ILEC 3Q11 Results Summary: Cincinnati Bell

Colocation Revenues Up 18% and Pointed Higher

Cincinnati Bell (Nasdaq:CBB) shrugged off steep declines in access lines and a drop in wireless subs in 3Q11, to turn in a solid quarter overall. Its revenue increased $17m YoY in 3Q11, or 5%, to $369m and its operating income rose 4% YoY and 11% QoQ to $86.3m. Cincinnati Bell’s bottom line also improved 20% YoY to $17.6m in the quarter. The key drivers for its success in 3Q11: data centers and IT services. 

The company increased its stake in the data centers last June when it purchased CyrusOne for $525m, adding 174k square feet of data center capacity. At the time Jack Cassidy, president and ceo of Cincinnati commented that the deal “an important step in our long-term strategy of becoming the preferred global data center colocation provider to Fortune 1000 companies.”  That strategy appears to be paying off, as its data center colocation revenue in 3Q11 was up 18% YoY from its 3Q10 levels to $47m, with a full quarter of CyrusOne operations in both periods.

The trend in Cincinnati Bell’s capex margins over the past five quarters reflects the success of its data center investments. Capital spending rose steadily from $43m in 3Q10 to $74.5 in 3Q11, $41m of which was spent on data centers. Capex margins meanwhile have jumped 75% from 12.2% to 20.2% YoY in 3Q11. As Cincinnati Bell gets more bang for its buck in data colocation, it looks to invest more in the business. It added 67k square feet of storage space in the 3Q11, and plans to add another 30k square feet in 4Q11.

The company also enjoyed growth in its IT services and hardware segment as increased business spending drove hardware revenues up $12.2m in 3Q11, while revenue from managed services such as web hosting and data backup rose $2.4m or 17% YoY.

While business-centric services fueled a majority of Cincinnati Bell’s gains, its fiber-based consumer services—branded “Fioptics”—have shown promise as well. It added 13k television subs and 14k Internet subs in the past year—51% and 58% growth—and increased its Fioptics ARPU from $114 to $122 YoY in 3Q11. Fioptics connections however still represent a small percentage of Cincinnati Bell’s overall connections mix. DSL customers outnumber its 38k fiber Internet customers 6 to 1, and despite beginning its Fioptics rollout in 2008, its expansion efforts have been slow.

This deliberate pace however sped up in 3Q11 as capital expenditures for Fioptics jumped 25% YoY to $12.5m. Cincinnati Bell expanded its fiber footprint to include another 25k houses in the quarter, increasing its homes passed to 115k, after building fiber to only 30k homes in all of 2010. A main reason for speeding up its build: strong demand. Fioptics’ penetration of homes passed is 29% in areas in which service has been offered for at least a year. By contrast, AT&T’s has achieved only 25% penetration of U-verse in the service areas in which it has marketed service for three years.

Despite a solid quarter overall, 3Q11 was not without its disappointments for Cincinnati Bell. Access lines tumbled 7.8% YoY to 635k in 3Q11, and it lost 27k postpaid wireless subs, or 8% of its postpaid customer base, driving wireless revenues down $5m YoY. The telco has cannibalized a portion of its own access lines, offering customers VoIP services as part of its revenue replacement strategy, while management attributed its wireless sub losses to stronger competition from national carriers. 

 

2Q11 Connections: ILEC Quarterly and Annual Growth Rates

Wireline Voice Losses Outpace Fiber Growth

The steady decline in wireline connections continued for ILECs in 2Q11, as overall connections fell around 1% for the publicly traded LECs QoQ.  Second quarter adds of broadband and video connections could not make up for the 1.8m loss of wireline voice connections.  

ILECs across the board experienced QoQ wireline losses in 2Q11 with the exception of slight gains reported by CenturyLink (NYSE:CTL) and SureWest (Nasdaq:SURW). CenturyLink’s overall gain was fueled 1.4% QoQ growth in video connections, while SureWest added broadband and video subs.

The smallest LEC in our sample, Warwick Valley Telephone Company (Nasdaq:WWVY), experienced the sample's largest percentage loss of wireline connections in 2Q11 (1.9% QoQ), driven by a 3.2% drop in voice connections.  Meanwhile, the largest LEC by connections, AT&T (NYSE:T), also lost approximately 3% of its voice connections in the quarter and accounted for 86% of the net wireline losses.

Growth in fiber optic video fueled the largest wireline gains in 2Q11.  Cincinnati Bell (NYSE:CBB) reported 10% connections growth in its “fioptics” video services, while NTELOS’ FTTH video customer base grew 5.2% in the quarter.

The annual wireline growth trends in 2Q11 were merely an extension of the quarterly results.  On a weighted average basis wireline voice connections fell 10.7% on the year, while broadband and video connections have grown 10.9% and 15.4% YoY.

The main area of wireline growth for both small and large ILECs has been in fiber based services. NTELOS (Nasdaq:NTLS) increased its wireline connections 75% YoY, using M&A to expand its fiber services, and now is in the middle of a FTTH build in Virginia. Verizon and AT&T have experienced wireline losses overall, but are increasingly reliant on their FiOS and U-verse FTTX services for growth. Elsewhere, Cincinnati Bell has invested $48.1m in its fiber optic network thus far in 2011, and SureWest plans to extend its FTTH services to 15.5k homes by the end of the year.

Six Degrees of Separation: ILEC Returns and Stock Prices Factored In

CenturyLink and Otelco Top Final Two Tests

Up to this point we have analyzed and graded the public ILECs in four categories: Profitability, Growth, Financial Condition and Efficiency. Our final two tests are perhaps what shareholders and potential investors pay attention to most: Return to Shareholders and Long-Term Performance. We believe that a company’s historical stock performance is the best indication of a company’s overall performance, as the eyes of millions of investors recognize sound/weak management, company risks and growth prospects. Accordingly, Return to Shareholders and Long-Term Performance are weighted more heavily (20% and 30% of composite rank) in determining  the winner of our “Six Degrees of Separation” analysis. Let’s take a look at how the public LECs measured up in 2010.

CenturyLink (NYSE:CTL) earned top marks in Return to Shareholders, finishing on top in its second category this year (in addition to Growth). Its $8.70 in free cash flow per share was 70% higher than the next closest ILEC, and its 2011 acquisition, Qwest, also topped a pair of tests—cash return on capital investment and return to investors. Qwest’s 92% return to investors in 2010 was aided by the 15% premium CenturyLink agreed to pay over Qwest’s stock price on the day its merger was struck. Elsewhere, second place AT&T (NYSE:T) generated the most in terms of (diluted) earnings per share of the public LECs in 2010.     

There were no surprises at the bottom of the ranks.  Burdened by its bankruptcy, Fairpoint’s (Nasdaq:FRP) return to shareholders was graded worst of all ILECs for the second year in a row. Its bottom of the barrel free cash flow and diluted earnings per share were both negative, while only Warwick Valley Telephone (Nasdaq:WWVY) generated less cash return on capital investments. With its third F in five categories, Fairpoint essentially sealed up last place overall with its poor performance in Return to Shareholders.

The only significant movement in the category was courtesy of Cincinnati Bell (NYSE:CBB) which fell six spots to fourteenth overall, earning a D in the process. A lagging stock price lowered its return to investors to -19% in 2010, a year after it generated the second best return to investors  (79%) of all the public LECs.

We now move on to the final and most heavily weighted category in our Six Degrees analysis: Long-Term Performance.  This final category consists of just a single test—the growth of a $10,000 investment over a three year period.  This measure of total return includes stock price appreciation and dividends paid. 

Finishing in first place, Otelco (Nasdaq:OTT) generated the highest total return for shareholders over the past three years, turning $10k into just under $19k. The return was 30% higher than the next best long-term performer, Warwick Valley. The market rewarded Otelco’s overall management and financial performance, driving its price up 34% in 2010. Investors also looked positively on Warwick Valley’s results in 2010, bidding its stock price up 15%.

On the downside, a pair of smaller LECs were beaten up by Wall Street over the past three years. A $10k investment in New Ulm Telecom (OTC:NULM) in January 2008 had lost half of its market value through 2010. Meanwhile, Shenandoah Telecommunications (Nasdaq:SHEN)--awarded an A for its long-term performance a year ago--dropped ten spots in this year’s test. The market shaved 10% off its stock price in 2010, reflective of its declining performance that we have observed in this year’s Six Degrees tests.

It has been a tale of two stories for Shenandoah the past two years.  In 2009, we crowned it the overall winner of “Six Degrees of Separation” as it tested well across the board in efficiency, financial condition, growth, and profitability measures. The market took notice of its strong performance, and kept its stock price high. On the other hand, in 2010, Shenandoah’s growth slowed, its operations became less profitable and less efficient, and investors found it less attractive.

With Shenandoah’s struggles, it’s safe to say that we will be crowning a new winner in the “ILEC Six Degrees of Separation” this year. The ballots have all been cast and just need to be counted.  Tune in tomorrow to get the results.

Six Degrees of Separation: ILECs Measured for Efficiency

Job Cuts Lead to Efficiency Gains for ILECs

Historically, the goliaths have dominated the "Six Degrees of Separation" Efficiency category, logically due to their economies scale. The third annual results provided little change, with AT&T (NYSE:T) cruising to a three-peat in the category. YoY the efficiency measures for the industry were stable, with one exception: revenue per employee was up. And with revenues relatively flat for ILECs in 2010, it’s clear that job cuts drove the gains.

AT&T topped the working capital to revenue test en route to its A+, as its test average was 4.5 in the four efficiency measures. Fellow giant Verizon (NYSE:VZ) followed close behind in third place, earning an A along side second place finisher Cincinnati Bell (NYSE:CBB).

Hickory Tech (Nasdaq:HTCO) was in the minority of ILECs that added jobs, but growth at its business segment, Enventis, drove its revenue per employee up 13% YoY. Hickory tested best in both asset turnover ratio and revenue per employee growth. Its two wins made it the top overall gainer in efficiency, moving up eight spots from last year to sixth place. Elsewhere, Shenandoah Telecommunications (Nasdaq:SHEN) rated as the most efficient ILEC in the gross PP&E per connection test, but its high working capital to revenue ratio (16.1x) dropped its overall grade to a B-.

At the bottom of the efficiency ranks this year we had a repeat loser from 2009. That dubious distinction went to Fairpoint (Nasdaq:FRP), also earning its second F this year (Profitability the other). While Fairpoint did not rank last in any one test, it placed in the bottom third of all four. Each efficiency test had a unique last place finisher: Warwick Valley Telephone (Nasdaq:WWVY) in working capital to revenue, New Ulm Telecom (OTC:NULM) in asset turnover ratio, CenturyLink (NYSE:CTL) in revenue per employee and Alaska Communications (Nasdaq:ALSK) in gross PP&E per connection.

The main storyline coming out of the efficiency category is bad news for telecom workers: companies became more efficient in 2010, but at the expense of American workers. After declining in 2009, revenue per employee increased around 3% YoY. Industry-wide a net 35k jobs were shed by the public LECs, driving the efficiency gains while revenues were flat. Ten of the eighteen ILECs in our sample cut employees, and the big boys—AT&T and Verizon—alone trimmed 44k from their payrolls.

This trend shows no signs of slowing in the future, especially given the projected job losses should the AT&T/T-Mobile merger go through. Despite AT&T’s promise to bring 5,000 quality jobs to America post merger, the truth is that more people will lose their jobs to ensure that synergy values are achieved and that efficiency improves. This is good news for AT&T’s Six Degrees efficiency rank down the line, not great news for AT&T/T-Mobile employees.

Six Degrees of Separation: Windstream and CenturyLink Top Profitability

Windstream and CenturyLink Grade Out as Most Profitable ILECs

On a daily basis we at JSI Capital Advisors monitor the public ILECs on a real-time basis, keeping tabs on business and growth strategies, industry trends and developments, and LEC mergers and acquisitions. Once a year however, we like to take a step back and analyze the public LECs based on a series of their financial ratios in an analysis we call “Six Degrees of Separation.” The series of measurements in Six Degrees evolved from the once-annual “Ten Part Test” which we created in 2002.

Using twenty-one financial tests, which we group into six broader categories, we compare the investment, financial, management and stock market performance of the publics LECs as of calendar year end. For each test, we rank the companies from 1 to 18 (1 being the best, 18 the worst) then calculate an average ranking in each category (Profitability, Growth, Financial Condition, Efficiency, Return to Shareholders, and Long-Term Performance). Based on these averages, we assign corresponding letter grades for each of the six categories based on a bell curve. After the companies are evaluated across the six degrees, a weighted composite score is generated, overall grades are assigned, and the Six Degrees of Separation winner is crowned.

This year in the third annual "ILEC Six Degrees of Separation," we will breakdown each of the six categories individually in Phone Numbers, revealing the top rated ILEC once all six degrees have been vetted. As a reminder, we are not suggesting that you go out and purchase the "ILEC Six Degrees of Separation" winner and short the loser, but the results should tell you that a closer look at the companies is warranted.

Without further ado, let’s crunch some numbers. First up: profitability. The four tests we use to measure profitability are return on equity, return on assets, OIBDA margin and free cash flow margin.

This year, two LECs—Windstream (Nasdaq:WIN) and CenturyLink (NYSE:CTL)—finished in a dead heat for first place in profitability, averaging a rank of 3.5 out of 18 in the four tests. Windstream posted the strongest ROE at 57%, while CenturyLink’s 50% OIBDA margin topped all ILECs. Rounding out the individual test winners were Otelco (Nasdaq:OTT) in free cash flow margin, and AT&T (NYSE:T) in return on assets. Using Windstream’s top three placements in 3 of 4 categories as a tiebreaker, we ranked it slightly higher than CenturyLink, good for first place and an A+ grade. 

A year ago, Windstream also graded out best in profitability with an identical score of 3.5, while CenturyLink improved on its average test rank of 7.0 in 2009. CenturyLink’s most notable improvement was in the OIBDA margin test, as its 2010 results included a full year of Embarq operations and the related cost synergies it gained after acquiring Embarq in 3Q09.

On the opposite end of the spectrum, Fairpoint (Nasdaq:FRP) and SureWest Communications (Nasdaq:SURW) both received F’s. Fairpoint—in bankruptcy throughout 2010—repeated its 2009 last place showing after finishing in the basement of the ROE and ROA tests. SureWest earned its F with consistency, finishing in the bottom third in all four profitability measures.

Last year’s overall Six Degrees winner, Shenandoah Communications (Nasdaq:SHEN), fell six spots in profitability rank this year, as its OIBDA margins eroded from 47% to 38% YoY. The decline was related to cash spent on upgrades to its acquired cable systems, and an amendment to its wireless agreement with Sprint that increased its payments from 8.8% of postpaid revenues in 2009, to 12% in 2010 (note: in 2011 the Sprint agreement updated Shenandoah’s payment to 20% of wireless revenues, further cutting into its margins).

On the upside, Consolidated Communications (Nasdaq:CNSL) jumped from ninth to third place in profitability YoY, as it improved its rank in all four tests and earned itself an A. Consolidated successfully trimmed expenses in 2010, reducing its number of customer care centers from six to two, which more than offset revenue declines.

While Windstream and CenturyLink tested as the most profitable public LECs in 2010, a shakeup in the category can be expected next year. Most notably, CenturyLink completed its acquisition of Qwest (#14 in profitability) in 2011 and has watched its OIBDA margins contract 20% in six months.

In closing, a few notes on the return on equity test: Qwest, Alaska Communications (Nasdaq:ALSK) and Fairpoint had negative net income in 2010 and were ranked below Otelco and Cincinnati Bell (NYSE:CBB) which had negative equity balances, but positive net income in 2010. Consistent with our historical methodology, negative net income was penalized more than negative equity.