RLEC M&A faces tough timing

The acquisition of Embarq this week by a company half its size illustrates the unpredictable result of the opposing dynamics now dominating the rural local exchange carrier (RLEC) sector: the pressure to participate in mergers and acquisitions (M&A) and the turbulence in the financial markets, which make M&A harder. The combination leaves RLECs with the difficult decision of acting now, when economic visibility and valuations are low and the cost of capital is high, or waiting and taking their chances with an unknowable future.

This summer, before the financial market meltdown, many had expected RLEC M&A to heat up in this year’s second half. In particular, speculation focused on Windstream and Embarq, which both saw tax restrictions (stipulated in their spinoffs from Alltel and Sprint, respectively) expire this summer, allowing them to issue more stock to fund deals. But Windstream, which has said for months that M&A might swell as credit markets improved, has only seen credit markets worsen. This summer, many high-yield lenders were offering debt at 3% or 5% above the LIBOR rate (an interbank interest rate); these days it’s more like 8% or 10%, according to Gerald Granovsky, vice president and senior analyst with Moody’s Investors Service.

As a result, even as recently as last week, many analysts expected RLEC M&A would likely pause until at least the new year.

“Until credit starts to flow, I don’t think we’re going to see much [RLEC M&A],” Francis Gallagher, Jr., managing director at Stifel Nicolaus, said in an email last week. “With the credit crunch, M&A has slowed down considerably, even though the fundamentals of the industry (competition, threats to regulatory revenue streams) would suggest a strong M&A market.”

However, all-equity deals such as the one CenturyTel and Embarq announced this week were the exception to that rule, since they don’t entail taking on new debt.

“M&A will be challenged, but not impossible,” Granovsky said last week. “Especially if it's done with equity and the RLECs get their banks to agree to waive change of control conditions.”

Some lenders include “change of control” provisions in their loans that could force borrowers to refinance in case the company changed hands, as in the case of a merger. (CenturyTel has said its debt includes no such provisions.)