By Michael A. Tyler
Consolidated Communications (NASDAQ:CNSL) is the primary telephone company in many rural communities in Illinois, Pennsylvania and Texas. Like almost every other phone company in the U.S., Consolidated in recent years has faced increasingly intense competition from cable television companies. To fend off rivals, Consolidated was an early adopter of high-speed Internet and video technology. Today, it offers an impressively wide array of telephone, data and video services, including one of the most advanced television-over-Internet video products available anywhere. The company serves about 310,000 telephone lines, 105,000 Internet lines and almost 30,000 video customers. The company does not operate any wireless networks.
With interest rates likely to remain quite low for an extended period, investors have been hungry for yield anywhere they can find it. Several rural phone companies have been favored for their high dividend payouts, and their stock prices have been on a tear; almost all of them have outperformed the S&P 500 this year. Consolidated is no exception.
Yet even after a strong year, the stock’s dividend yield is still about 8.4%, highest among its peers and far better than investors can get from most government or corporate bonds. Free cash flow is currently more than adequate to cover the dividend.
Even so, Super Stock Screener’s Ranking System hates this stock, giving Consolidated Communications a 4 rating. By comparison, three of its peers (Alaska Communications (NASDAQ:ALSK), Frontier Communications (NYSE:FTR) and Windstream (NASDAQ:WIN) are given 1 or 2 ratings. From a fundamental perspective, I agree: Consolidated’s investment appeal is illusory, and the stock could be a painful one to own.
But it’s still got that fat dividend, and recent operating results were good. So what’s not to like?
What Today’s Stock Price Really Tells Us
The answer, I’m afraid, is that there’s plenty not to like. In fact, I think this stock is heading for a very bumpy ride, and I’d rather choose other rural telcos if I’m chasing yield. Let’s look at a few comparisons:
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These companies all share some common characteristics. The typical rural phone company business model has high fixed costs and uses substantial debt leverage to amplify returns to equity. With fairly low growth rates, re-investment is somewhat low, meaning that there is usually plenty of free cash flow to return to shareholders in the form of dividends.
This leads to the high dividend yields and high P/Es shown in the table above. It’s unusual to see companies look so cheap on their dividends and yet so expensive on more traditional valuation measures such as P/E or EV/EBITDA (the ratio of enterprise value - market capitalization plus debt - to cash flow - earnings before interest, taxes, depreciation and amortization). In a nutshell, the market is saying that for these stocks, pretty much their only appeal is the dividend.
A Closer Look at Valuation
So let’s look a little more closely at Consolidated Communications against its peers. Note that the stock has the highest EV/EBITDA ratio. Because it’s both small and operating in only three states, Consolidated Communications is a rather easily digestible acquisition target – and that’s why investors have bid up the company’s value relative to its cash-flow generation.
That much is entirely reasonable. Yet it’s interesting that no one has stepped up to make a bid, despite plenty of incentives to do so. A larger phone company could easily afford to buy Consolidated, and the potential cost savings of the merged company would sharply reduce the risk of earnings dilution to the acquirer.
So why hasn’t it happened? In part, of course, it’s because management hasn’t wanted to sell. And in part it’s because the logical buyers (Windstream, Frontier, CenturyLink (NYSE:CTL) and others) have been distracted with other acquisitions lately. But it’s also because Consolidated’s business fundamentals don’t support the price.
Clouds on the Horizon
Earlier, I mentioned that the company has an impressive product portfolio and that it has been reasonably successful holding its ground against incursions from cable companies. That’s true in the residential market, and in fact Consolidated has arguably done a better job than its peers.
But in the commercial market, the story is beginning to look somewhat different. The company simply hasn’t been able to protect its commercial accounts as well as it has held its residential customers, and the result has been disappointing operating trends in the commercial segment. In a weak U.S. economy, there’s no reason to expect a significant turnaround anytime soon. So far, the weakness has been masked by the residential resiliency, but that may change soon.
In short, the company’s revenue and cash flow outlook is troubling. Citigroup Investment Research pegs the company to suffer revenue and profit declines in each of the next two years, while most of its peers should be able to hold steady.
Why the Stock is Dangerous
Now let’s look at the company’s balance sheet in comparison to its peers:
Consolidated Communications has, by a significant margin, the highest debt leverage among its peers. Worse, all of the company’s debt must be refinanced within the next five years. Frontier and Windstream have less than half their debt coming due in the same time period, and have much lower leverage.
As the company’s operating trends begin to turn south, Consolidated’s high debt leverage can hurt investors in two ways: First, weaker fundamentals scare away potential acquirers, so the premium valuation multiples might disappear. If the company’s 9.2x EV/EBITDA multiple were to drop just to the 8.2x level of Alaska Communications, the stock price would fall 26% to $13.60; and if it were to fall to the 7.2x level of Windstream, investors would lose more than half the value of their holdings in the company.
Second, the company’s debt means that more of its profits are absorbed by interest payments on the debt. That leaves less money for dividend payments. Consolidated already pays out almost 80% of its free cash flow to stockholders. A slight downturn in the business could squeeze out that last 20% cushion and force the company to reduce its dividend – and that would clobber the stock just as surely as a lower cash flow multiple.
In short, Consolidated has been too aggressive in managing its balance sheet and its dividend policy. Investors in the company are on the knife-edge of a delicate tension: The possibility of a takeover pulling the stock higher, and the risk of deteriorating business trends and a lower dividend dragging the stock lower. Even though an 8.4% yield looks awfully tempting compared with bond yields, I think it’s time to head for the exit.
Michael A. Tyler, CFA, is the managing member of West Shore Investment Management LLC, an independent investment advisor. He also manages the West Shore Fund LP, a long/short equity hedge fund. The West Shore Fund does not currently hold long or short positions in the shares of any of the companies mentioned herein. This document is not intended as and does not constitute an offer to sell any securities to any person or as a solicitation of any person to purchase any securities. Further information is available by contacting West Shore Investment Management LLC or Mr. Tyler at email@example.com.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.