Risk-Reward Balances Windstream

Zacks Equity Research
April 3, 2012

We have retained our Neutral recommendation on telecommunications services provider Windstream Corporation (WIN).

We remain encouraged by Windstream’s refinancing efforts to alleviate its high debt level, which will likely generate some synergies in the form of lower cash taxes, thereby increasing profitability in the long term. However, concerns related to a highly leveraged balance sheet as well as continued access-line erosion remain though these are partially offset by a high dividend yield and broadband opportunities.

In the fourth quarter, Windstream's adjusted earnings per share of 19 cents  missed the Zacks Consensus Estimate by a penny but increased 47% from the year-ago earnings.

Revenue performance also remained strong on the back of increased demand for high speed Internet services and a large customer base from the PAETEC acquisition.

Windstream continues to emphasize on business growth as well as revenue from consumer high-speed Internet in order to fend off competition from telecom giants like AT&T Inc. (T) and Verizon Communications (VZ) and attract new customers. The company focuses on expanding service offerings to businesses with IP services, managed services, data center co-location and fiber transport, along with growth of distribution channels.

Further, Windstream's strategy of bundling consumer voice service with high-speed Internet service provides further advantage to its ability to add subscribers while reducing churn rates.

Going forward, Windstream is expected to benefit from its last year’s acquisition of the leading broadband service provider PAETEC Holding Corp. The acquisition intends to reduce Windstream’s operating expenses by about $100 million and capital expenditure by $10 million annually over the next two years. Windstream also intends to claim PAETEC’s previous-year losses and thereby enjoy reduced taxation after completion of the deal.

We believe the acquisition would improve Windstream’s future strategic position by shifting its revenue mix to business and broadband, expanding service offerings, increasing wireless data backhaul services and offering managed services and cloud computing.

However, we remain concerned over the recent rules set by the Federal Communications Commission (:FCC) as well as state regulations, which limit the prices and rates that the company can charge to customers. On November 23, 2011, the FCC reformed its Universal Service Fund and inter-carrier compensation (fees that carriers pay each other when they connect telephone calls) rules.

The FCC highlighted its efforts to expand high-speed Internet services to rural areas over the next six years (2012–2018). Accordingly, it will reduce access and compensation rates charged by Windstream during these six years, resulting in a drastic decline in the company’s access revenues as well as profits in the year and beyond.

Additionally, Windstream’s acquisition activities have strained the balance sheet, as the company is predominantly funding most of them through debt. Windstream had approximately $9.0 billion in long-term debt (assuming $1.4 billion from PAETEC) at the end of 2011 (up from $7.19 billion at the end of 2010), which raises concerns about liquidity.

Last but not least, Windstream is expected to incur roughly $50 million in merger and integration costs in the initial year and $55 million of capital expenditure over through 2013 that is likely to dilute margins in the long term. 

As of now, we don't see any obvious catalyst in its business that would significantly push the stock price higher. Consequently, we see Windstream shares performing in line with the broader market. Our long-term Neutral recommendation is supported by a Zacks #3 Rank (short-term Hold rating).

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