DSL Prime: Hidden Risk in RLEC Finances

DSL Prime does not pick stocks, but it doesn't take a financial genius to spot serious problems in the pricing of U.S. rural telecoms.

by Dave Burstein DSL Prime [July 19, 2004]

IDS deals with unexplored risk
The buyout firms who paid extraordinary amounts for some rural telcos are trying to cash out, and five have filed to issue IDS Income Deposit Securities. The sales materials suggest these are safe investments with high income, but they aren't.

The companies involved receive half their income from access charges that may go down drastically. Their leverage is so high the interest could be unsustainable. Everyone near policy circles knows the access charge and USF system is broken, and will need to be overhauled. It's based on high long distance charges that are going away, and falls even further apart when VoIP gets into the act. The rural telcos answer "politician so-and-so will protect us," but most "politicians so-and-so" are also heavily influenced by the Bells. The Bells now are in long distance, paying these charges, and will be acting politically to bring them down. Anyone who borrowed money to buy rural telcos at $3,000 to $4,000 per line is at risk, especially after Verizon Hawaii sold for $2,100 per line and the Citizens sale failed.

Saul Fox and Dexter Paine have every reason to cash out of Alaska Communications, which lost thirty cents per share in Q1. Like every telco in North America, results are likely to get worse as cable and VoIP take away more lines.

Lisa Gewirtz and Chris Nolter report for TheDeal.com:

"The distributions to private equity backers seems more certain. Fox Paine & Co. LLC, which now holds 66 percent of Alaska Communications, will own "well south of 20 percent of the company," a source says, cashing out a chunk of its investment of $100 million. Sources thought that the firm could earn more than $120 million, with one person suggesting that the sum could be as high as $250 million.

Similar profits could be in store for other private equity firms, such as Thomas H. Lee Equity Fund and Kelso & Co., owners of FairPoint Communications; Welsh, Carson, Anderson & Stowe; Citigroup Venture Capital Ltd. and Vestar Capital Partners, owners of Valor Communications; Jefferies Capital Partners, owner of Iowa Telecommunications; and BancBoston Ventures, CEA Capital Partners and Seaport Capital LLC, owners of Rural LEC Acquisition.

'It's artificial arbitrage,' says the head of leverage finance at a major investment bank, calling IDSs a 'raw deal.' 'It's like selling used cars,' he says. 'If something is worth $20,000 and it's sold for $50,000, something is wrong. Someone is getting ripped off.'"

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Imagine if Washington realized the rural subsidies they are defending were instead going to Citigroup, BancBoston, Welsh Carson, and similar operatives.

Also please remember DSL Prime is not an investment publication. In fact, people I respect on the street, who are not among the promoters of these issues, believe the prices of rural telcos will go up and the bonds are a good bet. That's partly because they think the market doesn't care about political changes that may not have an effect on earnings for several years. The short-term views on wall street drive me (and most sensible CEOs) batty. They are essentially a self-fulfilling prophecy, with Wall Streeters making money because their peers share similar views.

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Copyright 2004 Dave Burstein.
The DSL Prime Newsletter is reprinted with permission.

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