Iowa Telecommunications Services Inc. Q4 2008 Earnings Call Transcript

| About: Iowa Telecommunications (IWA)

Iowa Telecommunications Services Inc. (IWA) Q4 2008 Earnings Call February 27, 2009 9:00 AM ET


Alan L. Wells – Chairman and Chief Executive Officer

Craig Knock – Vice President, Chief Financial Officer and Treasurer

Kevin Inda – Investor Relations


[Simon Slattery] – Morgan Stanley

David Coleman – RBC Capital Markets

Frank Louthan – Raymond James

Christopher King – Stifel Nicolaus

Patrick Rand – Barclays Capital


Good day and welcome to the Iowa Telecom fourth quarter conference call. Today's call is being recorded. At this time, for opening remarks and introductions, I would like to turn the call over to Mr. Kevin Inda. Please go ahead sir.

Kevin Inda

Thank you, [Tina] and welcome to this Iowa Telecom conference call to review the company's results for the fourth quarter and year, which ended December 31st, which we released this morning. During today's call, we'll refer to certain non-GAAP financial measures and we'd reconcile these measures to GAAP figures in our earnings release, which is available on our website at Conducting the call today will be Alan Wells, Chairman and Chief Executive Officer, and Craig Knock, Vice President and Chief Financial Officer and Treasurer.

Before we start, let me offer the cautionary note this call contains forward-looking statements that are not based on historical facts, including without limitations, statements containing the words believes, may, plan, will, estimate, anticipates, intends, expects, and similar expressions.

Those forward-looking statements involve known and unknown risks and uncertainties and other factors that may cause actual results, events, or developments to be materially different from future results, events, or developments described in the forward-looking statements. Such factors include those risks described in Iowa Telecom's Form 10-K on file with the SEC. These factors should be considered carefully and investors are cautioned not to place undue reliance on such forward-looking statements.

All information is current as of the date of this conference call and Iowa Telecom undertakes no duty to update that data. That's it. I'll turn the call over to Alan Wells.

Alan L. Wells

Thank you, Kevin, and god morning. We're glad you joined us this morning as we review results for the fourth quarter and for the year. I would like to take a few minutes to focus on our operational financial highlights and to update you on several events which occurred during the quarter. Craig Knock, our CFO, will then review the financial results in more detail and we'll then take your questions.

Overall, we are very pleased with results for the fourth quarter and for the year, which in part reflect our acquisition of Bishop Communications on July 18th. We are in the process of integrating the Bishop Properties into our systems and fully believe the Bishop acquisition will continue to enhance our financial performance going forward.

On November 21st, we announced an agreement to purchase our second Minnesota Telecommunications company, Sherburne Tele Systems, for $80.6 million, subject to certain balance sheet and tax adjustments. Sherburne is a closely held telecommunications company, headquartered in Big Lake, Minnesota, less than 30 miles from the headquarters of Bishop. As of December 31, 2008, Sherburne served 15,500 ILEC access lines, 10,200 CLEC lines, 13,900 DSL high speed Internet customers, and 3,700 video customers, primarily in communities and rural areas to the Minneapolis St. Paul metropolitan area.

Sherburne's operations include a succumbent local exchange carrier, which markets its connections and competitive local exchange carrier services provided through a totally owned subsidiary, North Star Access. We look forward to closing this transaction by mid-year and expect the transaction to be accretive to cash flow on per share basis. Even more importantly, we believe that Bishop and Sherburne transactions will illustrate the power of our strategy of growing our business through accretive acquisitions.

Before I review highlights for the quarter, let me provide an update for the current economic issues and the impacts they're having on our markets. While the current mortgage and credit crisis continues to have a significant impact across much of the nation, we believe the rural nature of our telecommunications business somewhat insulates us from the major effects of these challenges.

As many of you know, agriculture is one of the largest industries in Iowa, and thus far, we continue to believe this industry remains relatively stable. All in all, while we are experiencing some impacts due to the current economic conditions, we do not feel our markets are nearly as heavily impacted as are many other areas throughout the country.

Our financial results for the quarter include for the first time, the results of Bishop for a full quarter. For the quarter, total revenue was $65 million, operating income for the quarter was $17.5 million, our adjusted EBITDA was $33.1 million, and our net income was $5.2 million or $0.16 per diluted share. We are very pleased with our financial performance and think our results reflect the stability of our operations.

Our income tax expense for the quarter was $4 million, compared to $4.4 million a year ago. Craig will elaborate on income taxes during his remarks, but it's important to note that this income tax charge is primarily non-cash in nature, and thus does not impact either our cash flow or our ability to pay dividends. Despite this income tax charge in the income statement, our actual cash payments for income taxes during the quarter were only $53,000, reflecting the usage of both our net operating losses and our continued goodwill amortization for tax purposes.

Capital expenditures were $8 million for the quarter and $28.2 million for the year, in line with our prior guidance. Included in the results were capital expenditures for our newly acquired Bishop operation, as well as expenditures related to the historic flood we experienced during the second quarter of 2008. Our cash interest cost was $8.1 million for the quarter, and $30.8 million for the year, which is also in line with our prior guidance and includes the additional interest costs on debt related to the acquisition of Bishop.

For 2009 guidance on our existing operations, we expect that capital expenditures will be between $25 million and $27 million and cash interest expense will be between $29 million and $31 million. We expect to update our guidance for the impact of our Sherburne acquisition as that closing date becomes more certain.

Overall, our financial performance for the quarter was strong and reflects the continued expansion of our DSO service, our ability to control expenses and maintain our margins, and our successful Bishop acquisition. Inclusive of Bishop, total access lines decreased by 3,700 during the fourth quarter, as ILEC access lines decreased by 4,000 lines and CLEC increased by 300 lines.

On a combined basis, we had 75,500 DSL customers at the end of the quarter, an increase of 1,200 customers from the third quarter. We also had 16,700 dial up customers, and 146,400 long distance customers. In addition, we had approximately 20,300 video customers as of the end of the year.

Consistent with the past several quarters, we believe much of our ILEC line losses are attributable to both wireless substitution and cable competition in several of our markets. We have seen no major change in Mediacom's offerings since our last conference call, and continue to believe they are focused primarily on residential customers within the city limits of our ILEC markets, where they have launched service. We continue to respond to the offerings of our competitors with our bundle DSL and video offerings, which we believe are proving to be attractive, low cost alternatives for our customers.

In summary, we are very pleased with our solid performance for 2008. Our business is well capitalized and substantially all of our term debt is fixed at attractive interest rates through 2011. Despite the unrest in the financial markets, we have maintained our financial flexibility, enabling us to take advantage of acquisition opportunities during difficult times in the credit market. We're excited about our new operations in Minnesota, and believe these transactions will be beneficial to our operation for years to come.

Looking ahead, we intend to continue to focus on five areas; first, to increase cash flow by extending our sales of additional enhanced offerings, such as our DSL and bundled offerings; second, we also intend to continue to expand our CPE and data services to business customers; third, through our competitive local carrier exchange subsidiaries, we intend to continue the selective pursuit of new customers in markets which are near our existing markets; fourth, we will continue to pursue acquisitions that are in line with our free cash flow focus and that clearly meet our criteria for acquisitions to be accretive to cash flow on a per share basis, such as our recently closed acquisition of Bishop and our pending acquisition of Sherburne; and above all, we remain committed to returning a stable income stream to our shareholders in the form of our $1.62 annualized dividend.

I'll now turn the call over to Craig Knock, who will review our fourth quarter and full year results in more detail. Craig?

Craig Knock

Thank you, Alan, and good morning everyone. Since you have access to our full news release, let me review certain numbers of financial highlights, and then we will take your questions. As a reminder, our fourth quarter results for 2008 reflect the acquisition of Bishop Communications for the entire period.

Overall, operating revenues for the quarter were $65 million compared with $61.4 million in the fourth quarter of 2007, reflecting an increase of $3.6 million or 5.9%. Local service revenues increased $51,000 or 0.3% for the quarter, the increase was primarily due to the access line increases from our Bishop acquisition. Network access revenues increased $429,000 or 1.9% for the quarter. Again, the increase was primarily due to the Bishop acquisition.

Long distance revenues increased $263,000 or 4.9% for the quarter. The increase in revenue was due principally to the acquisition of Bishop, along with higher customer connection charges. Data and Internet service revenues increased by $1.8 million or 23.6% for the quarter. The increase was primarily due to growth in our DSL and growth in our enhanced data solutions products. Other services and sales increased $1.1 million or 14.8% for the quarter, the revenue increase is primarily due to higher CPE sales and the Bishop acquisition.

Our total operating costs and expenses increased $4.5 million or 10.4% for the quarter, principally as a result of the Bishop acquisition. Cost of services and sales decreased $139,000 or 0.7%, as a $2.5 million curtailment gain resulting from a modification to our post-retirement benefit obligation, offset increased cost of CPE sales and operating expenses for Bishop. SG&A costs increased $2.4 million compared to last year, due to operating cost of Bishop. Depreciation and amortization increased $2.2 million or 17.7%, primarily due to Bishop, along with higher plant balances.

Interest expense increased $329,000 to $8.3 million for the quarter. This was due to a combination of the lower interest rates partially offset by a higher average balance on our revolving line of credit. In terms of income tax expense, we reflected $4 million in booked income tax during the quarter, compared to $4.4 million last year. The recorded book tax expense did not impact the cash taxes paid during the quarter.

Again, let me remind everyone as it relates to cash income taxes, the book accounting for income tax expense does not change our outlook for paying cash income taxes, as we continue to expect the overwhelming majority to be deferred. Again, we have a very strong tax shield position driven by our continued goodwill amortization at the rate of approximately $41 million per year through June 2015, coupled with our existing NOL of approximately $49 million. Both these items will shield us from material cash income taxes for a good number of years.

However, as we previously disclosed, we may be required to pay AMT along with Minnesota cash taxes in the near-term. And as noted in the release, we paid cash income taxes of $53,000 during the fourth quarter.

The bottom line for us this quarter was net income of $5.2 million or diluted earnings per share of $0.16. Our adjusted EBITDA as defined in our credit agreement and reconciled in our press release was $33.1 million for the quarter, compared with $31.7 million a year ago.

Now, I would like to turn to the full year 2008 as compared to 2007. Operating revenues for the year decreased $4.4 million or 1.8% to $247 million. The decline is largely attributed to an $11.2 million decrease in network access revenues. The decrease was primarily due to a $5.8 million of revenue from a settlement with certain connecting carriers in 2007, and a similar item resulting in a $1.5 million unfavorable impact in 2008.

Local service revenues decreased $2.8 million or 3.8% for 2008. The decline is a result of fewer access lines compared to 2007. Long distance revenues increased $1.8 million or 8.5% for 2008, the increase in revenue was due to higher customer connection charges and the Bishop acquisition. Data and Internet service revenues increased by $5.7 million or 19.1% for the year, primarily as a result of growth in our DSL and in our enhanced data solutions.

Other services and sales increased by $2.1 million or 8.1% in 2008, the increase was principally due to growth in our CPE business and the acquisition of Bishop Communications. Our total operating costs and expenses increased $7 million or 4.2% in 2008. Costs of services and sales decreased $155,000 due to the $2.5 million curtailment gain resulting from a modification to our post-retirement benefit plan, which offset the higher cost of CPE sales and operating expenses for Bishop.

SG&A costs $2.5 million compared to last year, principally due to the operating cost of Bishop. And finally, depreciation and amortization increased $4.7 million or 9.6% for 2008, primarily due to higher plant balances for our Iowa properties, along with the Bishop acquisition. Interest expense decreased $441,000 and 1.4%, principally as a result of lower interest rates on our variable rate debt.

In terms of income tax expense, we reflected $17.3 million book income tax during the year, compared to $20.9 million in 2007. The bottom line for us this year was net income of $23.1 million or diluted earnings per share of $0.72. For the year, our adjusted EBITDA was $128.3 million as compared to $134.3 million. Again, the decrease was largely due to the settlement of our network access issues, which favorably impacted our 2007 results.

At this point, I would like to further expand on the changes to our post-retirement benefit obligation and address the benefit obligations and related funding for the OPEB, as well as our defined benefit pension plan. As we discussed, we modified our post-retirement welfare plan in the fourth quarter of 2008, which resulted in another 26 employees opting out of retiree medical plan. This action resulted in a curtailment gain of $2.5 million in the fourth quarter of 2008.

As it relates to the accumulated benefit obligation on the balance sheet at year end, we have a balance of only $2.8 million, which by design, is unfunded. The expected cash payments required for 2009 are approximately $285,000. Through our past actions, we have reduced a number of employees who will be eligible for future retiree health care coverage to approximately 6% of our workforce. Secondly, as it relates to our defined benefit pension plan, the projected benefit obligation on the balance sheet at year end is approximately $13 million, against the fair value of plan assets of approximately $9.4 million.

We anticipate that our funding for 2009 will be approximately $750,000. As you may recall, in 2005 we took significant steps to freeze and spin off most of the Legacy pension obligations that we took over from GTE, and as a result, now have less than 40 people accruing future benefits under the pension plan. As such, at year end, collectively we only have approximately $6 million in unfunded projected benefit obligations for both these benefits, a very manageable amount in our view.

In short, we believe the past actions we have taken have clearly helped to minimize our exposure to these items, as such, further enhancing the predictability of our cash flows.

I'd like to take a minute now to discuss our debt and related interest expense. As of December 31, 2008, we had outstanding $489 million under term facilities, $39 million drawn under our $100 million revolving credit facility, which are offset by $7.8 million of our TFC capital certificates, and $11.6 million of cash.

Our net debt, or adjusted total debt as defined in the credit agreement, was $509.8 million at quarter end. That level of adjusted total debt correlates to a leverage ratio as defined and calculated in the credit agreement of approximately 3.88 times. Our cash interest expense as defined in the credit agreement was on track with our expectations for the quarter at $8.1 million and $30.8 million for the year. For 2009 guidance, we expect our cash interest expense will be between $29 and $31 million, excluding the additional interest costs related to the pending Sherburne acquisition.

Turning to our capital expenditures, for the quarter our capital expenditures were $8 million and $28.2 million for the year. As Alan indicated, we expect that 2009 capital expenditures will be between $25 and $27 million, which exclude capital expenditures at Sherburne. Again, we expect to update our guidance on both for the impact of Sherburne as that closing date becomes more certain.

Now I'd like to summarize our cash sources and uses for the last 12 months, as I demonstrate the strength of our ability to pay dividends. Starting with adjusted EBITDA of $128.3 million, and deducting cash interest expense of $30.8 million, capital expenditures of $28.2 million, and cash income taxes of $399,000, results in $68.9 million in cash available for dividends. At our annual dividend rate of $1.62 per share, we paid dividends of $51.7 million. Thus, for the trailing 12 months, our payout ratio of our free cash flow was approximately 75%.

It is also equally important to note, that as of December 31, 2008, we had cumulative distributable cash for actual dividend capacity as defined in our credit agreement, of approximately $90.3 million, or said another way, well over one and a half years dividend requirement.

Overall, we are very pleased with the results for the quarter, as well as for the year. Operator, we will now answer any questions. Kindly provide instructions for the Q&A.

Question-and-Answer Session


(Operator Instructions) And our first question will come from [Simon Slattery] – Morgan Stanley.

[Simon Slattery] – Morgan Stanley

Could you talk about the broadband stimulus package and what you think the opportunities might be for Iowa there? And also on Sherburne, just you talked about some uncertainty on the closing, where are we with the state approvals and any other approvals you need to get and what's your best guess in timing at this point?

Alan L. Wells

Good morning, Simon. Thank you. Let me take those, I'll do it in reverse order. As far as Sherburne, we made the regulatory filings with both the Iowa Commission and the Minnesota Commission. I believe they've responded to some questions that were raised in Minnesota. I think our folks – that were fairly routine and don't see any obstacles in the way at this point, that we're aware of that would prevent the approvals of being obtained and pretty short order we hope.

We're hoping for a mid-year close, but it's dependent upon approvals of both the state level and the FCC, but we think things are on track for a mid-year close.

And as far as the broadband stimulus package, I think we like many other carriers are looking closely at the rules that might evolve of what the applications for those might look like. I think, as you know Simon, if you look at our operation despite our very, very rural nature, we've been unable to obtain U.S. sub funding in the past. We think given our profile, we probably – we think a fairly good candidate to stand in line for applications of both the RUS and NTIA, but until more details come out about how those plans are really going to work, it's kind of difficult to predict what might happen there.

[Simon Slattery] – Morgan Stanley

And maybe just a word on Bishop, you really didn't talk too much about the integration and how you feel about state of the plans and the customers and everything.

Alan L. Wells

Sure, I think we're very pleased with our Bishop transaction. The state of the plan is excellent; they've got an excellent network there. Customer base seems to be fairly stable and very happy with their operation and we're kind of in the midst of our integration. We're in the process of converting our systems over and we think we'll see the benefits of that sometime in the next quarter.


Your next question will come from David Coleman – RBC Capital Markets.

David Coleman – RBC Capital Markets

Thank you very much. Just two questions, just if you could talk about the competitive environment and if you're seeing any increased or decreased competition from cable providers in your territory? And then following up on the stimulus question, you have a stake in I think it's Wireless Communication Ventures, and wondering if the stimulus package influences your decision to possibly move forward with the building out spectrum you have to that venture? Thanks.

Alan L. Wells

Thank you, David. As far as the competitive situation, I mentioned in the remarks we continue to have cable competition but really haven't seen much change in the offerings or the level of competition in the last quarter, so not a whole lot new there.

As far as our spectrum that we've acquired in both the 700 mega hertz and the AWS options, I think again, we're looking closely at what the rules might look like from the single list package, and to the extent that'll look like we could utilize that spectrum that would have benefited us and our customer base, we would probably take a close look at it. But it's pretty early to call that at this point.

David Coleman – RBC Capital Markets

Just following up on the cable competition question, access lines lost in '08 have definitely been running at a higher rate for ACIs as well as most rural, land line carriers. How much of that would you attribute to competitive land line collect in the offerings versus economic pressures?

Alan L. Wells

I think that's a difficult question to ask, just because it's difficult to find exact reasons why you might have a line loss. I think it's a combination of cable competition, which really hasn't increased, but we just continue to have that competition, and wireless substitution I think, probably in our markets are probably the two items even more than economic pressures. I think we think the economy in our area has been much more stable than most of the rest of the nation, so we haven't seen huge line loss as a result of that.


Thank you and our next question comes from Frank Louthan – Raymond James.

Frank Louthan – Raymond James

Can you give us an idea of what percentage of your long distance revenue is usage based and not tied up with bundles or unlimited plans? And you mentioned that you've seen some improvement there with some higher surcharges, do you think those will stick or are you going to – would you expect to maybe see some more churn on that or see that growth slow down? Thanks.

Craig Knock

Actually, we've had some increased basic fees and so forth on our LD plans for, actually for all of 2008 and we haven't seen much additional churn on that. As you know, usage has tailed off across the entire system somewhat on a usage base, but again, we continue to have good margins on our LD and don't really see a whole lot of change there. Our penetration rate is still north of 60% across the entire system. So it's still a good money maker for us.

Frank Louthan – Raymond James

What percentage is – are customers sort of paying by the call or a permanent rate versus bundled on an unlimited dialing plan?

Craig Knock

Most of ours are on a per minute rate, Frank. We do bundle some that have like 100 minute package and so forth, but that's all fixed cost, upfront fee or part of a bundle.

Frank Louthan – Raymond James

Do you think that you need to try to encourage some customers to go to more fixed plans that, to sort of protect that revenue stream or you feel pretty confident that the usage is going to remain as it is?

Alan L. Wells

Well I think frankly, we've had a concerted effort for the past several years to migrate folks to bundle packages that include fixed number of minutes in their package. And I think we've been pleased with our success in doing that, but I think if you look at our total revenue, probably we still have more funding revenue coming in from permanent charges than we do the bundles. But I think that's a trend that we're going to see more of and frankly, as we bundle that with higher minutes we can usually up-sell and at the same time, lock them into other products simultaneously so that the migration's good for us, but it's still in process.


Thank you very much and our next question will come from Chris King – Stifel Nicolaus.

Christopher King – Stifel Nicolaus

Two quick questions for you, first of all, just I know you guys aren't giving specific guidance yet, with respect to Sherburne, but you guys are guiding toward essentially, CapEx down a little bit year-over-year, despite the fact that you had the one Minnesota acquisition in there. Just was wondering what we should be thinking about in terms of possible incremental CapEx related to Sherburne over the course of the first several quarters once that deal closes.

And second thing, just wanted to get your kind of broad commentary on the state of the M&A environment within the RLEC space. Right now you guys have obviously been successful here with a couple of recent acquisitions, just was wondering what the current state of the market is and if you do continue to view yourselves as having opportunities over the course of the next year or so with respect to other possible acquisitions. Thanks.

Alan L. Wells

Good morning, Chris. Let me talk about those for a second. As far as CapEx, you're right. We really haven't given guidance on Sherburne. I think in our comments, we indicated we'd come out and revise our guidance once they close that transaction, but I think the important point of that though is Sherburne's operations are self-sufficient today. So to the extent there's CapEx, it's generally internally funded from their operation and we'd expect that to be the case with our acquisition as well. So we'll have a little higher CapEx once we make that acquisition, but also on [area] stream at the same time.

As far as the M&A environment, I think there continues to be a lot of activity and interest in the M&A environment in this space. I think folks see the benefit of a consolidation across the nation and I think that the credit market's obviously made that more difficult recently but we've been successful and pleased to have been able to have two deals, one closed, one in the hopper in Minnesota. And we think particularly as folks think about U.S. [sep] and [inter-care] comp perform that environment's going to continue to move along pretty well.

Craig Knock

Yes, Chris, just to echo just one small point on the CapEx and while yes we are guiding down a nominal amount from our 2008 results, keep in mind 2008 included a couple unusual items, one of which was the flood cost that we had from June of 2008 and we actually had additional CapEx all the way through December in repairing and replacing some of that CapEx.

And secondly, we did some substantial upgrades in our IT area. We implemented a Siebel System or a CRM in 2008, and so that would be a cost that won't be reoccurring in 2009.


(Operator Instructions). Your next question comes from Patrick Rand – Barclays Capital.

Patrick Rand – Barclays Capital

Regarding – actually, first on M&A, it's been said there's about 150 or so small ILECs out in Iowa. Does that sound accurate? I mean are there a lot of opportunities out there for you to keep doing these small acquisitions?

Alan L. Wells

Yes, I think in Iowa alone there's about 150 small independent phone companies, and there's – I don't have the exact number, but there's roughly 70 in Minnesota, so there's quite a few just in the upper Midwest. I think if you look at the surrounding states, there's quite a few as well, but Iowa and Minnesota seem to be two of the states that have the most small independent companies.

Patrick Rand – Barclays Capital

All right, and then on margins real quick; if you x-d out that $2.5 million curtailment gain, looks like they're around 47%. Your usual run rate's about 50, is that mostly because you got the revenue from Bishop and just haven't seen the expense benefit yet? And if so, how do you think about margins going into 2009?

Craig Knock

You're banging on there, Patrick. Again, Bishop had a lower 30% margin and as Alan indicated, we're in the process of getting them onto our system and we then expect to see that margin improvement from that level perspectively.

Patrick Rand – Barclays Capital

Okay and then just one last one, looks like CapEx guidance is about 10 to 12% of revenue. Is that a maintenance level or is there any increase in 2009 where you're doing some more build outs for DSL? Is that kind of a level you can maintain going forward in 2010 and beyond?

Alan L. Wells

I think, Patrick, we view our CapEx level as more than just maintenance mode. I think that we continue to expand our fiber network across the state, and have had several growth oriented projects that we've included in that. If you think back in our history, if you were to look back in the 2002 2003 timeframe, we had much lower CapEx levels, and that probably would have been more maintenance related, but we think we can continue this trend for quite a while.


Thank you very much and that was our final question. (Operator Instructions). And at this time, we have no further questions. I'll turn it back over to our speakers for closing remarks.

Alan L. Wells

Okay thank you. Thank you again for joining us this morning. We appreciate your time. We welcome your questions and hope you can join us again next quarter for our regularly scheduled call. Thank you.


Thank you very much. We would like to conclude today's conference. Please have a wonderful day.

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