Yield signs

To call the success of Iowa Telecom's IPO a fluke would do disservice to the hours of work put in by employees to turn the company into a public entity. It also would give too much credit to an uncontrollable factor. But getting the investing public to take notice of a company whose sole business is providing local telephone service to towns with populations of less than 2000 people is more than just coincidental.

On Nov. 18, 2004, Iowa Telecom's shares began trading on the New York Stock Exchange. At the time, a few financial publications took note, if only because of the dearth of IPOs in the telecom industry throughout the year. But for telecom executives across the independent telco landscape, the day could, at some point, be seen as the shot heard ‘round the market.

That first day of trading, investors bumped Iowa Telecom's shares up 9%. That may sound paltry when compared with the late 1990s, when shares routinely doubled and tripled on their first day out, but when set against the background of a relatively flat market, it garners instant respect.

Originally, Iowa Telecom — which was formed by Iowa Network Services, the consortium owned by 135 local incumbents across the state and ING Barrings to acquire GTE access lines in Iowa — had planned to offer Income Deposit Securities (IDS), a kind of hybrid security that is one part stock and one part bond. The appeal to investors was the ability to own both in one entity, collecting interest on the bond and still having an equity stake. But after shopping the plan to investors, Alan Wells, president and CEO of Iowa Telecom, ran into some unexpected resistance. For one, there was and still is the unresolved question of how the IRS will tax the income generated by the bond portion of the IDS. Investors also didn't seem to grasp the idea, or simply didn't feel the need to understand, given the number of other financial options. The company decided to move forward with a traditional IPO instead.

“The IPO structure is a much simpler, cleaner structure and much easier understood by investors,” Wells said.

What made Iowa Telecom different at the time of its IPO, though, was the piece it kept from the IDS offer — an healthy dividend of $1.62 per share it was promising to pay investors. With an initial price of $19 per share and the stock hovering around $20 in mid-January, that dividend represents a yield of more than 8% annually. By comparison, SBC Communications yields 5.2%, and the S&P 500-stock index currently yields about 1.8%.

“I look at it as very stable and solid and relatively high dividend,” Wells said. “Since folks have focused on the dividend, why not do it in a way they can understand?”

Iowa Telecom certainly is not the first public company to use its dividend as an attraction for investors. And it's not even the first telco to do it: In July, Citizens Communications decided to pay out a special $2 per share dividend and instituted a $1 per share annual dividend. However, the fact that Iowa Telecom has been able to maintain its price well after its IPO has a lot of executives taking notice.

“A lot of excitement has been prompted by Iowa Telecom's IPO because they're really leading that high-dividend IPO wave,” said one private equity manager who requested anonymity.

Indeed, since Iowa Telecom's IPO, Alaska Communications Systems, Fair-Point Communications and Valor Communications all have dropped plans for IDS issues and instead moved forward with high-dividend financial structures (see figure, page 22 ). The same structure is being examined by RBOCs contemplating spinning off large chunks of rural access lines, according to one source. Only Otelco, an Alabama company created to acquire and operate rural local carriers, has opted for the IDS (see sidebar, page 24).

To some extent, the success of Iowa Telecom's IPO can be found in the current interest rates. With interest rates low, investors are looking for a safe place to put their money and still generate solid returns, Wells said.

“[The dividend] is a big selling feature to investors,” he said. “We're going to be at about 8% a year in dividend yield. With the current tax laws, that's pretty attractive.”

However, a number of telco executives and others are questioning the impact of such financial structures.

“When interest rates go up, as they inevitably will, the attractiveness of these high-dividend stocks will diminish,” said the private equity manager. “When treasuries are paying 6% or 6.25%, a 7% dividend with an [ILEC] is not going to be as attractive.”

Many also are questioning whether the telcos that have committed to paying high dividends can continue fulfilling that promise given their unique circumstances.

“In the Iowa Telecom deal, they're promising huge dividends,” said Bill King, president and managing principal with JSI Capital. “That's the formula everyone is going to. The problem with that is that unless management can take that and get into growing businesses, which by and large most of the ILECs haven't done a good job of, it's difficult to sustain.”

Wells, however, defends the sustainability of the company's financial structure by noting that the company has plenty of growth options, including acquisition. Currently, Iowa Telecom operates just north of 265,000 access lines, which makes it the 15th largest U.S. telco.

“I think there's a good chance that there will be some more access lines on the market soon,” he said. “We think there's a good chance we'll be in the hunt [for those]. We think we're a natural consolidator. [Our structure] gives us a lot of flexibility to acquire lines. We can issue stock; we can raise debt. We have a lot options.”

There also are a number of ways to expand product offerings without major investments, Garner said.

“How much does it take to resell long-distance?” he said. “Not much.”

Not every independent is convinced that the rush to pay out high dividends is a positive. In fact, many have expressed concern that with big chunks of cash committed to paying out dividends, carriers won't have enough for network investments in the face of changing competition.

“My view is that you've committed all your cash flow to paying dividends,” said Brian Strom, president and CEO of SureWest. “If you're in a competitive marketplace like SureWest, we need to invest in the future to stay ahead. It's a model that doesn't fit our company.”

CenturyTel, which faces some competition in a couple of markets but has yet to see a large threat, is taking more of a wait-and-see attitude. However, the company is now regularly asked by investors about raising the dividend, said Stewart Ewing, chief financial officer of CenturyTel.

“It's probably the number one question that we get now and has been since Citizens' restructuring,” he said. “Our answer has been that we have been able to drive returns to shareholders by not paying a higher dividend and reinvesting the cash internally. We're going to let this structure settle and see how these stocks perform in different interest rate cycles.”

There's also a bit of a dangerous precedent to setting a high dividend, Ewing added.

“Once you commit to a dividend, it's a long-term commitment. With everything that's going on in the industry with respect to competition and the regulatory items like Universal Service and intercarrier compensation reform, we felt it prudent not to commit a lot of cash to a dividend to the point that it would be hard to retrace our steps.”

Wells, however, said Iowa Telecom has enough predictable cash flow to pay its dividend and invest in the network.

“We've spent some time talking to investors about that,” he said. “We think $29 million to $30 million in capital expenses is pretty good. There's a certain amount to capex we're going to spend. On top of that, even though we pay out a high dividend, you'll see we have plenty of cushion.”

Wells' view on competition also is shaped by what he says is the reality of Iowa. The company faces competitors in about 40 of its 294 exchanges where it operates as the incumbent. Additionally, like many independents, Iowa Telecom operates a CLEC arm (Iowa Telecom Communications). But that doesn't mean the company is in a generally competitive situation. Nor does it see much of a threat from non-facilities based providers like Vonage and Packet 8.

“We serve a lot of towns that are 1000 or fewer in population,” Wells said. “Most towns recognize that small towns have a hard time supporting two gas stations, much less two telephone companies. Mediacom [the 8th largest U.S. MSO] has announced it will offer voice, but so far we haven't seen it. Given the nature of our territory, it's difficult for them to do that. As far as Vonage, we've seen it a little but not that much. It's more of an urban product.”

Despite their relative insulation from the type of competition bigger carriers face, rural carriers like Iowa Telecom will see competitors because of evolving technology and business models that make it easier for new entrants to compete, according to JSI Capital's King.

“ESPN's [mobile virtual network operator] announcement changed everything,” he said. “Wireless all of a sudden changed. Kids are going to be walking around with cell phones that are branded with specialized content.”

Many of those that are skeptical of the Iowa Telecom-like structure believe the high-dividend IPO is simply the most palatable way for the private equity and/or venture capital players to cash out on some of their investment.

“Companies like Valor and Iowa, for the most part, have been VC-backed, and it's a way for the VC folks to get some liquidity,” Ewing said.

At the same time, the structure provides a visible path for private equity players looking at the rural telco market, which is not necessarily a negative for the industry. The Carlyle Group, which has hired former FCC Chairman Bill Kennard as a managing director, is on the cusp of getting regulatory approval to acquire Verizon's access lines in Hawaii for $1.6 billion. Attracting a company with Carlyle's management roster (former IBM Chairman Louis Gerstner serves as chairman) and financial pull can only be construed as a positive for rural telcos.

“After the boom and bust of the '90s, I was afraid they would flee forever,” said SureWest's Strom. “They are paying some pretty decent prices for these properties. If they weren't there, I would be very concerned.”

Indeed, Wells said private equity activity as a good barometer for the entire industry.

“They serve a very useful role,” he said. “At times they get an undeserved reputation because they're focused on the financial performance of the market.”

Perhaps even more important, private equity participation has changed the way independent telcos are valued and how companies like Iowa Telecom look at future acquisitions.

“People look at valuations in so many different ways,” Wells said. “I hear price per access line, and it's all across the map. We have to be very cash-flow focused. There are not one or two criteria for acquisition; there's a lot. It needs to be geographically concentrated in the Midwest. It needs to be clearly additive or a new geography that makes sense. A thousand lines in Michigan might not make sense, but 1000 lines in Iowa might. For us, it doesn't make sense to make an acquisition just to buy something.”

VALUING INDEPENDENTS

>RECENT ACTIVITY OF INDEPENDENT TELCOS OFFERING SHARES TO THE PUBLIC

COMPANY	TYPE	VALUE	OWNERSHIP
FairPoint Communications	Traditional IPO	Net proceeds of $450 million	Thomas H. Lee Equity Fund and Kelso will own about 11.8% and 10%, respectively.
Iowa Telecom	Traditional IPO	Net proceeds of $141.2 million	INS owns roughly 20% after the IPO; ING (under FS Private Investments III LLC) maintains 10%.
Valor Communications	Traditional IPO	Net proceeds of $465.1 million	Welsh, Carson, Anderson & Stowe and affiliates of Vestar Capital Partners and Citicorp Venture Capital Ltd. maintain stakes.
Alaska Communications	Recapitalization	Net proceeds of $64.9 million $117.3 million to existing equity investors	Fox Pain & Co., which owned 64% and formed the company in 1998, will maintain 49% ownership after IPO.
Otelco	IDS issue Each IDS represents one share of Class A common stock and $7.50 principal amount of 13% senior subordinated notes due 2019.	$117.3 million to existing equity investors	Seaport Capital, CEA Capital and BancBoston Ventures all maintained their previous ownership levels after IDS was issued.
Source: SEC filings

OTELCO STAYS THE IDS COURSE

At the beginning of 2004, half a dozen carriers were talking about issuing Income Deposit Securities. By 2005, only Otelco had done it.

While many had questions about the IDS structure, which combines one share of stock and a certain principal amount of subordinate debt, Otelco saw it as the most viable option for its specific situation.

“If we had just done a straight equity issue, we would have been relatively small,” said Curtis Garner, chief financial officer of Otelco. “A lot of people may have backed away [from the IDS] because it was new, and the [Securities Exchange Commission] was being very thorough.”

Investors also had a hard time understanding the IDS model — and still do. “I get a call a day from brokers every day who can't believe we have equity and debt in the same security.”

Formed in 1998, Otelco has acquired four telcos in Alabama and Missouri. The IDS structure gives the company more options to finance future deals, Garner believes.

“Two-thirds of the return of taking the IDS is a debt instrument; that makes it a safer process [for the selling company],” he said.

Given the number of lines that may be coming on the market over the next year, Otelco may positioned to be an active acquirer. However, the company is setting strict parameters on potential targets.

“We're not interested in buying castoffs from Alltel and GTE,” Garner said. “We're looking to pick up companies in the 4000 to 15,000 access line range. Generally, they're owned by family businesses. If they haven't started fiber deployment and they're on an old crossbar switch, we're not interested.”
— Vince Vittore