While big-name telecom carriers have taken the investing spotlight recently, we at Standard & Poor's Equity Research see opportunity in a lesser known outfit: Commonwealth Telephone Enterprises (CTCO
; recent price, $33). Commonwealth is a rural local exchange carrier (RLEC), primarily operating in the eastern third of Pennsylvania.
We believe that its mountainous operating territory largely insulates Commonwealth from the competitive pressures facing other telecom providers. That has enabled its capital efficiency (capital spending as a percentage of revenues) to remain at around 13% -- toward the low end of the telecom average. As such, we think the company should be able to keep its earnings before interest, taxes, depreciation, and amortization (EBITDA) margins stable and its capital spending relatively low to support its dividend.
In our view, Commonwealth stands out among its peers for its dividend coverage. In June, 2005, the company paid a $13-a-share special dividend and initiated a $2.00 per share annual dividend, paid quarterly, to shareholders. Assuming a consistent payout, we forecast a dividend to EPS payout ratio of 81% in 2006, but believe Commonwealth has a greater cushion, using our free cash flow estimates. As of 2005, the company's net debt/EBITDA leverage of 2.0 was below that of a peer group of high dividend-paying rural telecom peers.
MOUNTAIN MARKET. We believe the shares are undervalued relative to Commonwealth's peers using our enterprise value/EBITDA analysis. With CTCO having declined 20% since paying out its special dividend, we believe risk/reward considerations warrant the purchase of the shares. Our recommendation is 5 STARS (strong buy).
Commonwealth's main business is as an incumbent RLEC in a 5,000 square mile territory in the eastern third of Pennsylvania, serving a population of about 450,000 people in a mountainous market with a line density of approximately 65 access lines per square mile as of December, 2005. Commonwealth served more than 461,000 access lines at the end of 2005, down 2% from a year earlier.
More than 70% of Commonwealth's access lines are in its RLEC territory, where it's exempt from competition by federal law. The remaining lines are in "edge-out" regional Pennsylvania markets such as Harrisburg, Wilkes-Barre/Scranton/Hazelton, and Lancaster/Reading/York that border its RLEC operations. In both markets, the company provides digital subscriber line (DSL) and long-distance service. Commonwealth had 29,262 DSL subscribers in service at the end of the 2005 fourth quarter, having added 10,650 net new broadband subscribers during the year.
FEWER CHALLENGES. The company is trying to grow by offering additional services to its established rural customer base and targeting business customers traditionally underserved by the competition. It has further expanded its edge-out efforts as total access line losses began in 2005. In 2004, Commonwealth was the only wireline provider under U.S. analytical coverage at Standard & Poor's Equity Research that had wireline customer growth.
In 2005, integrated telecom companies such as AT&T (T
; S&P investment rank, 2 STARS, sell; $27) and Verizon Communications (VZ
; 3 STARS, hold; $34) faced pressures in their wireline segments, as their respective access line bases declined more than 5%. We believe Commonwealth's wireline businesses face fewer challenges from technology substitution to cable telephony and wireless than its telecom peers due, in part, to its rural operating market, which has weak wireless coverage (reflecting the mountainous terrain) and low population density.
In its RLEC territory, the company competes with cable providers such as Adelphia Communications, and in its edge-out markets, Verizon, but to date that competition has been relatively muted. In order to offer a "triple-play" package of voice, Internet, and video services, in 2005, Commonwealth began a partnership with Echostar Communications (DISH
; 3 STARS; $29) to provide digital video services to its wireline customers.
MORE STABLE. The Pennsylvania Public Utility Commission (PUC) regulates prices for Commonwealth's local and intrastate long distance services provided in its incumbent territory. The company may increase its overall rates for regulated intrastate service annually by an amount equal to the rate of inflation, adjusted for any exogenous events.
In August, 2005, the PUC granted the company's request to raise certain rates on an annualized basis. Commonwealth also receives funding from the federal Universal Service Fund using formulas adopted by the FCC that are currently under review.
At the end of February, Commonwealth posted fourth-quarter 2005 operating EPS of 62 cents, vs. 67 cents, in line with our estimate, before one-time access and tax-related settlements. Revenues of $83.5 million were slightly below our $85 million estimate, but local access lines were more stable than peers, in our view, with only a 2% reduction. Fourth-quarter 2005 EBITDA margins of 51% were encouraging to us, and we believe Commonwealth generated sufficient free cash flow in 2005 to support its dividend.
We expect revenues to be down fractionally in 2006, as increased minutes of use and enhanced services penetration are outweighed by lower access rates and 2% access line declines. We have some concerns that Commonwealth's long-stable EBITDA margins will be pressured in 2006, as more second lines are replaced by faster DSL service. Following the fourth-quarter results, we lowered our 2006 EPS estimate by 5 cents, to $2.45.
DSL GROWTH. CTCO shares declined 7% after its fourth-quarter earnings release Feb. 28. Since paying its special dividend in June, 2005, CTCO shares have fallen 20%, even as we believe its fundamentals remain strong.
We forecast Commonwealth's revenues to be down fractionally in 2006, to $333 million, as increased minutes of use and enhanced services penetration are outweighed by lower access rates and 2% access line declines. We see a slight increase in competition in its edge-out markets and a reduction in second household lines causing the decline in total access lines. However, we expect that DSL customer growth will offset the second-line losses and believe the company faces minimal cable competition that would force price reductions that we believe have further constrained growth at fellow telecom service providers.
We look for 2006 EBITDA margins to narrow to 50%, from 51%, as cost reductions are likely offset by the rollout of new services and lower-margin DSL additions. We see margins relatively stronger at the company's RLEC operations, where 2005 margins were more than 65%. We expect depreciation expenses to decline as a result of the company's asset retirement activity.
OPTION COSTS. In 2006, we see operating EPS of $2.45, down from $2.57 in 2005. The company's share count rose more than 30% in the second half of 2005 due to a convertible stock offering. Fourth-quarter 2005 results were aided by 15 cents per share of one-time access and tax-related settlements. With $105 million in cash as of December, 2005, and our expectation of continued free cash flow generation in 2006, we believe Commonwealth has adequate funds to support the dividend payments that are expected to total approximately $59 million.
Based on our Standard & Poor's Core Earnings methodology, we believe that the quality of Commonwealth's earnings is above average compared to its peers, due to the small divergence in 2004 and 2005 between reported and S&P Core EPS. We estimate 2006 S&P Core EPS of $2.43, due to modest pension adjustments. The company is to begin expensing stock option costs in 2006 similar to other telecom providers. In 2005, S&P Core EPS of $2.62 was lower than reported EPS of $2.71, reflecting stock option expenses of 6 cents and pension adjustments of 3 cents.
Based on our estimates for 2006, Commonwealth trades at a p-e multiple of about 13 times and an enterprise value to EBITDA multiple of 5.7 times, below the average for our rural peer group. The company trades more in line with larger Regional Bell providers that, we think, face greater competition and have narrower margins.
With our view of Commonwealth's relatively strong EBITDA margins and lack of competitive pressures, we believe that the stock should trade in line with its rural peer average. Using this methodology and a multiple of 7 times EBITDA, we have a 12-month target price of $44. We think the recent 6% yield for ongoing dividends adds to the total return potential.
RELATED PARTIES. We believe Commonwealth's corporate-governance practices are above average relative to other telecom service providers we follow. Among the positive characteristics, in our view, are that the chairman and the CEO positions are separated, and Chairman Walter Scott is an independent outsider. Additionally, the company doesn't have a poison pill in place to stop takeover attempts by outsiders, and CEO Michael Mahoney doesn't serve on the boards of multiple companies.
On the negative side, Commonwealth has recently engaged in multiple "related party" transactions with directors and/or former directors, including using legal services and providing telecommunication services to such companies.
Risks to our recommendation and target price, in our view, include adjustments to the Universal Service Fund, a federal government subsidy which Commonwealth receives, a cut in the company's dividend, increased competition in its edge-out territories, and the conversion of convertible securities that would be dilutive to shareholders.