What to Buy: Alaska Communications (NSDQ: ALSK) < USD8

Why Now: Alaska Communications’ (NSDQ: ALSK) stock has been knocked down more than 35 percent this year and now yields about 12 percent, despite relatively few near-term risks to its dividend. This is a result of investors’ flight from risk rather than business weakness.

Our bet is the company will continue to perform by covering its distribution with free cash flow. Once the de-risking trend runs its course, it will then recover its lost ground in the market, handing us potential capital gains of at least 25 to 30 percent in addition to the current yield. Downside is probably the $5 to $6 per share range, which we could see if actual dividend risk grows. We’ll know more on Oct. 28 when the company releases third-quarter numbers.

As with all Big Yield Hunting recommendations, investors should hold Alaska Communications only in diversified portfolios and maintain enough mental discipline not to average down.

The Story

The young gun is a bit trigger-shy this week, but the old hand serves up a lesson in how to hunt high-risk, high-reward game.

This month’s super yielder is down a bundle in 2011, but that’s all a function of market fear. If you look at the numbers–and understand how to separate the important ones from the distractions–it’s clear that this rural telecom is more than capable of covering its dividend.

When that happens, and when the market regains some sense, the stock is likely to more than make up that lost ground.

David: This market de-risking is really getting out of control. People seem to be inventing something new to worry about every day, even when the market rises. I counted almost three-dozen bad news items on The Wall Street Journal’s front page this morning. The only positive note was less than an inch on how the Dow Industrials had risen 140 points–the only actual news on the page.

Roger: You’d certainly never pick up in the financial media that we’ve actually had a pretty decent rally in many stocks over the past month. That’s not the kind of thing that gets eyeballs. As you know, though, I always try to live on the sunny side of life. And there is a pretty huge positive to all this. Mainly, this market is rewarding investors for taking risk with some pretty huge yields.

David: Of course, the flip side is many prior Big Yield Hunting picks are trading at lower prices than where we got in initially. No one seems to care that the companies just put up good numbers that covered their dividends comfortably, or that there’s every indication they’ll do it again in the second half of 2011. It’s all about avoiding another 2008, or worse.

Roger: I think I told you about that question I got from a customer at a recent investment conference. He was worried about sunspots permanently taking out the US electric grid and wanted to know how to hedge his portfolio against it.

David: How did you possibly answer that?

Roger: That’s about the size of it. There are no answers to some of these questions. It’s the elevated fear level in the marketplace that makes almost anything negative seem plausible to so many. And, unfortunately, a lot of these people have responded by acting emotionally with their investments, always a disaster.

David: But there are concerns here.

Roger: Oh, yes, certainly. Europe is still struggling with getting a grip on government finances, and the problem clearly goes a lot further than Greece or even Spain. I still think the prognosis in the US is slow and jagged growth that leaves a lot of people out, rather than an outright recession. But there’s certainly a chance things get worse.

And despite my respect for the job Ben Bernanke has done avoiding a repeat of the 1930s, I have about as much faith as most people in our broken federal government’s ability to improve the situation.

David: We can argue about Helicopter Ben later. But this is clearly a tough environment for stocks.

Roger: Yes, but this isn’t 2008 before the crash. No one knew who held all that bad mortgage debt back then. But everyone knows which of these banks hold suspect sovereign debt–which, I might add, is still likely to be bailed out.

A 2008 debacle is only possible when enough bulls are caught out when trouble hits and have to dump stocks en masse, again clearly not the case now with so many bearish. Moreover, the bar of expectations is set so low for the economy and financial system now that it won’t be hard to beat it at all.

We might well see a wave of panic buying if things turn out to be only half as bad as the consensus now expects.

David: “Panic buying?”

Roger: Why not? Institutions can’t afford to sit out a market recovery, should one take shape later this year. Really, neither could individual investors–they’re just usually more stubborn.

David: So you’re counting on some kind of emotional swing in response to things not being as bad as people think, to get these trades back into the black this year? That sounds like kind of a leap of faith.

Roger: You would be right, if I were holding any of our open positions to a timetable for recovery. What I’m betting on, though, is really just the ability of these individual companies to hold their own as businesses as long as this tough environment persists. If they can do that, they’ll keep paying us those huge dividends.

And sooner or later, investors will want a piece of that enough to leave their fear aside. The only way this red ink becomes permanent is if the companies themselves falter.

David: I get you, but what about Zargon Oil & Gas (TSX: ZAR, OTC: ZARFF)? This week management cut the monthly dividend from 14 cents Canadian to just 10 cents, with no real warning. Should we be bailing out?

Roger: I think they have Penn West (TSX: PWT, NYSE: PWE) disease. That is this idea they should avoid accessing capital markets at all costs, but rather always cover all capital spending and dividends with operating cash flow. They’re certainly not moribund.

In fact, just a couple weeks ago they bought out a partner in the Alberta Plains North Jarrow property. Drilling results elsewhere look promising, though development was delayed by extreme weather conditions this year.

I still think we have the story right here from two weeks ago. What we missed is how extreme management’s conservatism is. If you read the guidance they issued with the dividend cut, they’ve maintained their expectations for end-year oil production and actually increased projected natural gas output by around 7 percent. Those aren’t bad numbers, and they’re in fact impressive given the adverse weather the company has faced this year.

Instead, almost incomprehensibly in my view, what they say is they’re reacting to the drop in oil prices from July in global market. That wasn’t inconsiderable. But Zargon management announced the 14 cents monthly rate last year when it released details about its conversion to a corporation, when oil was actually less than it is now.

This looks to me like a move to anticipate lower oil prices ahead, which I think is far from certain.

David: Well, they have been upgraded to buy by Salman Partners and Raymond James since the cut. I find that very encouraging.

Roger: That may have more to do with the drop in the share price. But Zargon is a bet on oil prices, plain and simple. They’re going to do well if prices stabilize here or head higher. As that’s what I think will happen over the next 12 to 18 months.

I’m OK living with the lower dividend and the red ink, at least until the next batch of earnings gives us a read on how production and reserve development are proceeding. I do, however, think this lower level of dividend is ridiculously conservative.

David: So investors should stick with this one?

Roger: I think so, with the caveat that no one should be averaging down any of these Big Yield Hunting positions. As we’ve said–and it bears repeating now–these stocks yield a lot because they do carry risks. The downward pressure on prices recently is market-driven and, outside of Zargon, has nothing to do with business health. But again, high-yield companies can stumble, particularly when macroeconomic conditions are less than optimal.

David: What about this month? Is the field bet–equal positions in all of the Open Trades–still a buy?

Roger: Again, I think so, but with the caveat that we’re not advising averaging down. But what I really want to talk now about is another high-yield pick that’s become a lot more attractive with all this de-risking: Alaska Communications (TSX: ALSK).

It’s a strictly local-based wireless/wireline communications company serving one of the strongest state economies in the US. There’s competition, but revenues and cash flows are very stable, the company is expanding its network and cash flow looks set to cover capital spending and dividends.

On top of that, it pays a dividend of almost 12 percent.

David: Certainly took you long enough to come to the point. I suppose Sarah Palin is a major shareholder?

Roger: No idea. I might be interested in finding out if she was still governor. But as CEO Anand Vadapalli pointed out in a presentation last month, management does pride itself on community involvement, and that’s a real advantage when you’re going up against out-of-state competition.

David: That’s clearly AT&T (NYSE: T) in wireless, with Verizon Communications (NYSE: VZ) possibly coming in by 2013, the Federal Communications Commission’s deadline for keeping its license I believe.

You yourself have pointed out that these companies spend upwards of $5 billion a quarter on networks and that rivals like Sprint Nextel (NYSE: S) and T-Mobile USA can’t possibly keep up. That’s in fact why T-Mobile owner Deutsche Telekom (OTC: DTEGY) is trying to bail out by selling to AT&T.

How can little Alaska Communications with just $328 million in market capitalization possibly compete?

Roger: Good question. The worry they can’t is clearly why this stock is yielding nearly 12 percent, despite one of the steadiest dividend records you’ll find anywhere.

In fact, Standard & Poor’s changed its ratings outlook on the company from “stable” to “negative” this week, precisely because of worries about what a Verizon entry could do to the company’s wireless business. The answer is they’ve been facing full-bore competition from AT&T, particularly in the state’s urban areas, and they have lost market share to the iPhone.

But they’re also still covering the distribution comfortably with free cash flow, with a payout ratio comfortably in management’s target range of 75 to 80 percent. And those losses to the iPhone have largely leveled off, in part because the company’s network is superior to AT&T’s in the state and because it’s been able to dramatically expand the array of wireless devices it offers.

Yeah, all that could change should Verizon and AT&T both decide Alaska’s market is the key to their futures. But these companies have many other battles to fight. I suspect they’ll expand in Alaska as much as is profitable. And in Verizon’s case, that will almost surely require renting space on Alaska Communications’ network. They just don’t have the pipe or towers in place–at least not to match Alaska Communications’ reach of 85 percent of Alaskans, from the North Slope oil drilling zone to the more temperate coastal south.

David: What about the wireline side? Surely Alaskans are cutting the cord as they are everywhere else.

Roger: Not as much as you might think. We’re talking about the biggest state in the union, and there are a lot of remote places where that basic copper connection is the only communications lifeline. In fact, it’s extremely unlikely that will change anytime soon. That adds up to a very low attrition rate, and management has been able to routinely replace lost revenue by adding business in broadband.

And don’t forget the company is able to use the infrastructure from its wireline network to support its wireless network, which is extremely important in the data business and when it comes to enterprise customers. Data is the focus and the company is now up to 42 percent of customers with a data-centric devices, growing average revenue per customer by 50 percent over the past year.

This company also owns two submarine cable systems that link Alaska to Seattle and Portland in the US Northwest. In fact, it serves about a third of the trans-Pacific cables that land on the West Coast of the US. These are extremely difficult to build and compete with.

Looking ahead, they’re getting ready to roll out 4G LTE for their wireless networks, with early 2012 the launch date. That will clearly establish network superiority.

David: But still no iPhone?

Roger: No. In fact, Mr. Vadapalli made a comment during the presentation he made last month that it was up to Apple (NSDQ: AAPL) to decide on timing, should it occur. He also said he was “probably on their ‘do not call’ list,” though an offering could come as part of a consortium. I was slightly non-plussed by those comments. But in any case, defections appear to be leveling off, and more than 90 percent of the company’s wireless customers are contract, or “post-paid.” That’s a pretty good sign they’re holding onto their best customers, iPhone or no.

My impression is they wouldn’t mind selling it. But in the meantime, I don’t think Google (NSDQ: GOOG) minds one bit having Alaska Communications virtually to itself. And they at least seem to be providing more than enough tools for this company to compete.

David: That all sounds good. But how committed are they to the dividend?

Roger: That’s always a question with any high-yield company. And as we saw with Zargon, there’s no guarantee management won’t cut, if for no other reason than to be conservative in a tough environment.

Mr. Vadapelli, though, did say something interesting in response to a question about that during the presentation last month. Mainly that paying a high dividend “really forces us to make very disciplined choices about how we can deploy money and how we can deploy capital.”

He went to say that “can be viewed as constraining on some days, but probably longer term, that discipline is good” and that “we haven’t been starving the business of capital” either. Other than that, he’s very confident the company will keep the payout ratio in “the midpoint” of its guidance range of 70 to 75 percent of free cash flow in 2011. That’s about the best vote of confidence I can think of for the dividend, at least for the time being–which is really all we can be sure of about any individual stock.

David: OK, but let’s look at the second-quarter numbers. They still have wireless customer turnover, or “churn,” of 2.1 percent. That’s a lot higher than Verizon’s, which is less than 1 percent nationwide. Revenue was up, but only by about 0.5 percent, and wireline retail revenue was off about 5.6 percent. Cash flow was down about 2.7 percent, and 5.3 percent on the wireline side.

None of these are catastrophic, but neither are they as solid as, say, Otelco (NYSE: OTT), a stock we recommended in Big Yield Hunting almost a year ago and which still yields around 10 percent. Why not just buy that one?

Then there’s the net loss of 8 cents per share for the second quarter, which I know was due to a $29.7 million non-cash charge. But doesn’t any of this concern you?

Roger: The earnings number certainly would, were management basing the dividend on earnings per share (EPS) as measured by Generally Accepted Accounting Principles. But they’re not, and neither is any other company in the rural telephone business. That’s because they try to minimize taxable earnings per share to keep taxes low.

EPS is simply not relevant. The rest of the numbers are snapshots on certain areas of the business and aren’t particularly robust.

But again, what we’re concerned about here is what’s supporting the dividend, and that’s free cash flow. And the key question is whether or not positive numbers offset the lackluster ones, keeping free cash flow strong. And here the big picture is matching up to management expectations, at least through the last set of numbers released.

We do have to keep checking every time earnings are released. But again, as of now, the company looks stable and so, therefore, is the dividend.

One other risk they don’t have is refinancing, should credit markets freeze up–something I don’t expect as you know. More than 95 percent of the company’s debt won’t mature before 2016. That means cash flow can be deployed to capital spending and dividends even if borrowing costs do rise sharply.

And lastly, this company cut operating expenses 4.5 percent in the second quarter and raised capital spending 13.9 percent over last year’s levels. That’s all very good news, and it points to a solid company that’s weathering competitive and economic pressures.

David: Third-quarter earnings are due out Oct. 28. What should we look for?

Roger: I’m obviously going to be concerned about the payout ratio. If there’s a miss, I’m going to get a lot more cautious very quickly. Otherwise, we’re going to be in good shape.

I haven’t recommended Alaska Communications in Utility Forecaster as a “buy” for a long time, mainly because I’ve seen it as too high priced for the risks entailed. But this stock is down about 35 percent year to date, and if it holds its dividend until this de-risking craze runs its course, it’s going to make up that ground in a hurry. That puts it right in the spirit of our Big Yield Hunting service–higher-risk but a lot of potential reward if the underlying business holds it together.

David: Where would you buy it?

Roger: I think anything under 8 is a good price, as it will produce a yield of close to 11 percent. This one did get as low as $6.33 in early August, however, so investors may want to use a strategy of investing what they want to incrementally, say a third now, a third in a couple of weeks, etc. I’m also not advising anyone bet the farm here. And in fact, that’s my answer to your query about why not just buy Otelco. Mainly, any of these companies can stumble. But if you own a basket of these, one loser will not take you down.

David: Sound like words to live buy. Let’s give Alaska Communications a shot. Alaska Communications–yielding 12.1 percent as of midday Thursday, Sept. 15–is a buy under USD8.

• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–Buy < USD6
• October 22, 2010: Otelco (NYSE: OTT)–Buy < USD20
• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–Buy < USD9
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–Buy < USD5.50
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–Buy < USD11.60
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–Buy < USD6
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–Buy < USD5.60
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–Buy < EUR16, USD23
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–Buy < CAD17.50, USD18
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–Buy < USD8

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)