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CenturyTel Blazes the Rural Route

By Todd Rosenbluth We at Standard & Poor's Equity Research Services think telecom-services provider CenturyTel (CTL

; recent price, $33) will continue to benefit as its enhanced voice and data services find increasing acceptance from the rural markets it serves. In addition, we believe prospects are more favorable than for most of its telecom peers, given our view of its limited competitive pressures from wireless, cable, and wholesale-wireline carriers.

We don't think this relative strength is fully factored into CenturyTel's current stock price, and we expect to see the stock's valuation expand by a number of key measures. Consistent with the more defensive view toward equities, S&P is recommending investors overweight their exposure to the U.S. telecom sector by gravitating toward high-cash-generating, dividend-paying stocks. We're positive on integrated telecom carriers like CenturyTel that show stronger revenue and earnings growth vs. peers. We have assigned our highest investment recommendation of 5

STARS, or buy, to the stock.

ENHANCED OFFERINGS. Following the 2002 sale of its wireless operations to Alltel (AT

; $55) for $1.6 billion in cash, CenturyTel now focuses solely on wireline local telecommunications. Beginning in 2004, its strategy included plans to pursue acquisitions of underserved incumbent local-exchange carrier markets, promote efficiencies through synergies with its existing network, and drive long-term earnings growth through enhanced service offerings. At June, 2004, CenturyTel operated 2.35 million phone-access lines, primarily in rural and suburban areas in 22 states. It's the eighth-largest U.S. local-exchange phone company, based on access lines.

CenturyTel's local exchange subsidiaries derive revenue from providing local phone services, network-access services, and other related services including billing and local directory publications. Local access lines declined 2.2% in the 12 months ended June, 2004 (after falling 1.6% in all of 2003). We believe that's due, in part, to the displacement of traditional wireline-phone services by other competitive service providers.

According to CenturyTel, installing digital switches and high-speed data circuits has been an important component of its growth strategy because that allows it offer enhanced voice and data services, which increase utilization of existing lines.

BETTER BILLING SYSTEMS. Network-access revenues relate to services provided to long-distance and wireless carriers in connection with the use of CenturyTel's facilities to originate and terminate interstate and intrastate long-distance calls. The company also generates revenues by offering long-distance service to about 1.1 million customers as of June, 2004, as well as by offering digital subscriber lines (DSL), caller ID, and call-waiting. As of June, 2004, CenturyTel had achieved long-distance penetration of 42.9% and DSL penetration of 7.1% of enabled lines. The latter figure is actually below the average of its industry peers.

This year, CenturyTel has been installing a new billing and customer-care system. As of July, 2004, it's available in 11 states, and CenturyTel expects to complete the installation by yearend. In addition, it's in discussions to partner with an independent wireless carrier to offer such services in product bundles. We expect an update on both the billing conversion and a potential wireless partnership to be highlighted during a Sept. 15 presentation before analysts in New York City.

With its relatively stable rural wireline customer base and its increasing penetration of enhanced services including DSL, long-distance, and caller identification, we believe CenturyTel will continue to generate EBITDA (earnings before interest, taxes, depreciation, and amortization) margins that are among the industry's best.

SATELLITE SUPPORT. We view positively the partnership CenturyTel announced in late August with EchoStar Communications (DISH

; $32) to provide satellite-TV services to CenturyTel's wireline customers in 22 states by yearend. CenturyTel will manage customer relationships and billing for the TV services, which will be part of a single CenturyTel bill. We expect the company to share more details on the planned rollout of satellite services during its Sept. 15 analyst gathering.

Unlike some telecom carriers, CenturyTel, we believe, is appropriately going on the offensive against looming cable telephony competition. In 2004, cable and voice over Internet protocol (VoIP) services have been predominantly rolled out in major metropolitan markets, but we expect enhanced competition to emerge on a national basis in 2005. The Echostar partnership gives us greater confidence that CenturyTel's operating arena will remain favorable relative to the Baby Bells over the next 12 months.

We expect revenues to grow 1% in 2004, with DSL, long-distance, and enhanced services penetration gains outweighing the effects of universal service funding adjustments, and an anticipated 2% loss of total access lines amid a slow-growing job market and moderate competitive pressures. CenturyTel has had recent success by raising the penetration rates of nontraditional voice services in its rural markets.

WIDENING MARGINS. Its penetration rates for long-distance service were below its peers, diluted partly by the approximately 675,000 primarily local-access lines in Alabama and Missouri that it acquired in mid-2002 from Verizon (VZ

; $40). As of the second quarter of 2004, CenturyTel provided long-distance service to nearly 43% of its customers, up more than 6% from 12 months earlier.

At S&P, we forecast that access-line erosion will continue at a moderate rate in 2005, but we expect the satellite partnership with Echostar will help to reduce customer churn. We see revenues down fractionally in 2005.

Following strong cost-cutting efforts in the first half, we expect EBITDA margins, among the industry's best, to widen slightly to 52% in 2004, as cost reductions from previously acquired properties offset the integration of a new billing system and increased compliance costs related to Sarbanes-Oxley financial-disclosure rules. In early July, CenturyTel had converted slightly more than 25% of its access lines to its new billing system and had not incurred any related customer-care issues. We expect that it will achieve its goal of completing the conversion in all of its states by the end of 2004.

ACQUISITIONS ON ICE. We look for interest expense to decline as proceeds from the prior sale of the company's wireless unit and free cash flow help pay down debt. At the end of the second quarter, CenturyTel had long-term debt of $2.9 billion, down 7% from December, 2003. Its ratio of net debt to annualized operating cash flow was 2.3 times -- a level that we consider to be reasonable.

In the first six months of 2004, CenturyTel repurchased nearly 9.9 million outstanding shares, completing more than 70% of its $400 million share-purchase program. We expect it to use its free cash flow to complete the program and authorize additional buybacks by the end of 2004, as its acquisition strategy appears to be on hold. CenturyTel hasn't made an acquisition in two years.

We project operating earnings per share of $2.37 in 2004 and $2.45 in 2005, aided by recent and likely future share repurchases.

NICELY PRICED. We're encouraged by CenturyTel's earnings quality. The divergence between our operating and Standard & Poor's Core Earnings estimates for CenturyTel is lower than that of other telecoms in our coverage universe. We estimate S&P Core EPS of $2.24 in 2004 and $2.33 in 2005. In 2004, our S&P Core EPS estimate includes estimated stock-based compensation expense of about $7.2 million (5 cents a share). We projected costs of about $10.9 million (8 cents) in 2004, which relate to our estimate of the difference between CenturyTel's actual pension costs and its use of pension accounting.

Despite what we view as favorable fundamentals relative to comparable telecom outfits, CenturyTel trades below its rural-carrier peers, based on our p-e and enterprise value/EBITDA analyses. Our 12-month target price of $39 values CenturyTel stock at approximately 16 times both our 2004 operating EPS estimate of $2.37 and our 2005 EPS estimate of $2.45. That's still a modest discount to its telecom peers, many of which we believe have higher longer-term growth potential from wireless segments. On an enterprise value/EBITDA basis, our target price values the stock at a multiple of 6.7, in line with peers despite relatively wide EBITDA margins.


discounted cash-flow model, based on a weighted average cost of capital of 8%, and expected cash flow growth of 5% to 8% from 2004 to 2009 and 3% thereafter, supports our valuation and target price.

Risks to our recommendation and target price include adjustments to the universal service fund or access charges, from which CenturyTel receives revenues, and a potential increase in customer switching to other provisers or substituting wireless for wireline service. Analyst Rosenbluth follows stocks of telecom services companies for Standard & Poor's Equity Research Services

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