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In this environment of low interest rates and generally anemic dividend yields, there seems to be a substantial movement toward investing for income. One of the last refuges for the dividend investor in the current environment is rural telephone companies. In this area, I have found Consolidated Communications Holdings, (NASDAQ:CNSL), which provides services in Illinois, Texas, and Pennsylvania. The company offers a dividend yield of 8.6%, which is well covered by free cash flow. Consolidated's free cash flow yield based on 2010's results is an attractive 11.4% after excess cash is taken into account.

As with many rural telephone companies, Consolidated has been losing traditional subscribers in favor of wireless customers. The company is attempting to maintain earnings power by expanding data services such as high speed Internet access and IPTV. Data services currently represent 19.6% of Consolidated's total sales, up from 15% in 2008. Although total sales are modestly down from 2008, the company is also making use of investments in several wireless partnerships, which have served to stabilize the firm's earnings and have for the moment at least erased the declines in land-line income.

Turning to the figures, the first item of note is the presence of significant excess cash on the balance sheet. Excess cash may be estimated as total cash minus the extent to which current liabilities exceed noncash current assets. Consolidated's current liabilities total $75.5 million and its noncash current assets (apart from deferred tax assets) total $54.5 million, leaving a difference of $21 million. The firm has $68 million in cash, of which $47 million may be considered excess cash. Based on the firm's current market cap of $548 million, this leaves $501 million as the market value of Consolidated's capital assets.

In 2010, sales were $383 million (normally the income from the excess cash would be removed from sales, but owing to the low returns on cash in the present environment, Consolidated's interest income is has been negligible for the past three years). Reported operating income was $66 million, and income from the wireless partnerships was $28 million. Furthermore, Consolidated has an additional source of cash flow in that its depreciation and amortization deductions have exceeded capital expenditures by a significant amount: $45 million dollars. As a result, total operating cash flows for 2010 were $139 million. Interest expense for 2010 was $51 million (producing an interest coverage ratio of 2.7x), leaving $88 million in pre-tax cash flows. Applying a 35% tax rate, this leaves $57 million in free cash flow to equity. Based on the market price without excess cash, this is a free cash flow yield of 11.4%, which is attractive for a stable business without any obvious prospects for significant growth. Dividends paid in 2010 totaled 46 million.

In 2009 sales were $406 million, reported operating income was $71 million, wireless partnership income was $25 million, and excess depreciation was $43 million, to total $139 million in operating cash flow. Interest expense was $56 million, leaving $83 million in pre-tax cash flows, or $54 million after tax. Dividends paid in 2009 totaled $46 million.

In 2008, sales were $418 million, reported operating income was $74 million, disregarding a noncash impairment, wireless partnership income was $21 million, and excess depreciation was $43 million, producing a total of $139 million in operating cash flow. Interest expense was $66 million, leaving $73 million in pretax earnings, or $47.5 million after taxes. Dividends paid in 2008 were $45.5 million.

CNSL Sales & Cash flows
2008-2010

2010

2009

2008

Sales

383

406

418

Reported Operating
Income

66

71

74

Wireless Partnership
Income

28

25

21

Excess Depreciation

45

43

44

Operating Cash Flow

139

139

139

Interest Expense

51

56

66

Pre-tax Free Cash Flow

88

83

73

After-tax Free Cash Flow

57

54

47.5

I should also point out that cash flows from excess depreciation and amortization are generally tax-free, although the above calculation treats them as taxable. The latter treatment is more conservative, and may be preferable, in that the purpose of this valuation is to arrive at a firm's long-term earnings power and over the long term the gap between depreciation and capital expenditures may be expected to resolve itself.

However, the tax benefit of excess depreciation is undeniably of value to shareholders and should not be ignored. In Consolidated's case, the amortization in question pertains to a customer lists, which amortizes over 15 years. The gap between depreciation and capital expenditures may be expected to resolve itself over the next seven years, based on the current rates of depreciation and capital expenditures. From these figures, I calculate the present value of the tax benefits of excess depreciation and amortization to be roughly $43 million at a 10% discount rate. Of course, this is one estimate among many that could be justifiably made, but I think that it would be of interest to investors examining the company.

My one concern with Consolidated Communications, apart from the possibility data services and wireless income may not completely compensate for the losses of traditional customers, is that the current dividend level does not leave much cash to pay down debt or apply to other purposes. Interest coverage based on 2010's earnings is adequate for a telephone company; as such companies have generally stable and predictable earnings. Furthermore, although Consolidated's debt is entirely variable rate, the firm has also taken the sensible step of locking in the present low rates using interest rate swaps for nearly all of its total debt balance. However, the debt agreement falls due to be refinanced in 2014, and although phone companies are generally viewed as having stable operations that can survive a significant debt balance, the interest rates may have risen uncomfortably by then.

On the whole, though, Consolidated Communications offers an attractive dividend yield and the stable cash flow situation that makes it likely that the company will be able to continue paying it. Therefore, I can recommend it as a candidate for purchase by any income-oriented investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Consolidated Communications: A Strong Candidate for Dividend Investors