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High Yields in Remote Places

“On July 1, Income Portfolio pick Frontier Communications (NYSE: FTR) absorbed 4.8 million rural phone lines formerly owned by fellow Income Portfolio denizen Verizon Communications (NYSE: VZ). A month earlier Windstream Corp (NYSE: WIN) subsumed Iowa Telecom in a $1.2 billion deal. The biggest yet is CenturyLink’s $10 billion bid for Qwest Communications (NYSE: Q), a move that will make it the third- largest provider of traditional phone service in the U.S. Takeover fever is heating up in the wireline telephone space. Driven by the need to cut costs and up-sell customers to broadband service before they bolt to wireless or cable competitors, providers are turning to scale for salvation. And the result is a growing string of deals that benefit both buyers and sellers. Cash is king in the traditional phone-service business. Every year, more people cut their connection to the copper network that’s served America for more than a century and move their business to cable broadband and wireless phones. The biggest providers of traditional service—AT&T (NYSE: T) and Verizon—are driving the switch. The giants’ motivation is simple. They make far more money providing wireless services—a space they dominate—than they ever did from their copper-wire networks. And wireless and broadband offerings enable the big boys to grow earnings far faster than traditional local and long-distance services. Verizon’s sale of lines to Frontier and other divestitures have dramatically enhanced the firm’s growth potential.

“Frontier also emerges a major winner from the deal, though integrating the acquired assets and upgrading them for broadband service won’t be cheap. Capital spending is expected to range from $220 million to $240 million in 2010, in addition to the estimated $180 million required to cover integration. From that point, however, opportunities to grow cash flow through up- selling and cost-cutting abound. And after up-sizing a March bond offering from $2 billion to $3.2 billion at low rates, Frontier has the financial strength to see it through. That adds up to considerable safety for the quarterly dividend of 18.75 cents a share—a nearly 10% yield at the stock’s current price.

“Some of the biggest winners are likely to be Verizon shareholders, who received 0.238 shares of Frontier per Verizon share. Not only do they receive $1.80 worth of stock up front, but the divestiture likely will increase the value of their Verizon shares as well. Providers of an essential service, communications companies need the approval of state and federal regulators to complete mergers. But officials have demonstrated a surprising willingness to sanction deals. For example, despite its ongoing dispute with Verizon over Internet access rules, the Federal Communications Commission (FCC) approved the Frontier deal with little fanfare. It did the same for Windstream’s acquisition of Iowa Telecom and likely will sign off on CenturyLink’s bid for Qwest. Compelling economics and agreeable regulators virtually ensure coming months will bring further consolidation, particularly when sub-investment-grade companies such as Frontier are able to raise capital so cheaply. The best candidates appear in the table ‘Rural Cash Cows.’

The Last Castles

“This spring the five FCC commissioners refused to certify the U.S. wireless industry as ‘competitive’ in its annual study. The agency’s two Republicans rejected the three Democrats’ conclusion. But the study underscores the growing dominance of AT&T and Verizon—an inevitable result in what’s essentially a scale business. Facing this reality, other players in the sector have little choice but to consolidate. And with a stable rural base of 6.2 million wireless and 1.1 million wireline customers, rising margins and steady finances, Telephone & Data Systems, Inc. (TDS 32.25 NYSE – yield 1.40%) is a prime candidate for acquisition. The stock doesn’t yield much, but it is cheap; down nearly 60% from its mid- 2007 highs, shares trade at just 1.7 times book value and 68 percent of sales. That leaves plenty of room for a buyer to pay a premium. Meanwhile, a market cap of $3.2 billion would be easy to swallow for many industry players or private equity firms. Buy Telephone & Data Systems up to 35.

“The remaining companies on our list are pure-wireline outfits. These operators offer scale to buyers and the ability to boost cash flow by cutting costs, buying back debt and up-selling customers to broadband services. CenturyLink, Inc. (CTL 34.86 NYSE – yield 8.30%) is the least likely candidate for a buyout; management is focused on being on the other end of deals. Last year the company absorbed the assets of Embarq, the wireline spinoff of Sprint Nextel (NYSE: S). Now it has an even bigger deal in place to snare Qwest, whose primary assets are those of former Baby Bell, US West. If regulators approve the deal, the combined company would serve 17 million phone connections in 40 states, as well as 5 million broadband and 2.4 million video customers. Both CenturyLink and Qwest have upgraded their networks aggressively for advanced services; the combined firm should hit the ground running when the merger is completed in spring 2011. ... CenturyLink is a buy up to 35.”

Elliott H. Gue, Personal Finance

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.