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A Rural Carrier Bucks the Trends

By Todd Rosenbluth Competitive pressure continued to hurt most wireline carriers in the second quarter. On average, the three largest Baby Bells -- BellSouth (BLS), SBC Communications (SBC), and Verizon Communications (VZ) -- had total access-line losses of 4% from the prior year, amid pricing and service challenges from cable, wireless, and wholesale-access wireline companies.

We at Standard & Poor's expect the operational arena for most wireline carriers to remain difficult following the late-August release of the Federal Communications Commission's order for the wireline-telecommunications industry. The order is largely consistent with the original 3-2 FCC vote in February, 2003, and we believe it keeps the door open for competitive local exchange carriers (CLECs) to use discounted wholesale access to enter the local voice market.

Far away from the operational challenges the Bells face from CLECs are a number of rural telecom carriers that operate primarily in markets exempt from such competition by federal law. The largest of these rural local exchange carriers (RLECs) are ALLTEL (AT) and CenturyTel (CTL). While the rural carriers still face modest competition, generally coming from wireless carriers offering large buckets of minutes, customer retention has been stronger, and their second-quarter total access-line counts held up better than those of their Baby Bell brethren.

TARGETED MARKETING. One RLEC that has stood out is Commonwealth Telephone Enterprises (CTCO), which operates in Eastern Pennsylvania. Commonwealth continued its exceptional customer growth by increasing total access lines by 4%, to 473,000, in the second quarter. In addition to facing no wireline competition in its 5,000-square-mile territory, Commonwealth isn't challenged by wireless substitution, given the mountainous terrain in which it operates.

Commonwealth has also had success leveraging its strong local brand name in what the company calls "edge-out" regions, such as Harrisburg and Wilkes-Barre/Scranton. In these Pennsylvania markets, Commonwealth competes with Verizon by targeting businesses, hospitals, and colleges, and by using primarily its own switches to keep costs down.

Commonwealth uses a technologically advanced, fiber-rich network based on digital switching, fiber-optic transport, and host/remote architecture. Revenues come primarily from fees paid by long-distance companies for access to Commonwealth's networks in connection with call completion, local-service revenue consisting of monthly tariffs for basic service, and enhanced services.

GROWTH FORECAST. During the second quarter, Commonwealth's revenues climbed -- a rare event in the wireline industry -- by 6%, to $83 million, thanks to access-line growth and increased minutes of use on its network. Also, we found it encouraging that Commonwealth was able to widen its margin, based on earnings before taxes, depreciation, and amortization (EBITDA), from 49% to 55% -- one of the highest margins in the wireline group.

Commonwealth's operating earnings beat our estimate and rose 6%, to 64 cents per share, in the period. For full-year 2003, we see revenue growth of 7% from 2002, to $342 million, and operating earnings rising 2.5%, to $2.47 per share. While we see the revenue-growth trend slowing somewhat in 2004, to about 2%, we forecast operating earnings per share to rise 5.3%, to $2.60, aided by continued cost controls.

Despite the relative strength of its customer base and margins, Commonwealth shares have fallen nearly 10% since July 14, when the carrier offered $250 million of convertible notes in a private placement. It was trading around $42 as of Sept. 4. We have accounted in our estimates for an increase in interest expenses and modest dilution related to the offering.

In our view, Commonwealth has one of the best balance sheets among the U.S. wireline outfits we follow, with debt-to-cash-flow leverage below its peers. There's still uncertainty about how it will use the proceeds from the offering -- a potential acquisition or dividend payout are strong possibilities. Still, we believe that the sell-off in the shares is unwarranted.

PREMIUM GRADE. We value the stock -- which was added to the S&P Small Cap 600 stock index on Sept. 4 -- on both a relative price-earnings and a relative enterprise value-to-EBITDA basis. Using our 2004 estimates, Commonwealth has an operating p-e of 16 and an enterprise value-to-EBITDA multiple of 6. We believe the stock warrants a premium to the Baby Bells due to its limited competition and wider margins. Our 12-month target price of $45 is based on a 2004 rural carrier peer average p-e of 17 and an EBITDA multiple of 6.5.

We believe Commonwealth's revenue stream is apt to be steadier than that of its peers, given the challenges facing most other wireline carriers, and we recommend that investors accumulate Commonwealth shares. Analyst Rosenbluth follows telecommunications services stocks for Standard & Poor's

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