IOWA TELECOM FILES IPO PAPERS AFTER NIXING HYBRID FINANCING

Iowa Telecommunications Services last week officially gave up on a new kind of financial security as a potential avenue for funding and instead filed papers to offer a traditional IPO. The move marks the first significant change for a group of five carriers that had initially intended to offer income deposit securities, or IDSs, a hybrid instrument that combines common stock and debt.

Almost six months after Iowa Telecom, FairPoint Communications, Valor Communications, Alaska Communications and Otelco Telecommunications filed plans to issue IDSs, no other carrier has moved forward. And speculation is now running high that IDSs may be put on hiatus or canceled altogether by some.

Though all of the carriers involved are barred from publicly discussing the issue, a number of sources involved in the deals say potential buyers, which include large retirement funds and mutual fund managers, are becoming more leery of the security, which offers both dividends on the stock element and interest from the bond element.

For the carriers, IDSs are a good way to de-leverage their balance sheets while providing investors a steady steam of income. For investors in rural telcos, that yield is much better than they would have been getting with regular dividend payments and represents a greater percentage of a company's cash flow than before.

“They're not really doing anything that is all that unusual; they're essentially securitizing junk debt,” said Bill King, president and managing partner of JSI Capital, which advises buyers and sellers of local access lines. “There are a lot of people that, over the last four or five years, would have been happy to have an 8 percent yield. A lot of people say this is smoke and mirrors, but I think it's a more efficient financial instrument.”

IDSs in general, however, have a number of significant question marks surrounding them and some specific dangers as they relate to rural carriers. First and foremost is how the IRS treats the dividend and interest income from IDSs. If the IRS treats IDS income as regular income or if there is a jump in tax rates on dividends, carriers will lose one of their biggest selling points, King said.

“If it goes up to 20 percent or it goes back to normal income rates, this issue is dead in the water,” he said. “My sense is there's a lot of smart people working on this, and they'll get something that the IRS can live with.”

According to the financial prospectuses put out by the five carriers, the IRS should treat IDS income and dividend in the same manner as other securities. But according to at least one investment banker involved in several offerings, potential buyers are concerned.

“The real question is what does “should” mean?” he said, referring to the lack of certainty about the IRS' position on the matter.

Just as important is how IDSs may impact rural carriers' ability to buy and sell access lines. For several years there has been significant speculation in the independent operator community that there would be a considerable consolidation of rural telcos. However, as of this year, the only major deal that has closed is Verizon's sale of its access lines in Hawaii to Carlisle Group. There is some concern that carriers that convert to an IDS structure may be at a disadvantage if and when consolidation begins because issuing IDS as deal currency could commit large amounts of company cash flow to paying interest on the resulting debt.

Citizens Communications, no stranger to the deal market, executed what King called a “homespun” IDS by opting not to sell off its properties and instead give shareholders a special $2 per share dividend plus instituting a $1 per share annual dividend. That annual dividend, according Citizens, represents 73% of the company's expected free cash flow for 2004.

“We considered every possible alternative and opportunity that all of us could collectively come up with,” said Jerry Elliott, chief financial officer and executive vice president of Citizens at the time the dividend was announced. “The sole objective was to find a way to cap on the strength and power of this company's free cash flow.”

From a competitive perspective, committing so much cash flow to paying back investors could be dangerous. Though rural carriers generally haven't faced significant competition yet, the ability to respond quickly to a company like AT&T offering voice over IP could be hamstrung.

“There's some inherent danger on how these companies will respond to significant capex increased for competitive reasons,” King said.

Ultimately, according to one source working on several deals, investors must decide how they view the telecom industry.

“It really comes down to the question of whether telecom is a growth industry or not,” said the source. “Everyone talks about cash flow, but the investors never see it, and this one way [through IDS dividends] they will.”

RECENT IDS FILINGS

3/25	FAIRPOINT COMMUNICATIONS	$750 million
4/8	IOWA TELECOM	$725 million
canceled for traditional IPO
4/8	VALOR COMMUNICATIONS	$875 million
4/12	ACS	$400 million
5/10	OTELCO TELECOMMUNICATIONS	$190 million
Source: Company information