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Within the broader telecommunications industry is a group of companies that primarily provide local and long distance voice services, sometimes referred to as plain old telephone service, or "POTS." These companies are each facing significant value destruction from the seemingly irreversible industry trend of rapidly declining POTS, and are therefore attempting to widen their offerings into a vast array of new data and Internet products and services for both residential and commercial customers.

The group that I will look at range in size from industry giant AT&T (NYSE:T) to the much smaller FairPoint Communications (NASDAQ:FRP), as well as those companies in between like Frontier Communications (NASDAQ:FTR), CenturyLink (NYSE:CTL), and Windstream (NASDAQ:WIN). I have excluded Verizon Communications (NYSE:VZ) from this discussion, even though it is a major player in POTS, because it is further along in its evolution away from POTS. Verizon now generates about 37% of its revenue from traditional phone service compared to just less than 49% for AT&T.

These POTS companies will expand and transform their offerings through acquisitions and capital spending funded by divestitures, excess operating cash flow, new borrowing, or a combination of all three. Therefore, it is critical to assess each company's cash generating capability to determine which will be most able to fund the needed acquisitions, capital expenditures, and higher debt service -- along with enough remaining to continue high-dividend payouts, yielding above 5.5% for all companies (except FairPoint). Those with the strongest cash flow are best positioned to successfully make the switch from POTS into the brave new world of telecom.

The first observation that needs to be made about these POTS companies and their ability to transform from their former selves is that they are starkly different in terms of resources. AT&T has revenue of about $127 billion and total assets of more than $270 billion. The next largest company in my group in terms of revenues and assets is CenturyLink, which has revenue of about $15 billion and total assets about $56 billion. The third largest company is Frontier Communications, with revenue of about $5.2 billion and total assets of about $17.5 billion. Windstream, which has revenue of about $4.3 billion and total assets of about $14 billion, is next. Finally there is FairPoint Communications, with revenue of about $963 million and total assets of about $2 billion. Because of the high fixed costs inherent in the telecom industry, these large discrepancies in scale are a significant factor impacting these individual companies' ability to effectively move into new business lines and product/service categories.

Over the past five years, the average operating cash margin (operating cash flow as a percentage of revenue) of these five companies has been about 26.2%, with Frontier the highest at 30.0% followed by Windstream at 28.7%, CenturyLink at 27.4%, AT&T at 27.3%, and FairPoint at 17.7%. These percentages reflect the robust cash flow of the broad communications industry, where the average operating cash margin was about 22.8% for the trailing 12 months compared to an average of only about 10.0% for all industries, as of the third quarter of 2011. Other than laggard FairPoint, these companies are roughly equal in their ability to generate cash flow from operations. However, capital expenditures and acquisitions must be included to get an accurate gauge of total cash-generating capability.

Frontier and CenturyLink spend roughly the same percentage on capital expenditures at 13.9% and 13.3%, respectively. So Frontier's free cash flow margin stays above CenturyLink's at about 19.3% compared to about 18.6%, respectively. Where the companies separate is in the amount they spend on acquisitions. Frontier's acquisitions have averaged about 6.8% of revenue over the past five years compared to only about 3.6% for CenturyLink. Including these uses of cash, CenturyLink emerges as the leader at an adjusted free cash flow margin (operating cash flow less capital expenditures less acquisitions plus divestitures as a percentage of revenues) of about 15.2%, compared to about 12.5% for Frontier, 10.8% for Windstream, 9.7% for AT&T, and 1.2% for FairPoint.

While CenturyLink's higher adjusted free cash flow margin suggests that it has better cash flow than its competitors to help it move beyond the declining POTS business, it is actually Windstream that has devoted the highest percentage of its sales to capital spending and acquisitions at about 22.1% average combined since 2007. However, Windstream has had to add to its long-term debt burden to fund this spending. Only AT&T has positive cash flow after deducting capital spending, acquisitions, and dividends from operating cash flow. Because AT&T has been able to achieve its capital investment (capex and acquisitions) without materially increasing its long-term debt load, I like this company's position better than each of its competitors. Add in its tremendous scale, and AT&T has great long-term potential to take significant market share and boost its intrinsic value.

The telecom sector is highly competitive, so future cash flows are influenced by many factors both within and beyond management's control. This analysis should not be construed as a predictor of future cash flow generation, but merely as a guide to how management has behaved in the past in terms of managing operations and debt, capital allocation, and dividends. Management that adheres to sound principles in these areas will put their companies in a better position to succeed, even though the telecom business of the future will certainly be different than the past.

Source: 5 Telecom Stocks For Strong Long-Term Gains