The Stock

What to Buy: Otelco (NYSE: OTT) @ 16

Why Now? The transition away from copper-wire communication is widely misunderstood. It’s not happening as rapidly as many investors may believe. In fact where Otelco operates “wireless” is just a rumor. And the company is adding broadband and increasing data-sales revenue. The bottom line is the rural phone business is a river of reliable cash flow, and the market doesn’t seem to get it. That means a healthy, sustainable 10 percent yield for us.

The Story

On his mark and set on a high-yielding overseas telecom, David’s BlackBerry chirps the chirp of the traffic cop. The accompanying flashing red light reinforces: stop.

It’s a text from Roger, who’s in Toronto visiting with investors at the Money Show.

Roger: Had a tough time deciding between the two. Both have strengths and flaws, but the rural phone company yields a little less than 11 percent. Let’s go with Otelco (NYSE: OTT).

Still smarting from his hometown-by-marriage Philadelphia Phillies’ loss in the National League Championship Series earlier Wednesday night, David struggles with the last-minute change. We have deadlines in our business. But soon the logic–like the promise of Roy Halladay taking the hill the next day–is clear: Let’s start the BIG telecom conversation with a close-to-home story about a solid business; better to get it right than just get it done.

That doesn’t mean the old sage gets a free pass, though. David takes to e-mail, the 160-character limit allowing no room to flesh out our newest target.

David: Like our first recommendation New Flyer Industries (TSX: NFI-U, OTC: NFYIF), this one trades as an income deposit security, or IDS. The distribution is part debt interest, which is tax deductable to Otelco, so it can pay out more than the average company in its industry.

I’ll raise the same question I did with New Flyer. We’ve seen several of these IDSes really blow up. Remember Centerplate? What makes this one different?

Roger: The most important thing is the rural phone business generates a ton of reliable cash flow, which is the essential feedstock of any dividend. Centerplate had a lot of interesting concessions for its food service business, including for our Washington Nationals.

But theirs was never a business that was able to deliver the cash that steadily. That’s what eventually did them in. They should never have tried to pay out that much cash.

David: First of all, what’s this “our” stuff? You can’t root for the Braves and the Nats. And I won’t root for any senior circuit club but the Phillies. Mrs. Dittman would kill me. (That doesn’t mean, of course, that I won’t take up any future offers from you to head across the river for a game; it’s always good to go to the yard.)

Now, to your substance, the world is transitioning away from the kind of copper-wire connections that are Otelco’s main business. How can that be sustainable or reliable?

Roger: As soon as Strasburg’s elbow is right and the Harper kid is launching bombs, you’ll be flying the “W.” And I’m certainly able to hold two competing teams in my heart and mind at the same time.

OK, this transition isn’t happening overnight. In fact, in the sparsely populated places where Otelco operates, it’s barely perceptible. There just aren’t that many alternative service providers, and the company has been able to consistently up-sell customers to its broadband service. The company lost 0.4 percent of its traditional lines in the second quarter of 2010, hardly an alarming rate.

If you factor in the growth of its high-speed broadband business and data revenue growth, access line equivalents actually rose 2.8 percent in the quarter.

The traditional phone business is shrinking but that’s not all this company does anymore. And those newer lines of business are growing and producing powerful revenue.

David: Does it bother you that the company’s properties are so widely dispersed?

(BTW, I’ve chosen baseball teams twice, once back in the days when Fred Lynn was crashing into walls for the Red Sox, and then during the summer of 1995 in the months leading up to my wedding.)

Roger: Only in the sense that it makes a takeover of the company less likely.

This industry has already consolidated greatly over the past 10 years and there are several deals in progress between rural phone companies like Otelco. Spreading 100,000 voice and data access lines over Alabama, Maine, Massachusetts, Missouri, New Hampshire and West Virginia assures that any would-be acquirer will have to have a fairly broad reach already. That limits the ranks of potential suitors for sure.

The flipside is any deal that does get done for Otelco will have to be weighted sharply in favor of the company. And that kind of geographic diversification does tend to stabilize cash flow over time.

(And, like I said, you’ll be on board when the Nats start winning.)

David: What about the structure of the IDS itself?

The overall distribution is 17.625 cents equity dividend and 24.375 cents debt interest, which essentially comes from senior subordinated notes with a 13 percent interest rate that are due 2019. The equity dividend was 100 percent return of capital in both 2008 and 2009, and management now says it will be again in 2010. Doesn’t that mean the company lacks earnings?

Also, can’t Otelco borrow at a better rate than 13 percent in this low-rate environment? Why don’t they just pay off the note portion and save the interest costs?

Roger: The lack of earnings is in large part because of the debt interest and was designed that way, to minimize taxes. As for a possible buyback of the bond portion, you’re really asking me to be a long-distance mind-reader here.

But it might interest you to know there’s only $31 million outstanding of the 13 percent bond. The company’s biggest pending rollover issue concerns credit lines totaling about $189 million that come due in 2013. That’s going to be their first objective.

Also keep in mind that the high yield is why Otelco’s share price in the mid-teens rather than mid-single digits. They won’t score many points by doing something to lower that payout.

One more point: Earlier this year, the company swapped all of its remaining Class B shares for IDSes, boosting the number of outstanding units to 13.2 million. If getting rid of the IDS format–i.e. selling the bond portion–were really the plan, would management have made that kind of swap?

David: What about the debt coming due in 2013? Should we worry about that? Also, what about December 2019 when the debt matures? Won’t that end the IDS then and there?

Roger: At this point, 2013 is an eternity for rolling over a credit line. And keep in mind that these lines are at no time fully drawn. As for 2019, if Otelco maintains the cash flow to pay dividends on the IDS, anyone who buys now will have received more than 90 percent of their initial investment back in dividends alone by 2019.

At that point, the company will have several options. It could pay us cash for the bond and leave us with the common stock portion, or it could try to roll over the bond portion. You might remember that Atlantic Power Corp (TSX: ATP, NYSE: AT) had a similar option to buy investors out of the debt portion of its IDS. The company chose to simply convert the entire IDS into a common equity. But had it elected to pay off the bond portion in advance, it would have paid a premium to face value.

The debt portion of Otelco’s IDS also has a face value the company would have to pay on any buyout, which is $7.50 per share. Assuming they found a way to pay that off, it would leave shareholders with an equity priced at $8.30 per share ($15.80 less $7.50), paying a dividend of 70.5 cents or 17.625 cents per quarter. That still equates to a yield of 8.5 percent, which I think you’ll admit is not too shabby for a worst-case scenario.

David: So the real concern here is just Otelco running its business well enough to keep covering distributions. Is there any hope of a dividend increase?

(PS: Of course, I’d be thrilled to watch a clinching World Series game for the hometown team at Nats Park in those seats of yours.)

Roger: If the company should pay off the debt portion of the IDS it may elect to deploy some of the interest cost savings to a higher equity dividend. But the whole purpose of an IDS is to maximize the tax advantage to the company from paying its dividend as partly debt interest. So dividend growth isn’t something I would count on.

On the subject of dividend coverage, the key metric is going to be distributable cash flow, not earnings per share, which the IDS structure intentionally minimizes.

We’ll know a lot more about how Otelco is doing when it releases its third-quarter numbers on Nov. 2 and holds its conference call the next day. As we’ve reported in Utility Forecaster, however, coverage has been solid to date, with second-quarter distributable cash flow covering by roughly 1.25-to-1.

David: What’s the biggest risk here?

Roger: I think it’s the same as it is for all rural wireline telecoms. That is, the transition in rural areas from copper to broadband accelerates to a much faster rate than we see now.

This company’s cash flow fundamentally depends on being able to replace business lost to switching with broadband revenue. It’s been very successful to date. But if I saw what I thought was an acceleration of line losses, I’d be concerned.

David: Buy target and dividend dates?

Roger: Any price paid that’s less than $16.80 per IDS is going to give us a 10 percent yield. Try to get this stock under $16 if possible, however, which represents the top of the range it’s held since the beginning of September.

The dividend pay dates are the 30th of March, June, September and December. The next ex-dividend date is likely to be in mid-December for the end-year payment. Otelco also trades on the New York Stock Exchange. Despite a relatively small market capitalization of $209 million, it should be plenty liquid.

Buy Otelco and its 10 percent-plus yield up to 16.

(I would, too, though you better not be late to this bandwagon, my friend. A lot of people are gonna want that seat.)