Target Growth, Hurry Your Harvest.....or Find the Door

The telephone industry is changing so rapidly, and from so many different directions, it’s almost impossible to keep pace.  The National Broadband Plan, Google Voice, LTE, DOCSIS 3.0, Magic Jack and the Connect America Fund are just a few of the emerging developments casting a shadow on the industry.  With so much going on, it’s easy to become a “deer in the headlights,” frozen by the magnitude, volume and pace of change.

With so much change and uncertainty facing RLEC owners, it is more important than ever to take the time to critically and objectively assess where you are and, more importantly, where you are going.  As they say, “No wind favors he who has no destined port.”

To assist RLEC owners with this task, we’ve defined six RLEC ownership strategies.  Three of those strategies – horizontal growth, vertical growth and organic growth - involve the pursuit of, you guessed it, growth.  Two strategies – the current exit and the smart exit – emphasize planning for the near- or long-term sale of your company.  The final strategy – the Harvest Mode - is for those that, for one reason or another, are restrained from either growing or exiting.

There is one more strategy, which we’ll reveal at the end.  Suffice it to say, you’re better off embracing one or a combination of the initial six strategies.

We have ordered the six ownership strategies in order of their ease of execution.  Our first ownership strategy, a current exit, is a relatively easy task.  On the other hand, our final ownership strategy, organic growth, is far easier to describe than execute.

Current Exit - Sometimes it seems like an increasing number of RLEC owners are opting to make for the exit rather than weather the uncertainty of what looks to be coming down the road.  Over the last few years, we’ve seen a number of high-profile names sell their companies including Walt Clay of Hutchinson Telephone Company, Bob Eddy of Sherburne Tele Systems, Mike Coltrane of CT Communications, Chris Dupree of Graceba Total Communications, and, more recently, the Henning Family of Cameron Communications.  These are stalwarts of the industry whose identities and legacies are permanently intertwined with the small and rural telephone company industry.  When folks such as these decide its time to “throw in the towel,” it’s got to be a bit disconcerting to those left carrying the torch.

While the number of annual ILEC sale transactions has remained relatively stable over the last decade, the percentage of ILECs hitting the market each year continues to tick upwards.  With about 20+/- ILECs changing hands each and every year, ownership churns at a rate of about 2.5% a year.  Discount that for the number of cooperative telephone companies, which have contributed only nominally to the number of ILEC sales over the last decade, and the annual rate of churn jumps to more than 5%.

You can’t really blame those who have opted to cash in their chips.  At some level its boils down to the preservation of wealth and security.  It’s generally fairly easy to pencil out how a current sale best achieves those goals.

Others have avoided this alternative, either because they are committed to the execution of one of our other ownership strategies, or because they are waiting for a renaissance of ILEC values before committing to a sale.  While the latter is possible, it seems increasingly unlikely.  The industry has experienced a steady decline in valuation multiples over the last decade.  There is likely a point through which valuation multiples will not descend; however, the same can not be said about the performance metrics to which multiples are applied.  Over the next decade, it will be competition and regulatory uncertainty (or change) that will erode financial performance and overall values.

Owners who pursue a current exit must prepare themselves and their properties for sale.  A sale process can often last as long as nine months to a full year and sometimes even longer (just ask someone who owns an RLEC in New York).  In some cases, particularly for smaller properties, owners must prepare themselves for the very real prospect that a qualified and motivated buyer of their property may not exist.

Harvest Mode - So what happens if you can’t find a buyer?  Or what happens if you can find a buyer, but by the time you finish paying the bank, the broker, and the IRS it doesn’t make financial sense for you to sell?  As we have suggested in the past, in light of current trends within the telephone industry many owners may be faced with the reality that their best course of action is to take “as much money out of the company as [they] can, ride it into the ground, and turn the keys over to the PUC when [they are] done.”  This is what we call the “Harvest Mode.”

The goal of the Harvest Mode is to maximize benefits realized by shareholders and owners of the company.  Often, these benefits are not limited to financial gain but include sustaining a family legacy, employing friends and family members, and/or honoring commitments to communities.  Typically, however, financial gain is a critical driver of the Harvest Mode, manifesting in the form of increased or enhanced owner salaries, dividends, benefits and/or perquisites.

But a harvesting strategy can be an emotionally draining process in a declining business.  This year’s gut-wrenching cost cuts must be followed by next year’s equally draconian cuts, and so on and so on.  It can easily be perceived that the objective of the Harvest Mode comes at the expense of the welfare of a telephone company’s employees and customers.  For this reason, the Harvest Mode is often viewed with suspicion or outright contempt, particularly by employees and regulators.

But there is nothing sinister about the Harvest Mode.  Properly executed, the strategy balances the needs of all stakeholders and can extend the viability of existing operations.  While it is not a growth strategy, it remains a very viable strategy that will increasingly serve as a default in cases where a satisfactory alternative is not available.

Horizontal Growth - You might wonder why, given the decidedly negative current prospects of the telephone industry, someone would pursue an ownership strategy centered on the objective of acquiring ILEC properties.  The industry is hemorrhaging access lines, top line growth is all but non-existent, and improvements in cash flows - if any - are more the result of cutting costs than growing revenues.  Doesn’t an ownership strategy dependent solely on the pursuit of horizontal growth simply create a bigger “Melting Ice Cube” (see The Default Strategy below)?

Perhaps, but there are nonetheless a number of groups pursuing a primarily “horizontal growth” strategy.  The former CenturyTel, which has morphed into CenturyLink through the acquisition of Embarq and the pending acquisition of Qwest, falls into this category.  Frontier Communications, with its recently completed acquisition of 4.2m Verizon lines (it was 4.8m access lines when the deal was first signed) in 14 states is another horizontal acquisition advocate.  American Broadband, which recently announced plans to acquire Cameron Communications from the Henning Family, has for many assumed the role of the industry’s buyer of last resort, a role previously held by the likes of FairPoint Communications and Telephone & Data Systems.

But with values continuing to decline, why are groups aggressively pursuing horizontal acquisitions that, if recent history is an indication, will likely be worth less tomorrow than today?  There are several likely answers to that question including the desire to capitalize on real or perceived synergies with existing operations; the need to capitalize on scarce RLEC acquisition opportunities; or the pursuit of the scale necessary to realize operational efficiencies, capitalize on vertical and/or organic growth opportunities, and to attract capital and management talent.  A somewhat more nefarious objective includes using horizontal acquisitions to mask the decline of existing operations.  And, of course, there’s always the belief that one can operate a property better than the former owners.

Growth through horizontal acquisitions is a strategy that can work, but frequently fails to enhance value.  Success is dependent on the ability to buy right and execute well.  Once all the pieces are put together, it would appear that the former CenturyTel will be able to claim it bought Embarq and Qwest at the right price.  On the other hand, Hawaiian Telcom’s ill-fated acquisition of Verizon’s Hawaii lines and FairPoint Communications’ disastrous acquisition of Verizon’s Northern New England lines are two high-profile examples of what happens when execution falls short of expectations.

Smart Exit - A “smart exit” strategy often involves using complex tax-advantaged techniques to maximize the after-tax proceeds (as opposed to before-tax proceeds) realized from a sale of a business.  In some cases, the goal of maximizing sale proceeds is subordinate to the ability to structure the transition of ownership to a target group (e.g., younger family members and employees).

The title “smart exit” isn’t meant to imply that this ownership strategy is wiser than other alternative ownership strategies including a current exit.  Rather, it’s intended to recognize the typically complex nature of these exits.  Smart exits usually unfold over longer periods of time and are typically engineered by legal and tax planning professionals.

For example, back in September 2009, the shareholders of Midvale Telephone Exchange filed paperwork with the FCC announcing their intention to transfer control of the 3,000-line Midvale, Idaho based RLEC to an employee stock ownership plan (ESOP).  The formation of an ESOP, and the transfer of control of an RLEC to that ESOP, is a complex, specialized transaction that requires significant planning and the involvement of qualified professionals knowledgeable in ESOP transactions.  Properly executed, the sale of an RLEC to an ESOP can result in exiting owners receiving tax-advantaged liquidity and cement their legacies by transitioning future ownership to employees.

Other examples of smart exits include the many creative estate and tax gifting strategies that, with an appropriate long-term planning and execution time frame, can result in the efficient transfer of some or all of a company to next generation family members.

Smart exits can also take the form of an amped up current exit.  For example, Verizon used a smart exit to facilitate the sale of its Northern New England properties to FairPoint Communications back in 2008 and the recently completed sale of its operations in 14 states to Frontier Communications.  Verizon employed a “Reverse Morris Trust” to transfer the ownership of the properties to FairPoint and Frontier on a tax-advantaged basis.

A well planned and executed smart exit is the closest thing the M&A field has to hitting for the cycle.  Unfortunately, the industry’s declining prospects and values have dulled the allure of these techniques.  After all, the objective of a smart exit is to make future generations or employees appreciate the opportunity of ownership, not leave them holding the bag.

Vertical Growth – A vertical growth strategy involves expanding into complimentary vertical services, typically via an acquisition.  Examples of notable recent vertical growth initiatives include Shenandoah Telecommunications’ (Nasdaq:SHEN) acquisition of JetBroadband Holdings’ cable operations in Virginia and West Virginia, Telephone & Data Systems’ acquisition of VISI, Inc., Ntelos Holdings’ (Nasdaq:NTLS) planned acquisition of FiberNet from One Communications, and Alaska Communications System’s (Nasdaq:ALSK) recent acquisition of 49% of information technology services firm TekMate. We view Windstream Corp. (NYSE:WIN), which in February 2010 completed its acquisition of Nuvox, Inc. and has recently announced plans to acquire Kentucky Data Link and Norlight, as the industry’s petri dish for vertical growth initiatives.

If you lack internal capabilities necessary to penetrate a new market, or lack the time necessary to gain an adequate foothold, growing through vertical acquisitions can be a viable and compelling strategy.  By marrying complimentary assets and services, vertical growth initiatives can not only realize significant operational efficiencies, but also position a telco for organic growth as well.

Similar to a horizontal growth strategy, identifying and realizing synergies between the two operations is critical to value creation under a vertical growth strategy.  However, unlike horizontal growth, which positions a company to provide legacy services to new customers, vertical growth positions a company to provide legacy and new services to legacy and new customers.  Properly executed, a vertical growth strategy can not only open up opportunities for growth through cross-selling new services, it can also enrich a company’s relationships with its existing customers, resulting in lower churn.

A vertical growth strategy has its share of risks.  The strategy involves buying into new and complimentary lines of business.  Not only are there execution risks as well as the risk that expected synergies fail to materialize, but because vertical growth strategies involve acquiring entities operating in unfamiliar lines of business, it is often necessary to rely on the abilities of a new, and often unfamiliar management team (who often come along in the deal).

Organic Growth – In the perfect world, organic growth would be plentiful and limitless.  Unfortunately, the world is not perfect, organic growth is neither plenty nor without limit, and recent efforts to fuel organic growth have proven illusory.  This is clearly the most difficult growth strategy to successfully execute.

Organic growth is typically realized by either increasing the number of customers served (other than through acquisition) and/or increasing the number of products and services sold to any given customer.  Back in the good old days of the 1990s, organic growth was plenty as customers hooked their dial-up modems and fax machines to second and third lines. Since then, the industry’s growth drivers have all but dried up.  Access lines are rapidly declining and the adoption of broadband services, the engine that fueled much of the industry’s growth through the better part of the last decade (or, in many cases, slowed the decline), has slowed significantly.

The industry continues to pursue organic growth.  Enhancing broadband speeds by extending fiber to the customer premise and continuing efforts to provide competitive video services represent the most significant organic growth initiatives.  Wireless isn’t the opportunity it used to be, but a handful of RLECs are nonetheless attempting to leverage their spectrum positions (and companies) to provide various flavors of wireless service.  Additionally, a number of companies continue to experiment with a myriad of ancillary services such as information technology services, Geek Squad-type computer services, security services, on-line data back-up, managed services and unified communications services.  The level of success realized by these ancillary initiatives is company-specific, but there is little evidence that any one of these emerging services can yet be considered a break-out opportunity for RLECs.

Hybrid Strategies

It would be nice if all ownership strategies fit neatly within one of the six alternatives outlined above.  In reality, many companies combine two or more of these strategies into a hybrid strategy.

Several companies are executing a combination of vertical and organic growth strategies.  For example, Windsteam’s recent acquisition of Lexcom was a horizontal acquisition while its acquisitions of D&E Communications and Iowa Telecom had characteristics of both horizontal and vertical acquisitions.

Other companies have arguably combined horizontal and vertical growth strategies with a harvest mentality.  Consider, for example, the so-called “High Yield Dividend Stocks” including Frontier Communications, Otelco (Nasdaq:OTT) and Consolidated Communications (Nasdaq:CNSL).  These companies have adopted a financial strategy that looks to maximize dividends paid to shareholders, an objective firmly rooted in the Harvest Mode.  But without sacrificing dividend levels, each of these companies has been active on the acquisition front over the last several years.

The Default Strategy

That brings us to our final ownership strategy, which is arguably the strategy followed by most RLECs.  This is a default strategy effectively followed by those which have not embraced one of the other six ownership strategies.  It is a strategy characterized by denial, ineffectiveness, or simple inaction.  RLECs falling within this category are called “Melting Ice Cubes” (at least that’s what we call them).

We don’t mean to be glib or pithy (well, not overly so).  Rather, we mean to make a point.  Inaction (or ineffectiveness) is not an alternative.  A deer frozen by the headlights of an oncoming car usually doesn’t survive the impact.  The trends in competition, technology and regulation are increasingly clear.  For RLECs, business as usual is not a strategy that promotes a sustainable future.  Failure to embrace a strategy that either effectively identifies and pursues opportunities for growth, that targets a current or smart exit, or that “harvests the hay while the sun shines,” relegates RLECs to a drawn-out and painful existence as a Melting Ice Cube.

All RLEC owners need to make an objective assessment of their companies current operating and financial realities and their realistic roles going forward.  If life as a Melting Ice Cube is acceptable, we predict easy sledding.  On the other hand, if preservation of wealth is your goal, you’ve got some serious work to do.