Description

Frontier Communications (FTR) presents an interesting value for the following reasons:

• Sustainable high dividend yield of 9.7% based on current stock price.

• Free cash flow after dividend payment, cash taxes and CAPX of 7'% rising to 10.5% post acquisition with synergies fully achieved as described below.

• Pending acquisition of over 4 million lines from Verizon.

 I think an investment in FTR  is a lower risk opportunity to make approximately 10% per year (dividend) with downside protection due to a large free cash flow cushion (after the dividend).   The upside is FTR's ability  to generate free cash flow that will be deployed largely for debt pay down.   This debt reduction has the potential to add another 5% to 10% a year for a total annual return of 15% to 20%. 

FTR is one of the nation's largest local exchange carriers (ILEC) offering wire-line telephone service, broadband internet access, wireless internet access and DISH satellite TV.   Frontier has approximately 2.1 million wire-line customers and 620,000 high-speed internet subscribers with operations in 24 states concentrated in the west, mid east and northeast states. 

FTR is a very well managed company operationally.    This is evidenced by their industry leading EBITDA margin of 55%.  Other landline operator's margins vary from 50% for Winstream to 25% for Verizon.  EBITDA per employee is also the highest of any company.   

So why invest in a business in decline?  Because I believe the market is so focused on the decline that that it is missing the cash flow potential of the business.  In that way I think it is similar to other declining businesses that produce large amounts of free cash flow in the process... such as paging companies (Arch Wireless and now US Mobility) and dial up internet (Earthlink) as two examples.    Those businesses too had excellent entry points where cash flow relative to value presented a very good risk reward.  The free cash generation became the catalyst to realizing returns in way of dividends and/or share price appreciation.

FTR line loss rate is improving; a year ago it was at a rate of 7% and is now 6%.   The rate is reduced to 2.9% when combined with high -peed internet additions.  This is second best rate in the space next to Winstream at 1.2%.  Broadband growth has been able to largely offset reduced voice line revenue. 

FTR is in process of closing on a very large and transformative acquisition of a portion of Verizon's wire line and broadband business.  I will discuss that below.   First to summarize FTR's current valuation and business.  Despite wire line losses, EBITDA has been stable over the last six years at the rate of $1.1 to $1.2 billion.  Current interest expense is $375 million, 2010 capx is projected at $225 million plus $75 million of integration expenses related to the Verizon acquisition, dividends are $310 million (13.5% current yield) and cash taxes of $60 million.  This leaves about $180 million of free cash flow (adjusting for the unusual one time Verizon expense), or about 7% on equity (after current 13% dividend).    Enterprise value is as follows:  Equity value $2.4billion and debt of $4.8 billion for total of $7.2billion. 

Verizon Acquisition

FTR is in process of acquiring 4 million access lines from Verizon in 14 states, 11 of which FTR has operations.  70% of lines are in rural areas (similar to FTR's existing business), have less competition as a result, less exposure to regulatory reform and are under-penetrated.    FTR will become the fifth largest ILEC with 7 million lines in 27 states and the largest focused on rural areas and small and medium size cities.   The acquisition presents the following value building opportunities:

• Achieve expense and operating synergies, which FTR projects at $500 million annually to be fully in place by the end of 2011. (Management, legal, information systems and accounting).

• Leverage FTR's management and operating platform to improve Verizon EBITDA margins from current 45% to 55% (which is level of FTR's current operations).

• Opportunity to expand broadband footprint. Broadband currently available in only 60% of the Verizon households being acquired compared to 90% with FTR's existing

business.    FTR's current penetration is 30% compared with Verizon groups 25%.  FTR will be "overinvesting" in this area spending an additional $100 million per year for the first three years to increase coverage from 60% to 90% plus.  This is a significant revenue opportunity as Verizon has under invested in broadband, as evidenced by coverage percentage. 

• Opportunity to increase long distance penetration. FTR is current penetration rate is 71% compared to Verizon groups 46%.

Transaction Structure

FRT will pay approximately $8.6 billion to Verizon, structured as $3.33 billion in cash or debt relief and stock for the remainder.  Current FTR shareholders will own approximately 32% of the combined entity and Verizon's ownership of the combined entity, approximately 68%, will be distributed to Verizon shareholders.   Like many spin off transactions, many Verizon shareholders may sell the stock, which I believe may create a great buying opportunity, post acquisition. 

Pro-Forma

Below is a summary pro-forma of the transaction.

What stands out is the free cash flow potential of the combined business AFTER the 10% dividend, approximately $800 million per year.  That equates to another 10% on current equity value of $7,668. This should accrete to the equity in some way.   FTR has stated it will use a majority of this free cash flow to pay down debt.   As an example, paying down $2 billion of debt over first three years, keeping the EV constant at $15,500 would boost share price by $2.2 dollars or 28%.  Combine this return with the dividend and you have a company providing a 20% return a year, in a business that has proven to be stable throughout good and bad economic times as evidenced by its recent performance.   I think the risk/reward is good.  There is a margin of safety here.  Say in three years after collecting 30% in dividends, the business fundamentals could play out much worse than anticipated with stock price then of $5.25 and still an investor would break even. 

RLEC M&A

I believe what may add to the selling of Verizon shareholders post spin, is the hangover from recent disaster of a previous Verizon sale of RLEC lines to FairPoint Communications.  The transaction was similar with Verizon shareholders owning 60% of FairPoint post transaction.   In 2008 FairPoint purchased 1.6 million lines in the rural New England for $2.4 billion.  FairPoint had tremendous service problems after the acquisition including problems with 911 emergency services and billing errors, very poor customer service, lack of (and delay of) an electronic bill-pay option, slow or intermittent services, and sluggish and inadequate response to customer complaints and service issues which ultimately eroded business to the degree that FairPoint filed Chapter 11 in October 2009. 

So why is this different you may ask?  Well first, FTR is a much better run company with a history of successful acquisitions including Rochester Telephone, Commonwealth Telephone and Global Valley Networks, all of which resulted in greater than anticipated cost savings.  FairPoint ran into trouble for following reasons: It acquired lines outside its market; it tried to convert the lines to its own systems (which were designed and deployed by consultants) day one and was grossly unprepared for the task. 

FTR is paying Verizon $90 million in fees to use its existing resources in 13 of 14 states.  There will be no change in service, billing, order process, inventory management etc at the time of the acquisition.  The same people will be doing the same thing they did the day before in these functions... just under a new company name.  FTR will then gradually transition all these processes to its own systems over time.... one state at a time.  The one state being converted at time of closing is West Virginia, which represents 13% of the business.  FTR has a strong history of integrating operations from acquisitions smoothly.  Additionally, the business being acquired by FTR is complimentary in that FTR has operations in 11 of the 14 states and has substantially the same rural profile as FTR's current business.  While FairPoint leveraged up to make the Verizon acquisition, FTR will be de-leveraging, with pro-forma leverage of 2.6 times.  FTR will be deploying free cash flow to pay down debt with a goal of achieving investment grade rating.

The expected closing of the transaction is late June 30^th, 2010.   As a possible approach an investor could start a position now and wait until the Verizon transaction closes.  I expect significant selling pressure from Verizon stockholders to create a great buying opportunity. 

Risks

The Verizon transaction still needs certain state and local regulatory approvals.  Hart Scott Roino is completed along with FTR shareholder approvals and several state and local approvals. 

Successful integration of the Verizon acquisition is required for the company to achieve expected synergies.

Acceleration of landline losses beyond current rate. 

Inability to grow broadband business

Catalyst

Acquisition of Verizon Lines

Potential sell off

Dividend

Debt paydown from free cash flow