I'll Take the Bengals and the Under on Cincy Bell

So here is the question – what organization in Cincinnati has the bleakest future. Well, let’s consider that for a moment. What about the Bengals? The situation with the Cats isn’t too bad since quarterback Carson Palmer has tons of upside, there is a great receiving corps and Coach Marvin Lewis seems to have his guys headed in the right direction. With that said, I wouldn’t pick the Bengals - but what about the Reds? That situation isn’t too rosy as the Reds are teetering on the edge of the Abyss and there is little hope with that pitching staff and the team’s restricted payroll. So the Reds are definitely a candidate. But if I had to choose the absolutely bleakest situation in town, I would have to say the honor goes to Cincinnati Bell, the city’s local telephone provider.

Here is the Thumbnail on Cincy Bell, listed on the NYSE under CBB. It is a highly levered telco whose business is slowly evaporating as technological changes overwhelm the traditional phone business. CBB’s big problem is its bread and butter is providing basic telephony services to people in Cincy, and that business is under attack from Time Warner - the incumbent cable provider. CBB also provides telecom services to businesses in Cincy and there is a small wireless business that they share with Cingular. In a nutshell, that is the business. When it is all said and done, the company will generate about $1.15 Billion in revenue this year and about $475 million in EBITDA.

So what is the problem? Well, the problem begins with the fact that revenue will be down about five percent this year. That wouldn’t be too problematic if it weren’t for the fact that the company has roughly $2.1 Billion of debt on its balance sheet. With debt four times greater then EBITDA and revenue declining, CBB could face a real liquidity crunch down the road. Now the company will tell you that it will generate $150 million of free cash flow this year, which can be used to pay down debt, but with the business in decline, how long will this pig keep spitting off this kind of cash?

The real key here is how long can that local telephone business stay vibrant? If you listen to Time Warner, the answer is “not too much longer.” Time Warner is expanding their telephony business at a rapid pace since it sees this business as a significant business opportunity. As such, they are spending considerable marketing resources on telephony and nationally, they are adding more then 10,000 customers per week. Such success is having a toll on CBB which has seen its numbers of residential lines fall from 611,000 to 584,000 over the past year. Now that isn’t a disaster, but what happens if the pace of loss accelerates as Time Warrner is predicting? What happens if Time Warner achieves just ten percent penetration over the next year? That equates to a loss of roughly 50,000 lines and $30 million in annual revenue. And what happens down the road when Time Warner really gets its hands on that business? It is not inconceivable that CBB’s line count will be slashed by a quarter, if not more, over the next few years.

This all adds up to big trouble for CBB since it is dogged by that huge balance sheet which requires the company to cough up $200 million in annual interest payments (this amount may be shaved as one particularly onerous loan is refinanced). On top of this, CBB is required to spend about $130-140 million a year to keep its networks running and there is not much more that can be cut from this figure. Thus, CBB has about $330 million in fixed costs that will continue to eat away at the company’s cash flow. Currently, CBB’s cash flow can easily accommodate these payments, but with the business in decline, can this continue forever? I believe the answer is no.

CBB is basically in a race to beat the clock. The bet is it can use its free cash flow to get its balance sheet under control faster then its business declines. This is a race that CBB cannot hope to win. It is delevering at a pace of $100-150 million a year, but at this rate, it would need at least a half dozen years to get its house in order. This is entirely too long for a business that is currently under fire and may be ready to break. It won’t be this year or next, but the time is coming when CBB’s cash flow will not be able to cover its fixed obligations and that means one thing – restructuring.

If the business outlook weren’t bleak enough, there is also a valuation component to this story that befuddles me. Currently, CBB has an enterprise value that approaches $3B. That is made up of about $2B of debt and $1B of equity. At this sum, CBB is trading for a bit more then six times its EBITDA. This is peculiar since CBB has only a very small wireless business and the market basically affords much lower multiples to the wireline businesses of the nation's regional bell operating companies. While it is hard to perfectly ascribe a market value to those businesses, it seems to this scribe that based on some recent acquisitions in telecom, basic non-rural telephony services are trading for about 3x EBITDA. If you throw that multiple on CBB, you get no equity value whatsoever. And, CBB is probably deserving of even a lower multiple since it doesn’t pay the fat dividends that its big brothers cough up every quarter. Another interesting facet to note is that CBB’s PP&E is only valued at $800 million while its debt is more then $2B. In other words, if the network were sold off at depreciated cost, it would fetch only 40 percent of the debt on the balance sheet. As a point of reference, Verizon’s depreciated plant is still twice that of its debt.

It all boils down a very ugly story in Cincinnati. The Reds may be bad right now, but you can count on them being around in a few years. The same cannot be said for CBB. They aren’t going anywhere this year, or even the year after. But come 2007, the bet here is the CBB situation will turn dire and calls for Cincy will be placed to the region’s top bankruptcy attorneys. It will take the stock a while to anticipate this eventuality since most still consider it an option on a turnaround at this point, but rest assured, no turnaround is coming. This story will end and it will end poorly for the city’s bleakest franchise.

Duke Swallows up Cinergy

So we had a little merger in the wonderful world of electricity today as Duke Energy moved north of the Mason-Dixon line to snag Ohio-based Cinergy for a mere nine billion dollars. The deal really makes perfect sense for Duke which was sitting on a bloated currency that was just screaming to be used for an acquisition. After all, if you have a currency that is trading at almost 19x earnings, it is a no brainer to buy similar assets that are trading at only 15x 2005 estimates. And lets be frank here – there are no huge differences in the underlying assets of these two companies. Sure Cinergy has some environmental costs coming down the pike (more coal fired plants then Duke) and they operate in a state (Ohio) with a less favorable regulatory and economic environment then North Carolina, but at the end of the day, we are talking about two basic power producers. Now the one aspect of the deal that is appealing is Duke has a bunch of natural gas units in the Midwest that are currently underutilized because their fuel costs are too high to be competitive. It is possible that some of this excess capacity could be soaked up and perhaps used to offset some of the capacity constraints that Cinergy will soon face under both existing and new pollution control requirements. I am not sure Ohio regulators will bless this plan, but it is possible that the Newco will be able to fold those gas plants into the company’s rate base and have Ohio consumers pick up the tab for higher electricity costs. We’ll have to see if that flies. Regardless, of whether it does or not, you can’t fault Duke for pursuing this move. They had a valuable currency and they used it as a weapon to secure valuable assets. However, as with all utility merges, this one may have trouble getting approved. I am sure Duke is touting it as a done deal, but FPL-ETR fell apart and EXC-PEG doesn’t exactly look clean at this point. As such, I don’t think you can take this one to the bank.