INVESTORS EYE RURAL TELEPHONY AS NEW MARKET

One of biggest drivers will be Bell company divestiture of exchanges, panelists said, with Legg Mason analyst Michael Balhoff predicting Qwest would divest up to 40% of its exchanges in near future. He said he also expected divestitures soon by other Bells, although probably not as high percentage. Bells already have divested 10 million lines and Balhoff said he expected number to rise to 40 million in year or 2. He said such action was seen as plus for Bells by freeing them from regulatory burdens and possibly increasing their stock price.

Already, several telephone companies are turning into “consolidators,” expanding their operations or starting new companies based on divested Bell exchanges and smaller telcos willing to sell all or part of their operations, speakers said. Consolidation-based companies such as Valor Communications and Citizens Communications said they made their money by upgrading those exchanges, adding broadband services or at least dial-up Internet access, voice mail, caller ID, other services. They generally aren’t CLECs, instead base their businesses on developing larger, upgraded rural ILECs. “Conditions in the industry have changed a great deal,” TDS Telecom CEO James Barr said. TDS “bought companies wherever we could” and now is in 28 states, he said. “Sometimes those companies were in good shape, more often not.” As company improved service, it was able to recoup costs by raising prices, he said. Many acquired telcos are “fixer-uppers,” Century Tel CFO Stewart Ewing said.

Iowa Telecom CEO Alan Wells said his company was built on exchanges divested by GTE in wake of Verizon merger. Most of those exchanges had no dial-up Internet, which Iowa Telecom quickly added, he said, gaining praise from customers. Valor Chmn. Anne Bingaman, former Dept. of Justice antitrust chief, said her company buys up exchanges in N.M., Okla. and Tex. from Bells as well as small telcos and provides advanced services and other upgrades. Local govts. have welcomed Valor’s efforts to upgrade exchanges. “There is a sense of excitement” because most small communities would prefer to get their broadband services from local telco and are happy that Valor is making that happen, she said. “This is what is going on the in the future,” Balhoff said after various consolidators gave presentations.

Another driver is technology, panelists said. Rural telcos that used dividends to offer shareholders value now finding now that those dividends are impeding them from upgrading their services, panelists said, because dividends use up so much cash there isn’t money left for upgrades. Financial experts told audience that such companies have only 2 choices -- cut dividends or sell, and cutting dividends usually creates shareholder outcry. Speakers tended to portray many family-owned rural telcos as sleepy companies, with little emphasis on appreciation, that suddenly are faced with tough choices of competition and technology. Founders are getting older and looking for “graceful exit strategy,” Citizens Communications COO Rudy Graf said. Viewed as “safe companies” with little emphasis on growth, they have been forced into CLEC business, advanced services and other growth businesses with “detrimental” effect on their balance sheets, said Dan Lascano, portfolio mgr. at Caxton investment firm. They've grown their businesses but are depleting what cash flow is left after dividends, he said: “The choice is cut dividends or sell” and companies such as TDS and Century are willing to buy. “If they don’t sell, 6 months later someone hostile will come in and that could be a disaster for these companies and they don’t realize it yet.”

“There are tremendous opportunities for those of us who consider ourselves consolidators,” Citizens Exec. Vp Scott Schneider said. However, while there is “sea change in telco ownership and regulation, there also needs to be a sea change on the financial side,” Schneider said. Consolidators haven’t marketed themselves enough to equity and debt markets and need funds to upgrade facilities and assure Bell companies and regulators that their purchase of lines is in public interest, he said.

Industry-recommended regulatory changes in universal service and access regimes, which are under study by FCC, are designed to encourage investment by providing more certainty, said regulators and trade association representatives who drew up proposals. FCC Common Carrier Bureau Chief Dorothy Attwood said Commission was is keenly aware of importance of providing “regulatory certainty and thus a better investment climate.” However, balancing regulations against investment certainty isn’t easy, she said. For example, she said there was policy reason for placing restrictions on amount of universal service funding that carrier could receive when purchasing exchanges. Rule was designed to ward off manipulation of sale price, she said. On other hand, there’s legitimate concern about its effect on sales, she said. “Regulatory policy has lots of layers,” Attwood said. However, bottom line is that “regulation ought not to be dictating the business plan,” she said. She indicated FCC wasn’t averse to consolidator phone companies, saying many were adding value to communities by improving services. “There is a thirst in smaller communities for advanced services.” FCC’s job is “to make sure the incentives are right” to encourage investment and economic development, Attwood said.

There are offsetting factors for investment in rural telephony, such as “complexity of the revenue stream,” said Dexter Paine, pres. of Fox Paine & Co. “Some people hate revenue streams where some comes from the federal government,” he said, referring to universal service subsidies. Other problems: (1) Exit alternatives are “very challenging” because there are not a lot of consolidators. (2) Changes in regulatory dynamics. (3) Increases in competition down road. However, Fox Paine is in rural investment business because “we happen to think long term these are terrific businesses,” Paine said.