Replies to post #440 on High-yield/macroeconomics (fka YIELD)

[Democritus_of_Abdera]

Abreis, Re: IWA 2008 Q4 ....

Presuming that you are still invested in IWA, this is my take-home from yesterday’s CC and 10-K.

1. Dividends are fully covered and not at risk. Revenues are growing, albeit modestly. Net operating cash flow is strong. Debt is being paid down even while capital expenditures continue at the historical rate. Note, however, new debt ($44M) will be used to purchase Bishop Communications during the next fiscal year. But, absent any other purchases, this debt can be paid down quickly at the historical debt-reduction rate of about $20M/yr from free cash flow.

2. My biggest surprise was that the new competition, VoIP entrant Mediacom, has been a non-event. Mediacom initiated service using an interconnection agreement between IWA and Sprint in Q2 of 2007. IWA is contesting this usage in state and federal courts. In the interim, IWA’s preemptive counter-measures have been effective. These counter-measures have included aggressive roll-out of a bundled DSL-Video-Phone package and aggressive courtship of business accounts through CLEC subsidiaries. IWA is CLEC certified in all markets served by Qwest in Iowa; the current agreement expires in 2011 (which, coincidentally, is when IWAs long-term debt comes due).

3. I’m keeping a watchful eye on the Iowa Communications Network (ICN). The ICN is fiber optic cable system extending throughout Iowa that currently provides voice and video communications to educational and governmental institutions. Current law prevents use of the ICN for commerical use. The Iowa legislature has considered modifying state law to allow sale of the ICN to a private party, but so far it has not done so.

[Democritus_of_Abdera]

Abreis, Re: IWA’s 2008 Q1 CC of May 1, 2008

Upon reviewing the CC, I did not find anything exciting or distressing...

IWA’s revenue and earnings were slightly down from the previous year. They are losing access lines, but growing DSL and CPE (Customer Premise voice and data Equipment) business. The loss of access lines and growth of DSL in part reflects customer conversion from dial-up to high-speed modem internet access, a good thing for IWA in the long run.

Basically, I view IWA’s market as mature and do not see substantial growth in the near future. However, their 9-10% dividend remains covered and is safe, so I continue to see this as a good high yield stock.

The only thing new that I saw of interest in the CC was that IWA obtained three of the FCC’s recently auctioned 700 MHz spectra. Combined with the AWS spectrum acquired last year, IWA now has spectrum which covers approximately 84% of their access lines. They claim to have no immediate plans to deploy this spectrum. If and when they do, they may need to reduce the dividend to meet the capital investment requirements. In any event, this spectrum is not available to competitors, a good thing in my estimation.

[Democritus_of_Abdera]

Abreis, regarding IWA...

Today’s presentation by IWA management at the Lehman Brothers Worldwide Wireless and Wireline Conference reiterated IWA’s strengths. It is available at http://cc.talkpoint.com/LEHM002/052808a_jw/default.asp?entity=lowa for 90 days.

I didn’t see anything new in the presentation per se. However, the slide set is good and can be downloaded; the question and answer session was interesting, even though it only lasted about five minutes. There were two question strings, one asking why Mediacom has not been a serious competitive threat and the other related to mergers and acquisitions (I have appended a transcript of this latter string below).

The M&A discussion builds upon current conjectures regarding consolidation in the rural telecom arena (see http://telephonyonline.com/mag/telecom_rlec_ma_next/ ).

On a related note, there seems to be an extraordinary interest in Dec 20 calls. The open interest for this strike is 2,173 contracts; whereas, the summed open interest for all call strikes in Jun is about 1,300, for Jul about 100, and for Sept about 1200 (see http://finance.yahoo.com/q/op?s=IWA&m=2008-12 ). It is hard to know what to make of this pattern; however, somebody might be very interested in keeping the price below 20 when December comes.

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My transcript of the Q&A session regarding mergers and acquisitions:

Minute 27:04 - 30:05:

1st Question (the moderator): Let me ask you about consolidation in the space. That clearly is the buzz word these days. You mentioned that you think that you’re safer. And you have definitely kept perhaps much cleaner than maybe some of your peers. Are you open to consolidation in the RLEC space from both being a buyer and/or being a seller? Can you give us your thoughts on that perspective?

Alan Wells, Chairman & CEO: Well first of all, I think that consolidation will happen. It has happened up to now. As you know there have been a lot of transactions over the past several years. I think that there will be more transactions as time goes by. We obviously have been a participant of that because we have made some acquisitions in the state of Iowa. And the Bishop transaction has been outside the state. And the transactions will continue. I think we would certainly be a participant in that. Clearly on the side of looking for transactions that make sense to us to acquire. But obviously as a public company, if someone were to make an overture to us at an attractive price, that is something that our Board has to consider. I don’t think you can ever rule that out. But I certainly couldn’t talk to you about that today even if we had a transaction underway.

2nd questioner (from the audience): I mean how would that happen. I understand M&A and the dynamics within. I guess I’m wondering from your standpoint how accretive can a transaction be when your peers trade at 2-3 multiple points below where you stand right now. Can you explain to me if it is possible for them to acquire you and still be accretive. Because that is one thing that I tried to understand from Embarq and I couldn’t get that. Meaning Embarq trades at 5 times EBITA and you guys are at 8.8 times. There is a big value gap there. I’m wondering with M&A could somepay pay say a modest premium to you and still collect a... I mean what kind of EBITA multiple synergies can you generate from a transaction. That’s what I’m trying to understand with this... the dynamic that we are hearing about the dynamic M&A. I think that you guys are a very likely buyer because you’re positioned brilliantly now because you have such a great multiple. But I’m wondering from a seller’s standpoint what multiple would the buyer have to be at such that it could pay for you and it be accretive. You know what I am saying. It’s a strange question, I understand, but I’m just trying to understand the dynamics.

Alan Wells: I am not sure that I can talk about how somebody would look at us if someone were going to buy us. But like any other M&A transaction you need to look at what the free cash flow accretion would be. There would be a lot of factors to consider. You would have to look at what the incremental borrowing costs would be. You would have to look also at what the synergies would be as part of the transaction. Much like we would look at a transaction if we were the acquirer. But I think that it would be safe to say that there are probably accretive transactions that could be had either by us or somebody else or by somebody else of us throughout the space, even though the multiples may be different and I would think that probably Tom and others who look at that sort of thing more closely could answer this more ...

[Democritus_of_Abdera]

IWA & Reverse Morris Trust...

Abreis, if you continue to hold IWA, you may want to think through what you will do if Verizon (VZ) spins off its rural lines in the north central US (Illinois, Indiana, Ohio, and Michigan) to IWA as a reverse Morris Trust, a recurring speculation these days.

The reverse Morris Trust is a tax strategy whereby VZ would avoid substantial taxes on its depreciated rural copper telephone lines they got from GTE. IWA would become a much larger regional telephone company that might benefit from economies of scale. Because of the tax advantage one would expect that VZ would sell (divest) the property to IWA at a substantial discount. They might also pay IWA for its wireless spectrum.

In short, to execute a reverse Morris trust, VZ must create a subsidiary that is bigger than IWA. This subsidiary then merges with IWA. The VZ shareholders get IWA stock prorated to their VZ holding. IWA management takes over the merged company.

VZ just completed a similar reverse Morris Trust divestiture of its New England rural telephone land lines to Fairpoint Communications (FRP). It took about 1.5 yrs after the announced intent before the deal was actually completed. This deal with FRP can be used to predict what will happen if a similar merger is made with IWA. The details can be found in FRP’s Form 434B3 filed on February 29, 2008.

The most important lesson relevant to IWA’s dividend policy was that the New England states required that Fairpoint reduce its dividend and paydown debt as a precondition for regulatory approval of the deal. I suspect that similar concessions would be likely if IWA were to take over the VZ north central GTE lines.

A second lesson was that the merger itself created selling pressure. This is because VZ is in both the S&P 500 and the Dow Jones Industrial Average. Index funds that received Fairpoint shares as a result of the deal were forced to sell them. The number of shares that they receive in a reverse Morris Trust deal is large (i.e. Verizon shareholders must control at least 50% of the resultant entity for the deal to be tax advantaged). Additional selling pressure may have resulted from those original VZ shareholders invested in VZ for the wireless story, not the rural telephone franchise.

Personally, I think that IWA would be greatly strengthened by addition of VZ’s north central GTE lines. But there would be some integration turbulence and the dividend will probably be reduced. If such a deal is announced, I don’t expect any big swings in stock price. However, I will probably liquidate my position because I am in it for the current yield, not long term growth.

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Some useful websites:

http://telephonyonline.com/mag/telecom_rlec_ma_next/ - Early speculation about IWA involvement in reverse Morris Trust for VZ properties (5/22/06).

http://www.raymondjames.com/pdfs/industry/itell013007b_0843.pdf - Discussion of the financial rationale for a union (1/30/07).

http://biz.yahoo.com/ap/080409/fairpoint_analyst_note.html?.v=1 – Discussion of why Fairpoint share price dropped after reverse Morris Trust deal was announced (4/9/08).

http://www.sec.gov/Archives/edgar/data/1062613/000095012308002306/y40915bxe424b3.htm
SEC form 434B3 filed by FRP on 2/29/08.

[Democritus_of_Abdera]

Abreis, Re: IWA’s Aug 2008 CC and RBC Presentations

The good news is that the dividend is safe. It is paid out of cash flow that is more than adequate, largely due to minimal taxes until June 2015.

The bad news is that there is no growth. There is chronic loss of land lines (ILECs) partially balanced by increases in DSL and CLEC lines. The net land line loss is periodically remediated by incremental purchases of private rural telecoms such as the recent purchase of Bishop.

IWA continues to point out that they do not participate in the Universal Service Fund, USF (at least in any meaningful way). The USF has been a cash cow for their rural telecom peers. There is a growing consensus that the federal USF and high cost loop support of rural telephone systems will be reduced. I suspect that if and when this happens, rural telecoms in general will see their stock Price/Earnings ratios contract. I’m assuming that IWA will experience a sympathetic reduction in its stock price even though they have made it clear that loss of this federal support will have no impact on their operations.

On the bright side for IWA, loss of federal USF support will likely push small rural telecoms to insolvency making acquisitions cheaper. IWA claims that there are 150 small rural telecoms in Iowa and a smaller number in Minnesota that could be up for grabs in such a consolidation. I also continue to believe that Verizon might divest its midwest rural land lines through a Reverse Morris Trust (#msg-29791035). Thus, IWA’s strategy of maintaining cash flow through intermittent acquisitions will likely remain successful.... again supporting the dividend for years to come.

When asked what IWA plans to do with the AWS and 700 spectrum they have purchased, the CFO, Craig Knock, explained that IWA made the purchases for strategic reasons and have no immediate plans. However, the most likely scenario, when they do decide to capitalize on thier investments, is to use this wireless spectrum to support the broadband network when laying lines for DSL is not economical or to support the CLEC program (which targets business customers in the Quest marketplace).

In my summary of the May 2008 CC (#msg-29623158) I had noted that disproportionately large open interest in December 20 calls (currently 6,000+ contracts, where the expected number would be in the hundreds). Holew explained the phenomenon in his June 4th message on the Yahoo IWA message board; i.e. an investment newsletter suggested buying IWA covered calls to collect the dividend and the option premium.