CenturyLink: Link Up To This High-Yielding Rural Telecom

We recently reviewed CenturyLink (CTL) versus Frontier Communications Corporation (FTR) and Windstream Corporation (WIN), two other leading rural telecommunications firms and we believe that CenturyLink offers the best risk-reward scenario of the three firms.

CenturyLink, Inc. CenturyLink is the leader in the rural-telecom services industry segment and the third-largest U.S. telecom company by market capitalization, with a market cap of $23.6B as well as the third-largest by total access lines. CTL provides local and long-distance, network access, private line (including special access), public access, broadband, data, managed hosting (including cloud hosting), colocation, wireless and video services. In the portion of the 37 states where CTL has local service area access lines, CTL is the incumbent local telephone company. CTL also operates 68 data centers throughout North America, South America, Europe, and Asia. CTL became a top-tier telecom provider through its acquisition of Embarq (legacy local telephone division of Sprint Nextel (S)), Qwest Communications International (The Former Baby Bell US West) and Savvis, a leader in global information technology solutions.

Frontier Communications Corporation Frontier is a communications company providing services predominantly to rural areas and small and medium-sized towns and cities in the U.S. Frontier offer voice, data, internet, and television services and products, some that are available á la carte, and others that are available as bundled or packaged solutions. On July 1, 2010, Frontier acquired the defined assets and liabilities of the local exchange business and related landline activities of Verizon Communications Inc. (VZ), including Internet access and long distance services and broadband video provided to designated customers in the Territories (which we refer to as the Acquired Business). This transaction was financed with approximately $5.2 billion of common stock (Verizon shareholders received 678.5 million shares of Frontier common stock) plus the assumption of approximately $3.5 billion principal amount of debt. We think Frontier should have heeded the lessons that FairPoint (FRP) and Idearc [Now Known as SuperMedia (SPMD)] learned with regards to not buying what Verizon is selling.

Windstream Corporation Windstream was created when VALOR Communications merged with Alltel Corporation's spun-off landline division. It provides advanced communications and technology solutions, including managed services and cloud computing, to businesses nationwide. In addition to business services, it offers broadband, voice and video services to consumers in primarily rural markets. WIN operates in 48 states and the District of Columbia, a local and long-haul fiber network spanning approximately 115,000 miles and 21 data centers offering managed services and cloud computing. WIN's notable recent acquisitions include Iowa Telecom in June 2010, which added 247,000 voice lines, 96,000 high-speed Internet customers and 25,000 video customers in Iowa and Minnesota. In February 2010, it acquired NuVox, which added a broad portfolio of Internet protocol ("IP") based services. In December 2010, it purchased Hosted Solutions Acquisition, LLC, an eastern United States data center operator offering cloud computing, managed hosting and managed services. WIN gained five state-of-the-art data centers and approximately 600 business customers. It also completed the acquisition of Q-Comm Corporation's wholly owned subsidiaries Kentucky Data Link, a regional transport services provider with 30,000 miles of fiber, and Norlight, a business services provider with approximately 5,500 customers. This transaction allows WIN to reach more business customers and to compete for more wireless backhaul contracts. KDL's fiber transport network enables WIN to carry more traffic on its own network rather than paying other carriers for this service. In 2011, WIN acquired PAETEC Holding Corporation, a leading national business services provider with approximately 36,700 miles of fiber and seven data centers; enhancing WIN's IP based services, cloud computing and managed services, advancing WIN's strategy to expanding its focus on business and fiber transport services.

Since Windstream went public in February 2005, we ran a performance comparison of CenturyLink versus Frontier and Windstream for February 2005, to March 2002, on a monthly basis. It is obvious that CenturyLink's strongest competitor is Windstream as both generated positive total returns primarily from the high dividends paid out to shareholders. CenturyLink also eked out a nearly 15% cumulative price appreciation during this time period.

(Click charts to enlarge)

Source: Bloomberg Finance LP

Based on our analysis, we have determined that CenturyLink offers a better investment opportunity than Windstream (and both certainly offer a stronger investment opportunity relative to Frontier for the following reasons).

• Though CTL's dividend yield is the lowest in the peer group, it is still over 7.6%. Moreover it is due to the fact that it has a lower dividend payout ratio relative to its peers. CTL paid out 87% of its $1.79B in free cash to the firm versus 98.6% for FTR and 97.3% for WIN. Also, FTR announced in February that it needed to cut quarterly dividends by 46.67%, from $.1875/share to $.10/share.

Source: Bloomberg Finance LP, All Amounts in $M except ratios

• In 2013, barring any acquisitions by the companies, we will begin to see financial and operating comparability and clarity for the results of CTL and WIN as 2013 will be the first year that these companies will have had consecutive years without a middle of the year. FTR will see 2012 as the first year that it will have consecutive years without an acquisition in the middle of the year. We feel confident in this projection as all three RLECs have engaged in significant strategic acquisitions recently and will be more focused on integrating operations and conserving cash to sustain dividends, as well as in the case of CTL, pay down debt
• Though CenturyLink's credit rating is only two notches higher than Frontier and Windstream, CenturyLink is still an investment-grade company and it pledged to pay down $1.5B-2B in long-term debt in order to preserve its investment grade credit rating in 2012. CTL raised $2.05B in the sale of unsecured debt in March to purchase outstanding Embarq Corporation and Qwest notes in a tender offer. $1.14B was tendered from the Embarq notes and $878M was tendered from the Qwest notes.

Source: Bloomberg Finance LP, All Amounts in $M except ratios

• CTL has five key markets that we are attracted to; Denver, Phoenix, Seattle, Portland and Las Vegas. Denver (17.9%), Phoenix (33.1%) and Las Vegas (36.6%) have seen strong population growth. Portland and Seattle have also seen above-average population growth over the last 10 years.
• CTL has a lower estimated revenue decline that FTR on a pro forma basis assuming all acquisitions are booked at the beginning of the year. Windstream only made a pro forma adjustment for the PAETEC acquisition in 2011 so we can't determine what WIN's organic pro forma growth is after adjusting for its 2010 acquisitions.
• CenturyLink is also the only one of the three rural telecom companies offering wireless service. CenturyLink became an authorized Verizon Wireless agent last year and will offer Verizon Wireless equipment and service plans to its residential and small business customers.
• In conclusion, we are intrigued by CenturyLink's and Windstream's efforts to transform each company's respective business away from the declining core rural telephone businesses. We like the high dividend yields each company pays as well, which effectively pays us to wait by retiring its old existing asset base and redeploying a portion of it towards higher value adding assets. We also like the efforts of the companies to transform its businesses toward higher-value offerings, most notably cloud computing services.

We like CenturyLink better than Windstream due to the following factors:

• Authorized Wireless reseller agreement with Verizon Wireless
• Higher Margin of safety with regards to paying out of Free Cash Flows
• CTL's Investment-Grade Credit Rating
• Presence in fast-growing metro markets as a result of the Qwest acquisition
• CTL's total return exceeding WIN's since WIN's Initial Public Offering.

Disclosure: I am long CTL.