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Iowa Telecommunications (NYSE: IWA, $16.14) The company is the largest fixed-line local phone company in rural Iowa and the second-largest provider in the state behind Qwest (NYSE: Q). As one of the 20 largest phone companies in the entire U.S., it serves over 450 communities with local and long-distance phone access over its extensive fixed-line networks. Local phone services and network access fees from other long-distance operators that originate or terminate calls on IWA's network account for the majority of its revenues. The company also uses its dominant market position to cross-sell dial-up and DSL high-speed Internet access to its existing phone customers. Dividends: The company aims to pay out roughly 75% of its free cash flow via dividends to shareholders. It has paid $0.405 a share for the past 15 quarters. That equates to $1.62 a year, giving a yield of 10.0% ($1.62/$16.14). Of the $100.2 million cash flow generated in 2007, $73.3 million was available as free cash flow. However, the company paid out just $51.5 million in dividends. That gives IWA a payout ratio of just 70%. In addition, as of June 30th the company had cumulative distributable cash of $83.7 million, well over 1.5 years' worth of dividends. The payout consists of about equal doses oftax-deferred return of capital and ordinary income. In 2007, for example, 55% of the annual payment was return of capital while 45% was ordinary dividends. The telecom's assets throw off huge amounts of depreciation and amortization. Unlike the return of capital provided by many closed-end funds, this is simply an accounting issue. Depreciation and amortization are non-cash expenses which, when added back to net income, count as return of capital. The return of capital portion is not taxed until you sell the shares. When you sell your stock, you reduce your cost basis by the total amount of the return of capital you received to determine your gain or loss. That amount is then taxable at the capital gains rate, currently at 15% for long-term (more than one year) holdings. The income portion is taxable as ordinary income -- up to 35% for investors in the top tax bracket. Given the tax breakdown, this stock could be held in either a tax-deferred IRA or taxable brokerage account. The company doesn't currently have a dividend reinvestment plan, but can be contacted by phone at 641-787-2089 or via email. Performance: Over the eight years since inception, Iowa Telecom has grown from offering only local phone service to providing long-distance service and high-speed Internet access. The company is the sole fixed-line phone operator in about 85% of its markets and has tapped into about 30% of the high-speed Internet market and 50% of the long-distance market in its service areas. Besides expanding its service offerings, the company has grown through acquisition. In July, Iowa Telecom bought Bishop Communications, a privately held rural telecom that serves six towns in nearby central Minnesota. The purchase added 16,600 local phone lines, 4,800 high-speed Internet customers, and 3,800 video subscribers. Bishop generated $19.6 million in revenues and $5.7 million in EBITDA last year, which should boost Iowa Telecom's bottom line. Although the local phone business is under pressure from increased cable competition and wireless substitution, high-speed Internet sales are largely offsetting losses on the fixed-line side. For the first half of this year, revenues from local phone services decreased $2.5 million, or -6.6%. Data and Internet services revenue, however, increased $2.2 million, or +15.8%, primarily due to growth in DSL Internet access and data services. Operating income (before tax) has grown a steady +6.5% over the past three years, from $77 million in 2005 to $82 million in 2007. Net income (after tax) has been negatively affected by income tax charges, but they are mainly non-cash charges that don't affect the company's cash flow. Outlook: Going forward, Iowa Telecom plans to continue to grow its high-speed Internet unit, expand its customer base, and pursue more acquisitions. The company will leverage its large subscriber base through bundling DSL connections and other data services with existing local phone services. It will also focus on expanding its data services to the more lucrative business market. Business customers tend to be heavier users of telecom services and attract higher margins. Historically, the company's customer mix has been 75% residential customers and 25% business customers. However, recent efforts to diversify the customer base are moving that profile closer to 50% residential and 50% commercial. Like other rural operators, the company receives payments from the government-funded Universal Service Fund to support the high cost of doing business in rural markets. These payments can increase or decrease with changing government regulations. However, less than 2% of Iowa Telecom's revenues come from the USF, so the company is largely immune to these regulatory changes. Also, in June 2008 the Iowa Utilities Board essentially deregulated all telecom pricing at the state level, so the company can now raise or lower prices on short notice. Fees received from other carriers that access the company's network are also subject to regulatory review and could affect cash flow. The company carries a somewhat heavy debt load of nearly $500 million, but about 90% of the debt is fixed at just 6% through 2011. That, together with its ability to generate around $100 million a year in cash flow, leaves the company well positioned to grow through acquisitions. Action to Take --> For investors seeking high income supported by steady cash flow, this rural telecom is well worth considering. It sports a 10% yield and has returned a total (including dividends) of +10.9% so far this year. The shares have gyrated between a 52-week low of $11.54 and high of $20.99. Now trading near the low end of that range, they represent good value. However, investors should be aware that even a fundamentally strong stock like IWA may not be immune from the market volatility.
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