Qwest Isn't As Hale As It Looks

The Bell is back from the brink. But its cash flow could come under pressure

Four years ago, Qwest Communications International Inc. (Q ) was on bankruptcy's doorstep, its shares fetching just a buck apiece. The company was saddled with a $26 billion debt load, was en route to posting a $35 billion loss, and was being swarmed by regulators looking into its accounting practices and allegations of insider trading.

Yet in the past year, shares of the Denver-based telco have soared 31%, to 5.90, trouncing the average 3% return of its fellow Bells and the 11% return for the Standard & Poor's 500-stock index. Investors have rewarded the company for its U-turn from negative free cash flow of $400 million in 2002 to a positive estimate of $1 billion to $1.3 billion in 2006. And with Chief Executive Richard C. Notebaert recently hinting that Qwest might soon post an actual profit, some are betting that management will throw off a chunk of that newfound cash to shareholders as a dividend. Qwest currently pays nothing, while the other Bells -- Verizon, the newly merged AT&T (T ), and BellSouth (BLS ) -- boast an average dividend yield of 5%. Says CFO Oren G. Schaffer: "I think we can sustain this model and continue to generate free cash flow that we can return to shareholders."

Investors shouldn't expect to see a fat check in the mail just yet. Some analysts say Qwest's financial situation isn't nearly as solid as Schaffer and bullish investors think, and that its vaunted cash flow improvements might be near an end. In fact, the financial picture could get cloudy again -- and soon.

After the recent run-up, Qwest now trades at a premium to its larger, richer peers. Because telecommunications is a capital-intensive business that requires huge amounts of debt -- and interest payments -- the price-equity ratio isn't an especially useful investing gauge. Analysts weigh the Bells based on their enterprise value (EV), or market capitalization plus debt, minus cash and equivalents, divided by their earnings before interest, taxes, depreciation, and amortization

That 30% premium reflects Qwest's supposed position as a rurally entrenched carrier, says Viktor Shvets, a telecom analyst for Deutsche Bank Securities Inc. (DB ) Qwest customers, spread over a 14-state swath that includes New Mexico, Nebraska, and the Dakotas, are thought to be less likely to flee than, say, Verizon's landline customers in the Northeast, who have the option to sign up for the bundled cable telephony offered by the likes of Cablevision Systems Corp. (CVC ) and Time Warner Cable Inc. (TWX ). Qwest's annual customer defection rate of 4.8% trails the average of 5.5% sustained by Verizon, BellSouth, and AT&T.

The relative stability means Qwest doesn't have to ramp up its capital spending as aggressively to compete with rivals, or so the thinking goes. According to Deutsche Bank, Qwest's landline business boasts a capital spending to sales ratio of 13%, vs. nearly 22% for Verizon, 18% for BellSouth, and 14% for AT&T. "Our region does have a lot of rural areas," says CFO Shaffer. "These customers are very stable.... Cable companies would rather invest in dense areas. They're not prepared for a rollout [to rural areas]."

Perhaps. But a close look at the concentration of Qwest customers belies the rural claim, says Deutsche Bank's Shvets. At the end of 2004, he notes, the Federal Communications Commission clocked Qwest at about 10,000 access lines per switch. (Think of a hub and spoke system, with many lines flowing into one switch.) That 10,000 wasn't far behind AT&T and BellSouth and was actually 20% more than Verizon's density. The true rural carriers, meanwhile, showed line densities of just 500 to 3,000. Shvets found that five states -- Arizona, Colorado, Washington, Minnesota, and Oregon -- represent two-thirds of Qwest's access lines and more than 80% of its local line revenue. His conclusion: "Qwest is not a rural carrier."

The more densely populated the area, the more competition from cable and wireless players. As a result, says Shvets, "you need to assume that Qwest's free cash flow will decline" in the future as competition and customer churn increase. For that reason, Shvets downgraded the stock to "sell" from "hold" on Jan. 17.

Standard & Poor's (MHP ) equity analyst Todd Rosenbluth agrees. "Denver, Seattle, and Phoenix are not small rural markets," he says. "We think [Qwest is] going to have to spend more to compete." Rosenbluth has a "sell" rating on Qwest, which is trading at a 30% premium to his 12-month price target.

One area where Qwest can't compete is in wireless service. Unlike all three of its Bell rivals, Qwest doesn't have a wireless unit to absorb its landline defections. When customers ask for wireless, Qwest can only resell them Sprint Nextel Corp.'s (S ) service, hardly a recipe for future subscriber growth.

The carrier lacks another cash-flow cushion: a telephone directories business. In 2002, with its back to the wall, Qwest sold its directory publishing operation to a private equity consortium for $7.05 billion to help pare its then-$26.5 billion debt load. The move helped Qwest to slash its debt to the current $14 billion. But QwestDex was a cash cow, helping the company ride out business slumps. No longer.

And $14 billion is still a ton of debt, so much so that Qwest has little margin for error, say analysts. S&P's Rosenbluth points out that Qwest's total debt still stands at nearly six times its EBITDA, while the regional Bells' are closer to two times. That means Qwest's interest expenses are still disproportionately burdensome, making it all the more difficult to generate free cash.

Put all of these factors together, and Qwest could see its free cash flow drop from the $1 billion-plus expected this year to $500 million to $700 million in the next three years, estimates Shvets. That wouldn't bode well for a stock price buoyed by supposedly improving cash flow.

Give management credit for acting to improve Qwest's balance sheet instead of seeking bankruptcy protection, as had many telecom companies that binged on debt in the late 1990s. Its savvy moves have paid off. In November, for example, Qwest raised $2.9 billion to fund a debt tender offer, the third in two years, that will slash its annual interest expense by $350 million. "We worked our way back from the brink of insolvency without wiping out shareholders," says CFO Shaffer. "You couldn't be any flatter on our backs than we were."

True enough, but Qwest still has a ways to go on the road to redemption. "What they've done in reining in losses and refinancing debt has been great," says Shvets. "Now for the hard part."

By Roben Farzad

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