Windstream releases useful merger financial statements, is still cheap

January 19, 2011

As my loyal readers will know, I have been following Windstream (WIN), a phone company focusing on rural areas, for some time. Over the last couple of years, it has made a number of acquisitions in order to facilitate its strategy of expanding high speed internet and business services in order to offset losses of retail customers. Many of these acquisitions are of private companies, which gives me pause because there are no audited public reports of these companies available, and without these I have no way to determine whether Windstream is paying a fair price or not. Sure, they release their expected synergies and a figure called “adjusted EBITDA,” but experience counsels me that synergy is something that can’t be counted on, and EBITDA is often meaningless to equity investors even if we knew what the adjustments were.

Fortunately, last week Windstream released here an estimate of what their operating figures would look like for 2009 and the first three quarters of 2010, if the acquisitions had occurred at the beginning of 2009, including depreciation and capital expenditures. This finally allows us to calculate the overall free cash flows for the combined company to determine whether Windstream’s current price represents a good value or not.

Free cash flow can be estimated as reported earnings plus depreciation and amortization, minus capital expenditure. This figure represents the amount that a business can pay to its owners in a given period without diminishing its own earnings power. It is probably the most useful single measure an equity holder’s earnings.

Windstream calculates that operating earnings including depreciation and amortization, were $1940.8 million in 2009 and $1479.4 million for the first three quarters in 2010. (The release goes on to remove expenditures that they consider noncash or nonrecurring, like pensions, restructuring charges, and stock-based compensation. I would prefer to leave these in, particularly stock-based compensation, as it is the shareholders whose share this comes out of). Capital expenditures in 2009 for the combined businesses were $487.4 million, and 2010 year to date were $330.9 million, producing operating cash flow of 1453.4 in 2009 and $1148.5 in 2010 so far, which would be $1531.3 on a full year basis.

Of course this is only operating cash flow, which must further be adjusted for Windstream’s capital structure, interest requirements, and of course, taxes. Windstream did not consolidate this information, of course, because the results would have simply been an amalgamation of the balance sheets of the separate companies, which would be meaningless for projecting future results.

So, we have to examine Windstream’s own capital structure and interest. Windstream, although it has generally assumed the debts of its acquisition targets, cannot simply step into their shoes as a debtor and as such its borrowings are subject to its own interest rate. The company has recently issued an additional $500 million in 7.75% notes to cover the Q-comm acquisition, their latest, but other than that their interest payments can be approximated by the interest they have paid in the first three quarters of the current year. Their interest charges are $378.9 million year to date, which would be $505.2 million on a full year basis. Adding in the interest on the new bonds we get $543.95 million for their future interest requirements. Subtract that from of operating earnings we have pretax earnings of $909.45 million for 2009 and $987.35 million on a current basis. This also gives us an interest coverage ratio of 2.67x, which I think is reasonable for a utility company.

Finally, we have to apply a tax rate of, say, 38% to deal with state and federal income taxes. A significant portion of free cash flow for Windstream comes from the excess of depreciation over capital expenditures, which means that it comes to them tax-free. However, all things being equal we may expect depreciation and capital expenditures to align with each other in the eventual future, so this free cash flow will eventually become taxable in the fullness of time. Taking away 38% in taxation we have $563.9 million in estimated consolidated free cash flow for 2009, and $612.1 million projected in 2010. This also means that their dividend requirements of roughly $120 million a quarter are covered, thus dispelling the concerns of people who argue, based on reported earnings and not free cash flow, that Windstream is paying out more money than its is making.

At present, Windstream’s market cap is $6.33 billion, which represents a multiple of 10.34x, a figure that is reasonable or even low in today’s market. As a further advantage, the gap between depreciation and capital expenditures, projected to be $381 million for full year 2010, is still tax-free at present, which lets them squeeze out millions in extra cash flow for the near future. There is also the possibility that Windstream will be able to produce the synergy that they are counting on, but as I’ve said I believe in synergy when I see it, as studies show that it fails to materialize in a large proportion of mergers, as demonstrated in Damodaran’s highly useful The Dark Side of Valuation. I would therefore say that Windstream is very attractive at this level.

What pleases me most, though, is simply that Windstream is willing to give investors the information we need in order to rationally analyze their acquisitions. I wish more acquisitive companies would be this helpful.

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