Description

Fairpoint Communications - Long - (COMP: FRP)July 2011 - $8.83

Investment Thesis

Fairpoint Communications ("Fairpoint", "FRP" or the "Company") is an attractive long at current levels, with asymmetric risk / reward characteristics.  I think shares are worth at least $15 over the near-term and potentially closer to $20+ over the mid / long-term.  FRP is a recently emerged post-reorg equity, which has sold off 65% since emergence, on legitimate concerns, but I believe an operational turnaround is much closer than the market believes.  Customer service metrics have and will continue to improve, given FRP's recent broadband investments, improved processes and systems and upgraded management.  The improved customer service is leading to reductions in churn, which will allow FRP to pursue cost saving initiatives, which have not yet been announced, but I believe are increasingly likely in the second half of 2011.  The Company may never achieve peer-level profitability, nor receive a "market" multiple, but at these levels, the Company only needs to show a reasonable degree of operational stability to be re-rated.  At 4.2x my base case 2012E EBITDA, and 30% free cash flow to equity, FRP is a long.

Company Background and History

Fairpoint is one the nation's largest local exchange carriers ("LEC"), with assets in mid-southeastern states and northern New England.  The Company was founded in 1991, with the intent of rolling up RLEC assets in Virginia, North Carolina and other rural regions.  The strategy worked well, with Fairpoint growing access lines organically and through acquisitions.  The Company maintained excellent profitability levels, had sound financial management, and was well-regarded by the (admittedly small) investor community.
In early 2007, Fairpoint announced the purchase of Verizon's northern New England ("NNE") assets, consisting of incumbent properties in Maine, New Hampshire and Vermont.  Verizon, at the time, had executed several divestitures which were designed to lower exposure to legacy assets (see Hawaii Telcom and Idearc, and the subsequent RLEC divestiture to Frontier).  Verizon reached an agreement to sell the properties to Fairpoint for $2.7bn, via a reverse Morris trust, which achieved favorable tax benefits for VZ.  This transaction, obviously sizable for Fairpoint given limited financial and operational scale, was reviewed for almost one year by the NNE public utility commissions ("PUCs").  The transaction was ultimately approved, although the purchase price was reduced and Fairpoint was forced to agree to several regulatory agreements with the PUCs.  These agreements, amongst other things, mandated certain broadband availability levels, provided for recurring customer service checks, and laid the groundwork for what was ultimately a disastrous transaction.
Verizon mandated a "flash" cutover, meaning once the properties were sold and the back-office agreement terminated (FRP paid VZ ~$15mm monthly prior to the cutover), there would be no redundant operating systems or support to manage processes.  As everyone now knows, the cutover was a disaster, and Fairpoint suffered tremendously.  Customers received incorrect bills, were forced to wait weeks to address the errors and service times, and spiked to (previously) unimaginable levels.  There were many other issues, all of which were related, but needless to say these issues created a tremendous amount of negative publicity with the NNE customer base.  Making matters worse, cable companies (primarily Time Warner and Comcast, operating the old Adelphia plant) and CLECs were quick to take advantage of FRP's weakened state (the increased competition began during the regulatory review, and continued throughout the bankruptcy; e.g. FRP was an easy target).  FRP spent almost ~$30mm in incremental expenses during 1H 2009, brought in CapGemini, and was forced to divert significant management attention towards these issues (nearly 800 additional employees were brought in to help manage the transition).  As most know, between a combination of terrible operating performance, poor economic conditions, and a highly levered balance sheet, Fairpoint filed for bankruptcy protection in October 2009.
The Company emerged from bankruptcy in January 2011 with a $1bn exit term loan, and pre-petition secured creditors owning ~90% of the equity.  Unsecured noteholders received warrants, along with the rights to a litigation trust (against Verizon).  The CEO and CFO were replaced in 2H 2010, along with several middle managers in product development, sales and marketing, and NNE state-level presidents.

Company Overview

Fairpoint has 1.4mm access equivalents ("ALEs"), spread amongst across 33 individual LECs in 12 states.  The majority (0.9mm) of ALEs reside in the NNE, down from ~1.4mm in September 2009 and ~2.0mm in March 2008.  The balance reside in Virginia, North Carolina, Florida, and other southeastern states, referred to as the Telecom Group.  The Telecom Group is generally well-managed, with fewer competitive threats relative to the NNE properties.  These divisions are separately managed, and are not integrated from a systems perspective (I think they will divest Telecom Group in the next year).  While FRP no longer breaks out details for each division, a large profitability gap exists between the two properties.  I've heard that Telecom generates ~$250mm in revenue and ~$110mm in EBITDA, while NNE generates ~$775mm in revenue and ~$150mm in EBITDA.  I think they could sell Telecom Group for at least 6x EBITDA.
Employee BaseFairpoint has ~4,000 employees, comprised of ~2,600 unionized employees (primarily in NNE).  The vast majority of these unionized employees are represented by the International Brotherhood of Electrical Workers (IBEW) and the Communications Workers of America (CWA).  2,350 of these employees are "protected", meaning they are covered under collective bargaining agreements, which expire in August 2014.  The other 250 unionized employees who are unprotected were brought in as temporary help to manage the transition.  Now that Fairpoint's operational metrics are stabilizing and "almost there", I expect an announcement in the back half of 2011 regarding the layoff of these employees.  The vast majority of these "un-protected" employees will flip into mandatory protection in September 2011, and given the current level of overstaffing, I do not expect management to allow this to happen (the reduction in costs is likely ~$20mm).  I also expect an announcement later in 2011 regarding the protected employees, given the Company is significantly overstaffed, by almost any metric.
On this last point, I'd note that the ideal time for Fairpoint to shed these expenses was during bankruptcy.  Unfortunately, this was not possible given the significant, ongoing operational issues during 2009 and 2010 (customer service does not typically improve with layoffs).  Furthermore, contentious labor disputes are seldom viewed favorably in the local communities, and given the widespread, well-known customer service issues in NNE, workforce reductions were not practical.  The re-instated agreements do provide for a joint committee between FRP and the unions, and while this committee is supposed to reduce expenses by ~$25mm annually, I am not optimistic that the joint committee will produce tangible results.  The bulk of the workforce related savings will come from negotiated personnel reductions, likely through employee buyouts.
Financial DetailsFRP has struggled financially for many reasons, but from a high-level perspective they have (i) too few access lines per employee and (ii) their employees are overpaid and unproductive (on a relative basis).  Consider (i) the numerator has suffered due to churn and customer service issues, while (ii) the denominator has actually grown due to the aforementioned operational issues.  In short, I expect line-losses to moderate given the recent historical trends, and continued improvements in customer service and operating metrics.  In thinking about the operating model, I'd note the following:

• Voice - FRP's incumbent status has eroded over the past several years, but switched telephony remains the dominant product @ ~45% of revenue. Voice revenue has declined meaningfully, given terrible yoy access line losses. Line losses have begun to stabilize in Q4 2010, Q1 2011, and more recently in Q2 2011. I expect Q2 yoy access line losses of less than 9%, with run-rate loss rates closer to 7%. Voice is obviously a declining product, but over time I'd actually expect FRP to perform well given they have already experienced so much company-specific churn. Data - the NNE properties have ~25% broadband penetration (as % of access lines), whereas the Telecom Group is closer to 40% (in line with peers). FRP's high-speed data products are underpenetrated relative to peers, and I do expect outperformance here. Q1 HSD subs grew 4.8% yoy, and given the improved customer service and network, I expect continued outperformance. I see data penetration reaching ~32% by year-end 2012, still well below peers. Access & Other - FRP's hybrid copper & fiber-based network in three contiguous NNE states has meaningful monetization potential, and has been substantially improved in recent years. The Company obviously resells access to CLECs, but more importantly, is leveraging fiber-to-the-tower and carrier services opportunities. While FRP has yet to release details on any customers or contracts, they are building fiber to 800 of the 1,600 in-network wireless towers. Given the Company's weak financial state, I would expect that this level of capital spending is supported by a long-term contract (through AT&T or Verizon). Longer-term, access revenues could reach ~45/50% of revenue. Cash Operating Costs - FRP's current cost structure is bloated, relative to the current size of the operation. Of the ~$800mm in cash operating costs, ~$400mm is allocated towards employees (compensation, pension, OPEB). As discussed above, I expect the Company to reduce this line item meaningfully over the next two years. In addition to the unionized labor, the Company has recently been overly reliant on Capgemini for outsourced bank-office services. As we reach operational stability, our reliance on CapGemini will reduce, as should the overall expense base. I believe there are other opportunities for cost reductions (circuit & systems expenses), but for now, the focal point is labor. Margins - FRP operates with ~25/26% EBITDA margins; whereas broader LEC peers operate with margins of closer to 40% (I'm excluding larger, more diversified peers like CTL & FTR given scale and lack of USF revenue). Three of the main reasons for the low margins are (i) low wireline market share, (ii) low broadband penetration and (iii) overstaffing. While the bull case several months ago rested on FRP's ability to drive ~$400mm in EBITDA, I think the market consensus now is closer to ~$220mm. The longer-term margin expansion opportunity is real, but I'm not sure that FRP will ever get to peer-level profitability. Capital Intensity - Peers spend ~13/14% of revenue on capex, whereas FRP has been investing nearly 19%. Much of this capital has gone towards PUC-mandated network improvements, which will benefit FRP longer-term (these are nearly complete; VT was just completed at the end of June). The capital cycle is at an inflection point, and I believe 2012 capital expenditures are much closer to $130mm than the $190mm likely spent in 2011. Prospective shareholders will benefit from the meaningful (2009 and 2010) invested capital, which has yet to generate meaningful returns (given the operational mess). Capital Structure - FRP has a ~$75mm undrawn revolver and a $1,000mm syndicated term loan, for trailing leverage of ~3.9x. The debt has minimal mandatory amortization payments until 2012, and has a 4.75x maintenance covenant. I believe that the Company has ample flexibility here, but investors clearly anticipate liquidity / covenant issues. I think these fears are overblown, and the term loan @ 88 offers reasonable value and current yield, with upside once the operational turnaround becomes visible for investors. NOLs - The Company has ~$137mm in NOLs, and will not pay cash taxes for the foreseeable future.

• Operational Upside - As described below, FRP's operations are stabilizing and improving, and I believe financial (outperformance) will follow (four key operational points here - the formatting wasn't working for me).
• Access Line Losses - Fairpoint's access line attrition has underperformed peers since 2009, with yoy access line losses in the mid to low teens. More recent trends have shown moderating losses, closer to ~10% (-9.6% in Q1 2011), but even this number outpaces industry-wide declines of ~7/8%. These losses are surely driven by secular trends, such as wireless substitution, competition from cable and VoIP telephony providers, and an aging customer base, but have also been impacted by FRP's terrible customer service. Given the aforementioned improvements in operational performance (mean time to repair, customer complaints, call center volumes), I expect access line losses to decline. Recent data points confirm this assumption, as we can see through regulatory filings.
• New Hampshire and Maine publish monthly and quarterly service quality reports, which detail certain regulated quality metrics (such as time-to-repair, un-attended complaints, failures per 1000 calls, etc.). Each one of these trends has been improving relative to trend lines, for some time now. Discussions with regulatory and industry professionals confirm the improved operational performance. More importantly, New Hampshire publishes monthly access line data, and as we can see through April and May, access line losses have continued to moderate (in fact, they actually went up by 424 in May). New Hampshire represents ~25% of access lines, but closer to ~35% of attrition on a historical quarterly basis. While a gain of 424 access lines is admittedly small on a NH customer base of 240k, the direction of the change here is important. These numbers imply quarterly churn rates (through May) of 1.3% in New Hampshire, or 6.9% annualized. Given this data, and other reasonable assumptions, I expect yoy churn to trend closer to 7% by Q3 / Q4 2011.
• Broadband Growth - Fairpoint is growing broadband subs again, with Q1 broadband subs up ~4.8% yoy. Broadband growth and penetration are important, since FRP is so under-penetrated with respect to access lines. FRP has ~27% penetration, whereas larger, more established peers such as FTR, WIN, and CTL have penetration rates closer to ~35 or 40%. Broadband penetration drives higher ARPU, lower churn and higher profits. While FRP's primary broadband product is an 8MBPS ADSL product, the company invested ~$200mm in 2010 to drive broadband improvements, and per the regulatory settlement, is investing ~$150mm in 2011 to improve broadband availability and speeds.
• Employee Costs - As discussed above, at ~$400mm annually FRP's employment-related costs are out of control. I expect that this will be remedied over time, where appropriate. The first reductions will deal with temporary employees, and I expect details on a negotiated union settlement later in 2011 (Verizon is facing similar issues with the exact same unions).
• Improving Regulatory Dynamics - Discussions with regulators paint a much improved relationship with FRP, who is "almost there". The regulators are key constituents, and their importance cannot be underestimated. Maine passed a recent law, outlining telecom reform, which, in my view, will level the playing field for FRP. Taking a step back, many of the current regulations were enacted back in 2007, when Verizon's properties had ~50%+ market share, and regulators were concerned about price gouging. This is no longer the case, and in many cases, aggressive CLECs are able to exploit this regulation. Improved relationships with the PUCs can drive regulatory improvements. New state-level presidents in VT, ME and NH were all formerly with Duke (the utility) and are key in driving these improved relationships.
• Technicals - FRP is covered by one sell-side analyst, and trades ~200k shares per day. The YTD stock performance has been terrible, with Marathon selling a significant portion of their stake, and Angelo Gordon (20% owner with BOD seats) buying. CEO Paul Sunu had been buying after Q1 as well. The technicals lead to asymmetric information flow (e.g. ME / NH access line & customer service data), something I love in long ideas. I'd also note that June 30 short interest has jumped up to 3mm shares, a meaningful number given maybe ~14mm of freely floating shares. I think these technical characteristics create a great setup for prospective owners. At these levels, small changes in operating assumptions will lead to outsized moves in the equity. For the reasons discussed, I believe the operating changes are very clearly moving in the right direction.

• Declining Industry - The switched copper access line industry is in structural decline, and faces intense competitive threats from cable, CLECs, wireless providers, and alternative telecommunications providers. The industry's valuation multiples have re-rated, and could have another leg down. 
• Mitigant - FRP's performance will be driven by idiosyncratic factors, many of which are now in the Company's control. Industry multiple compression may squeeze the relative discount, but the story is much more dependant on earnings power (versus multiple expansion).
• Limited Operational Flexibility - In addition to senior creditors, two other creditor-like constituents are the PUCs and unions. Both limit FRP's near-term operational flexibility, and while I expect this to change over time, this is a concern.
• Mitigant - FRP's PUC relationships are much improved relative to one or two years ago (the ME regulatory reform is a great example). Employee / union relationships are good, for now, and while meaningful changes are needed, these will come through a negotiated outcome.
• Historical Operating Performance - FRP's historical operating performance has been awful. Mid to low teens access line losses, coupled with a bloated cost structure and poor management, have led to ~25% EBITDA margins.
• Mitigant - Run-rate operating performance is much more stable than one would think given the stock price chart. Between moderations in access line losses, growth in HSD subs and access revenue, and eventual cost structure improvements, operating and financial performance will improve meaningfully.

• At $8.83, FRP is down 65% YTD since emergence, and has a $240mm market cap. The Company has a $1,075mm senior credit facility which consists of (i) an undrawn, $75mm revolver and (ii) a $1.0bn term loan. This credit facility is held by pre-petition senior lenders, and was given as partial consideration for their claims. The Company also has ~$89mm of under-funded pension liabilities and ~$76mm in cash, for an enterprise value of ~$1,254mm.o The Company expects to hit the low end of 2011 EBITDAR guidance, or $260mm (guidance was $260mm to $280mm; the market probably anticipates something closer to $220mm). I think 2011E EBITDA comes in below guidance, but for me a key piece of the investment thesis is the EBITDA trajectory into 2012 (e.g. meaningful leverage given operational improvements). I think FRP is worth ~$15, based on 5x 2012E base case EBITDA of $268mm. I do think the Company has earnings power of at least $300mm, and plan to refine these analyses once we have additional detail on cost reductions.

• Q2 Earnings - I expect Q2 earnings to be meaningfully better than the market perceives. More specifically, I expect continued reductions in access line losses, to less than 9% from 9.6% in Q1. I also expect continued HSD sub growth, in fact we know that the Company grew HSD subs by at least 3.6%, given last week's announcement with respect to the Vermont buildout (at least 300k HSD subs). I expect earnings quality to improve meaningfully going forward; both in terms of addbacks and clarity (see June non-deal roadshow which more clearly outlines EBITDA adjustments).
• Cost Reduction Announcements - While I do not expect full clarity on unprotected & protected employee reductions in Q2, I do believe that these will be forthcoming in 2H 2011. The key point here is that once FRP has more clearly demonstrated operational stability; investors will be able to see a path towards ~$300mm of sustainable profitability.

Catalyst