TC2's David Rohde on Telecom

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Is the party over for the big independent ILEC?

By Posted May 29, 2012

Can a big independent incumbent local exchange carrier give up the good life? I don’t know, but they may have to. One such carrier has already cut its shareholder dividend, and there’s a warning out today about a possible shareholder dividend cut at another.

That might sound bad but is actually a potential positive for the enterprise market. If there’s ever going to be a challenger for the Big 2 from this corner of the telecom world, they’re going to have to change their business model toward a more aggressive national outreach, rather than just taking in profits from a captive local user base.

Here’s the situation. There are hundreds of mainly small-town “independent” ILECs. They’re every bit as “incumbent” as AT&T and Verizon are in their legacy SBC and Bell Atlantic territories – arguably more so since they have little or no CLEC competition.

Three of these independents stand out – CenturyLink, Windstream, and Frontier. They’re largely “roll-ups” of separate telcos whose original owners (often literally family businesses) sold out, plus local territories offloaded by the big carriers, added to legacy areas they already served.

These three carriers aren’t exactly alike because they’ve diversified somewhat. CenturyLink bought Qwest and Savvis, and now operates an enterprise business that can bid on typical competitive national deals. By contrast, Frontier has been the most conservative, but recently had to cut its shareholder dividend as results came in below par.

Windstream (which ironically I mentioned in passing last Friday) is in a way the most interesting. Last year it bought PaeTec, a somewhat under-the-radar CLEC but one that’s fairly prominent in serving middle markets, university campuses, and professional offices. The news right now is that Windstream may also have to cut its shareholder dividend. J.P. Morgan issued a note today saying that the stock market “has little conviction about the sustainability of Windstream’s dividend,” which is now eating up 70% of its cash flow.

A clear indication of trouble: Wall Street has cut Windstream’s stock price to a level where the annual dividend yield is now over 10%. When you see that, there’s typically more to fall in the stock price (because the market doesn’t believe anybody can pay 10%) unless the company cuts the yield by chopping the dividend itself. In this way, dividend yields over 10% paradoxically often presage trouble, including bankruptcy, at real estate, mortgage, and energy pipeline companies. Morgan indicates that Windstream can only sustain its dividend now by cutting capital expenditures, something we almost always view as a no-no for carriers that have any hope of serving large users.

The core trend behind all this is that all of the ILECs are suffering loss of primary access lines from consumers cutting the cord. Smaller ILECs may not be seeing quite the level of 9%-10% year-over-year line loss that the huge carriers are seeing. Conversely, they may not have much of anything to replace lost copper lines, as Verizon frequently does with FiOS for wireline broadband and 4G LTE for mobile broadband.

The question now is whether the old model, in which independent telcos attracted a “widows and orphans” type investor base similar to electric utilities, is gone with the wind. That model worked in providing reliable local access but did nothing for national competition. Ultimately, the question is really whether CenturyLink, as the largest of these carriers, will have to accelerate its change of stripes into an aggressive national enterprise carrier, prospectively including a wireless network (right now it resells Verizon Wireless), with piles of network spending and far less in dividends for a different type of investor. Current trends suggest that’s something that has to be on the table for them.

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