Description

Fairpoint Communications: FRP [Long, Px Tgt $15, 92%; Risk Px 5.18, 25%]

Summary:

Levered bet on the ability for Fairpoint Communications to transform revenue by adding next generation (high speed data) services while simultaneously slowing churn on core voice access line customers. Given highly levered nature of the company small improvements materially enhance company’s free cash flow profile.  As company continues to illustrate execution of strategy believe that market will re-rate the multiple.

Thesis / Type of Trade:

• Multiple Re-rate:  Currently FRP is trading at a distressed valuation of less than 4x (3.89x) 2013 EBITDA.  Believe that the market is not appropriately recognizing management’s ability to mitigate churn and grow the high speed data segment of their business.  As the company illustrates growth in their fiber assets and continues to reduce churn rate believe market will re-rate the name to a comp multiple. 

Thesis detail / Background:

Fairpoint was put into bankruptcy in October of 2009 because of the debt it incurred from its $2.3B purchase of Verizon’s land line franchise in New England in 2008.  During bankruptcy the company resolved back office / billing issues in addition to a financial restructuring.  The financial restructuring involved cancelling all shares and reducing the debt from 2.5B to 1.0B.  Pre-bankruptcy debt holders received 25.6M shares and seven year warrants to buy 3.6M shares at a strike price of 48.81 per share.  The bankruptcy plan reduced yearly interest payments from $200M to $65M and gave the company an additional $75M revolver.

Fairpoint outlined a 4 pillar strategy to increase FCF:

1. Improve operations.
2. Execute human resource strategy.
3. Change regulatory environment
4. Transform and grow revenue.

The company has executed on 3 out of 4 of these initiatives, the exception being revenue growth.  

1.  Service levels have been repaired to industry averages, Company saw 26% reduction in repair calls / trouble last year. 
2. The company has reduced its work force by 15% last year, pension contributions should be down by $8-10M next year thanks to funding legislation in the  transport bill.   Furthermore, FRP will have negotiations with their Union in 2014, expect the company to gain greater flexibility after these negotiations, note that FRP union does not have a meaningful strike fund.
3. The company has succeeded in lobbying states of VT / Maine and NH to deregulate the residential wire-line market.  As of August the company can set their own pricing without consulting the regulator, thus levelling the playing field with its competitors.
4. Slowing the churn is the last piece of the 4 pillar strategy that management has not completed.  Revenue has declined between 4-5% 2010-12, and management looking for revenue growth in ’13 relative to ’12.  A chief revenue officer was appointed in May to improve the sales process.  Management noted on their last conference call (Q2) bookings were up 15-16% quarter over quarter, and the company has done $68M in FCF this year relative to their guide of $90-100M, they should solidly beat the guide.

Path To Getting Paid, how will the expectational gap close?:

• Continued execution of the company’s revenue strategy.  Ability to mitigate / stabalize churn.  This will be illustrated through quarterly EPS.
• Note that on 9/4 company made a voluntary prepayment of $25M on their debt.  Believe this illustrates companies confidence that they’re starting to see a turn.
• Company also noted on their last conference call (Q2) that they saw bookings up 15-16% q/q.
• August, regulation in NH will roll on allowing FRP to more dynamically adjust pricing competitive with industry.
• Further execution on their FCF guide.  As noted above, FRP guided to 90-100M in FCF, through Q2 the company had printed 68M in FCF.  Believe as the street recognizes this the multiple will continue to re-rate.  
• Potential for small assets sales, management has said they would entertain selling small pieces of the business either for strategic reason or to illustrate to market the valuation of such assets.

Price Target:

• My price target of $15 is predicated on 4.5x ’13 EBITDA estimate of 297M (in-line with consensus).  Believe that through continued execution FRP stock multiple re-rates from a current 3.85x to 4.5x.  Note that the 4.5x 2013 estimate is still a substantial discount to peers which trade between, 5.4x -6.4x ’13.  See comp table below.

Sensitivity analysis, EBITDA multiple sensitized for 2013 EBITDA estimate.

  see attached

Comp Table per reference above. Note multiple discount / premium relative to comps.

   see attached

Risks:

• Primary risk is that the company is unable to execute on their revenue strategy (minimize churn, growth in data and internet).
• 3.25 EBITDA coverage covenant, however, in the above table note strong interest coverage ratio >4X.
• LIBOR spike causing interest rate to rise materially.

Sentiment:

• Current analyst coverage is thin with only 4 boutiques with coverage of the name: CRT, Drexel, Seaport Group and Vivid Research.  Any bulge bracket institutional sponsorship would go a long way.
• Nearly 70% of the shareholder base is made up of hedge funds.  Angelo Gordan, ~20%; Anchorage Capital ~10%;  New Generation ~6%, Lombard ~5.5%.
• Short Interest:  Currently there are 4.9M shares short the name or 25% of the float.  This equates to 49 days to cover.  Bears on the name look at the company as a structural short, dying wire line business.

Company background:

Fairpoint is broken into two divisions, Northern New England (NNE) and the Telecom Group:

1. NNE, Incumbant communications provider in ME, NH, and VT (“Northern New England”):

• Over 1mln access line equivalents.
• Significant opportunity in business market.
• Over 14k route miles of fiber.
• 85% avg broadband availability.

• 263k access line equivalents
• Less competition
• 90% broadband avaialability
• 49% broadband penetration.

Catalyst