the rollout of its nationwide FiOS network. Some younger users have cut the cord entirely, relying solely on wireless phones. And VoIP is also gaining popularity, with cable television companies the market leaders.

The actual attrition rate for the copper network, however, is still in the mid single digit area, even in the urban areas. And it's even lower in the rural areas, where the population is simply too sparse to support competing networks. Rural pay television service is more often provided by satellite rather than high capacity coaxial wire, and wireless reception is considerably less reliable than in urban areas.

In short, even though the number of connections is declining, the old copper network is still the dominant form of communications in America. And it's certain to remain so for many years to come, particularly in the rural areas.

Slow decline rates mean rural telecoms to date have been able to completely offset their losses and then some by signing up customers to broadband service, holding their total revenue generating units steady. In addition, this upselling of customers requires very little additional investment. Profitability per customer is actually rising, particularly combined with cost cutting.

Consequently, the key metric for rural telecoms isn't the number of copper connections they have, or are at risk to losing. It's cash flow. With total revenue generating units steady, sales are stable to rising. That means cost cutting and debt reduction impact directly on cash flow, which in turn can be used for further debt and stock buybacks as well as distributions.

Rural telecoms also have another advantage over others in their industry: a guaranteed government subsidy under the Universal Service Fund (USF). USF is basically a fee levied against urban carriers to help offset the cost of providing rural service, where the economies of scale are more difficult. The actual amounts provided can vary and depend on the Federal Communications Commission and others to stay on top of them. But they're a handy source of additional income for rural players.

Taken together, these advantages made rural telecoms literal cash machines. Unlike many dividend-paying companies in other industries, rural telecoms pay their dividends entirely from free cash flow, with an average funding payout ratio of about 60 percent.

Here's where the complexity issue arises. The traditional way of calculating a payout ratio is to use earnings per share as the denominator, with the resulting figure dividends as a percentage of earnings.

With a rural telecom the result of that calculation will almost always dramatically understate dividend safety. For one thing, because the business is mature it carries huge non-cash expenses like depreciation and amortization that can be written off every year.

In most businesses, this money must be reinvested in productive equipment systematically, or else the company will soon go out of business. But rural telecom infrastructure requires little additional investment to maintain. In fact, virtually anything these companies spend on capital costs is in assets that will produce additional revenue. Cash from depreciation and amortization is generally free to be used to pay off debt, buy back stock or pay dividends.

The rural telecom business is also rapidly consolidating, as companies buy properties and even merge with each other. Citizens Communications this week completed the purchase of Commonwealth Telephone. Windstream was built on the merger of the wireline assets of Alltel with the former Valor Communications. OTELCO (NYSE: OTT) last year purchased a Maine communications company. And there are many more deals ahead, including Verizon's spinoff of some of its rural New England properties to FAIRPOINT COMMUNICATIONS (NYSE: FRP) in a deal to be completed later this year.

Every purchase like this creates a mountain of goodwill on the balance sheet of the acquirer, which can be written off over time. Other rural telecoms, meanwhile, have huge loss carry-forwards that can be matched against taxable earnings per share.

The result of all these machinations is that rural telecoms can keep taxable earnings per share low. That minimizes tax liability and maximizes free cash flow. Citizens Communications hasn't paid federal income taxes for the past several years. And the Commonwealth deal is likely to keep future liability on the low side as well.

Otelco, meanwhile, has gone a step further by organizing as an Income Deposit Security (IDS). IDSes are basically a single security combining an equity portion with a high-yield debt component. The debt interest is deductible by the company on taxes, further boosting free cash flow, and allows it to pay a much higher dividend as well.

The confusion comes in with popular investment data and research services, which continue to insist on using earnings per share to calculate rural telecom payout ratios. One of these issued repeated warnings about Citizens' dividend over the past several years based on this data.

Those who followed their lead have missed out on the juicy dividend as well as modest appreciation. But the opinion has no doubt kept many investors away from Citizens, as well as other rural telecom stocks.

Looking ahead, rural telecom stocks are going to continue to lose basic phone line connections. They'll offset those losses by upgrading customers to broadband service and by making more acquisitions, which will subsequently increase their pool of customers to upsell broadband service to. They'll continue to squeeze costs out of their networks and will use cash to reduce debt and buy back stock. And all of these actions will boost free cash flow.

Some of the rural telecoms I follow are starting to spend more on network upgrades to enhance their advanced services. That fact has been cited by the bears as something that might crimp further cash flows and ability to pay dividends.

I view it, however, as a further affirmation that this business model works, and that rural telecoms can generate enough cash flow to grow as well as pay bid dividends. It may crimp further distribution growth for some. But it should ultimately make the companies' current yields--which still range from 7 to 9 percent paid quarterly--a whole lot more sustainable for the long term.

That's still not fully recognized in the marketplace and certainly not in their share prices. The result: Rural telecoms still have plenty of generous total returns left in them, and they remain one of the few remaining pockets of real value in the universe of yield-paying investments.

No one type of income investment is a portfolio panacea. In fact, it's exceedingly dangerous to invest too heavily in one particular asset or stock group.

But held in a diversified portfolio that includes a range of high-quality investments such as utilities, REITs, trusts, limited partnerships, bonds, preferred stocks, bank stocks and super oils, rural telecoms are more than worthy investments. And they're especially good buys when Wall Street is in a bashing mood.

By Roger Conrad
KCI Communications

Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.

KCI has assembled a team of top investment analysts to create the finest financial news service possible. With well-developed research skills and years of expertise in their particular fields, our analysts provide quality information that few others can match.

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