Opportunity keeps knocking

In preparing for any acquisition, rural LECs should do more than review historical prices. Strategies that involve evaluating the tactical rationale, forming a consortium, and establishing a price ceiling should be considered.

Solo or tandem?

The lines should be sold in “big buckets,” Nacchio said. This suggests that any divestitures would be targeted toward consolidators like Citizens or Fairpoint Communications. Most rural divestitures have been sold this way. However, smaller independent LECs have also formed consortiums to purchase divestitures.

In 1993, for example, six Montana cooperatives--Blackfoot Telephone, Mid-Rivers Telephone, Nemont Telephone, Range Telephone, 3 Rivers Telephone, and Triangle Telephone Association--formed a buyers consortium to acquire one of the first rounds of U S West exchange sales. The members appointed a deal team to represent the consortium. This provided a unified negotiating liaison and helped facilitate the transaction.

U S West was more likely to sell to a consortium instead of negotiating six separate smaller sales. In 1999, five Utah-based independent LECs--Central Utah Telephone, Manti Telephone, UBTA Communications, Skyline Telecom, and Carbon/Emery Telcom--formed another similarly effective consortium to purchase several exchanges in rural Utah.

A smaller or less-experienced buyer can also align with a larger LEC to share experience, resources and expenses. The smaller buyers improve their bargaining position and the larger buyer can help ensure that their purchase is targeted to an exchanges it wants. The seller can sell a larger and more diverse block of exchanges.

This worked effectively for Spectra Communications Group in the 1999 acquisition of 116,000 GTE lines in Missouri. In this venture, a telecommunications infrastructure construction contractor in Atlanta, Spectronics, teamed with Louisiana-based regional LEC Century Tel. and Kansas City, Mo.-based private equity firm Local Exchange Carriers to make the successful bid.

Cooperation is key

While a consortium or strategic alliance offers many advantages, it also means managing differing strategic interests and investment philosophies. Some purchasers might consider the acquisition of a contiguous exchange simply to build a larger exchange or to offer their new rural customers improved telecommunication services.

Others may purchase purely for economic gain while maintaining a clear target rate of return and exit strategy for their investment. Differing investment philosophies and conflicting negotiating styles can create friction and lead to infighting between the consortium members.

Establishing a formal agreement among consortium members can enhance cooperation. This agreement should outline the process and clearly define rights and responsibilities of the group during negotiations. In addition, a deal team should be formed to represent the consortium to the seller. Be sure to consider any deadlines or time constraints that the seller may be under to complete the transaction.

Obviously, consultants and financial advisers are essential to the bidding process, but to the degree possible, limit the number of advisers and make sure these advisors represent the consortium, not the interests of any individual member. Be flexible, and be prepared to compromise to achieve the larger goal of successfully negotiating the deal.

Cost justifications

Past divestitures have been relatively easy to justify. Rural LECs could easily recoup their investment through network access charge revenues and Universal Service Fund revenues. But today, access charge reform and competition from cable, satellite, and wireless are forcing many LECs to supplement and defend their traditional revenue base by investing in new non-regulated operations.

This means higher capital expenditures and related expenses to develop non-regulated revenue streams such as Internet, fiber transport, wireless, and possibly CLASS, second lines, DSL, and cable television. Today’s growing demand for broadband connectivity requires new outside plant and central office upgrades in order to provide high speed data services such as ISDN and DSL. Many LECs are also now engaging in CLEC activities in contiguous markets or even overbuilding an adjacent incumbent carrier.

The proliferation of new telecommunication products and services in rural America is causing a trend toward increasingly higher leverage. The increased variability of core LEC cash flows, and the trend toward cannibalization of those cash flows by non-regulated activities and stiffer competition, has caused many lenders to ask for a higher proportion of equity required to support line acquisitions.

Many rural LECs are cooperatives and view the acquisition of contiguous local exchanges as an opportunity to better serve their communities. While social and economic factors have always played a role in justifying the purchase of rural telephone exchanges, the absolute rate of return on those assets was often not the primary consideration for many cooperatives. Recent trends, however, affect the predictability of core LEC cash flows. This, coupled with increased equity requirements, makes justifying the economics of a new exchange purchase more important than ever.

The best way to evaluate the economic rationale for an exchange acquisition is by discounting the free cash flows from a carefully prepared seven- to ten-year financial projection. Generally, the definition of free cash flow is (EBIDTA less capital expenditures and working capital needs. Discounted cash flow (DCF) analysis requires the buyer to specify a “discount rate” which is a blended target rate of return for the investment. In DCF analysis, this rate is usually referred to as the weighted-average cost of capital (WACC). The WACC is the rate of return from the investment that, if obtained, will satisfy both the equity investors and any creditors. The weights are percentage representation of equity and debt in the acquisition capital structure.

In DCF analysis, the projected free cash flows from the exchange and a terminal value, or estimated price to be received by selling the exchange at the end of the projection period are discounted at the WACC to arrive at a present value for the series of cash flows expected to be realized from the exchange. This value represents the theoretical maximum price the buyer should pay for the exchange. Acquiring the exchange for less than this price simply increases the returns to the equity investors.

It is still possible to pay too much for an exchange, as long as the purchase price is less than the value calculated in the DCF analysis. The buyer's cash flow projections could be wrong, the discount rate or WACC might be dramatically underestimated--there are dozens of issues to consider in calculating a DCF analysis. It is imperative that an experienced financial advisor prepare or at least review projections.

Here are some points to consider when performing or reviewing a DCF analysis:

Are the underlying projections of cash flows reasonable? Scrutinize growth, product penetration, capital expenditures, and pricing assumptions for reasonability and compare your assumptions against industry benchmarks.

How were the components of the WACC calculated? Choose a WACC that is too low for prevailing market conditions and you may find you've paid too much for the property. Choose a WACC that is too high, and you’ve lost the bid. The WACC will shift over time, in response to the perceived volatility of returns from LEC assets, the general level of interest rates, and the rates of return offered by alternative investments.

Carefully examine the assumed mix of debt and equity in the WACC calculation. Is the assumed percentage of equity capitalization consistent with the present underwriting preferences of creditors? Is the required rate of return on equity consistent with the risk-adjusted returns available on alternative investments (could the equity be more profitably employed elsewhere)? Closely scrutinize WACCs higher than 15% or less than 11%.

How was the terminal value established? There are various approaches to calculating a terminal value. The two most widely used are the market multiple method and the perpetuity growth model (PGM). The PGM is a mathematical formula that derives a terminal value by taking the projected free cash flow in the terminal year, usually between seven and ten years from purchase, and applying an average growth rate at which the free cash flow can be expected to grow from that point on--forever.

It is critical to seriously question LEC perpetuity growth rates exceeding 10%. Most PGM calculations use growth rates between 3% and 7%, depending on the nature of the business. If using a market multiple, consider the fact that current market conditions may either overstate or understate today’s valuation multiples. For example, the telecom industry saw valuation multiples for LECs rise from six to seven times EBITDA to nine to 12 times EBITDA between 1996 and 2000. Many factors account for this increase, but one of the most fundamental is the high growth in cash flows promised by broadband data services.

Will those growth rates continue ten years from now? Is today’s conservative approach to valuing telecommunications companies justified? While it is unlikely to determine the true terminal value of a project, it is worthwhile to note whether the PGM is a conservative or optimistic assessment of the project’s likely value.

Perform sensitivity analysis. Incorporating different projection scenarios will test how sensitive the bid price (present value) will be to reasonable changes in the WACC, terminal value, and the cash flows of the project. This will provide the bidder with a range of prices that might justify this investment instead of a single upper-end price. Realize that the WACC and terminal value assumptions often have an even more profound impact on the results of a DCF analysis than the projected cash flows.

Solve for “implied” DCF assumptions when evaluating offers or counter-offers. You can uncover some very interesting information by inputting a certain price into a DCF analysis, then solving for the terminal value assumptions or WACC that is implied by the purchase price.

Suppose, for example, that an exchange seller or financial advisor proposed that $4,000 per line is a good price for this exchange. Based on your forecast of cash flows from this exchange, the terminal value, and the expected cost of the debt to acquire the exchange, what would the rate of return to the equity investors be? Does it meet the hurdle rate? Alternatively, holding the WACC and the projected cash flows constant, a carrier could easily back into the terminal value that would be required to make $4000 per line the right number.

After establishing a reasonable terminal value for a project, a logical next step is to determine the implied perpetuity growth rate of cash flows needed to produce predicted terminal value. If a terminal value for a project was $10 million, for example, solving for an implied perpetuity growth rate could shed light on the reasonableness of this value. If a $10 million terminal value can only be achieved through a continual 20% growth in perpetuity, then it likely that some assumptions are dramatically off. However, if the implied perpetuity growth rate is closer to 2% to 3%, then the estimated terminal value might be considered achievable.

If you did this kind of analysis on next generation long-haul carriers and large CLECs in early 2000, you might have been floored by implied perpetuity growth rates or terminal year cash flow multiples that were necessary to justify these companies’ public valuations. Solving the implied DCF assumptions needed to justify a certain price is a useful part of evaluating a seller's counter-offer, and even your financial adviser's own estimates of value.

A new round of rural line divestitures can provide opportunities for independent local exchange carriers, but these opportunities must be carefully weighed against the economic costs and alternatives. While it readily accepted that DCF is the premier financial analytical tool for evaluating a project, it is important to employ key considerations in scrutinizing the underlying assumptions. By generating realistic projections, developing a range of likely operating scenarios, and considering recent trends in the telecommunications industry, local exchange carriers can make good capital budgeting decisions that will both serve their customers and maximize their exchanges’ value.
Robert F. West is Senior Vice President of the Communications Division for CoBank, Michael Ivie is Credit Manager for CoBank and Levi Richardson is Assistant Vice President for CoBank. Their e-mail addresses are rwest@cobank.com, mivie@cobank.com and lrichardson@cobank.com, respectively.

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