Description

Summary

FairPoint’s 12.5% Senior Subordinated Notes present an opportunity to buy into a stable, “monopoly” type business, with strong asset protection, at approximately 5x EBITDA. For your efforts, you should be rewarded over the next nine months with a roughly 18% current yield to compensate you “while you wait” plus almost 30% appreciation potential). And, yes, there’s a catalyst involved here also to increase the likelihood of realizing that appreciation potential.

Business Description

FairPoint operates 29 rural local exchange carriers (RLECs) across 18 states offering local, long distance, ancillary services, and DSL. In total, FairPoint has about 245,000 lines. The Company formerly also ran a CLEC that it sold/wound-down in Q4 2001. 78% of FairPoint’s business is residential; the balance is commercial, of which 85% do not have more than 2 lines. FairPoint benefits from operating in rural markets that historically have lacked the density necessary to support meaningful competition. FairPoint has no public equity. Thomas H. Lee and Kelso are the primary private equity sponsors behind the company, having invested $500 million to date.

The primary strength of the business is its “monopoly” nature – for the most part, FairPoint’s RLECs are the “only game in town” in the areas in which they operate, leading to recurring and predictable revenues and cash flows and high profit margins (e.g., EBITDA margins in the mid 50s%). Another positive of the business is that incremental services (e.g., caller ID, DSL) require little in the way of incremental costs, thereby allowing for margin expansion as FairPoint is able to increase the penetration of such services. The main weaknesses of the business are its low top line growth (access lines decreased 0.3% in the most recent quarter due primarily to some cannibalization by FairPoint’s DSL product and the weak economy) and potential exposure to future competition (e.g., rural wireless and cable telephony). Fortunately for FairPoint, the economics for wireless and cable companies of building out the necessary infrastructure to compete with RLECs in low density rural markets are typically not compelling, and thus FairPoint is meaningfully more protected from such competition than its more urban peers.

The Investment Opportunity

As a result of the ongoing debacle in the telecom sector and concerns over the required refinancing of FairPoint’s Senior Debt by September 30, 2004, FairPoint’s 12.5% Senior Subordinated Notes have traded down to prices that provide a compelling investment opportunity.

At face value, FairPoint has approximately $355 million of Senior Debt and $400 million of Subordinated Debt (the 12.5%s are $200 million of this $400 million). 2002 EBITDA will be approximately $125 million, resulting in the Senior Debt/EBITDA = 2.8x and Total Debt/EBITDA = 6.0x. With the 12.5s% currently trading at 70, the Total Debt (at market)/EBITDA = 5.1x. TH Lee’s and Kelso’s entire $500 million investment sits behind all of the debt. FairPoint has approximately $110 million in liquidity through its small cash position ($5 million) and revolver availability. After all interest and capex, FairPoint should generate $10-$15 million in FCF in 2002 and $20-$25 million in FCF in 2003. Pre the interest on the Subordinated Debt (adding back the tax-effected interest savings, conservatively assuming a 40% tax rate), FCF in 2002 and 2003 would be approximately $40 million and $50 million, respectively.

So, what are the 12.5s% worth? Well, based on the public and private comps trading in the range of 6-8x EBITDA, the 12.5s% are worth par. Looking at valuations per access line in the RLEC space (both for public comps as well as for recent asset sales), the 12.5s% should be worth somewhere between 95 and par. It should also be noted (with a big grain of salt given the foolish investments in the telecom space made by many private equity players) that TH Lee’s and Kelso’s $500 equity investment is junior to the 12.5s%, so unless they’re worth par, the sponsors’ investments are worth nothing. Looking at the situation one more way, if all the Subordinated Debt were converted to equity you would have a FCF yield to that new equity of 10%-12.5% (assuming conversion at par ($40-$50 million/$400 million)) or 14.3%-17.9% (assuming conversion at your purchase price of 70 (($40-$50 million/$280 million)).

One of the most attractive parts of the FairPoint investment thesis is that there are several potential catalysts to unlock the value in the 12.5s% and, furthermore, you get paid while you wait. First, let’s address the payment while you wait -- in purchasing the 12.5s% at 70, you will get paid an approximately 18% current yield (12.5%/.70) (the Company is FCF positive after all interest payments and within all of its covenants). In addition to this 18% current yield, you should get almost 30% in appreciation on the bonds (.90 discounted future price/.70 current price). The first catalyst to achieving this appreciation is removal of the refinancing overhang through attainment of a new Senior Debt package. Given the low leverage of Senior Debt/EBITDA (2.8x currently falling to 2.5x by September 30, 2004), the asset protection in the subscriber lines for the banks (valuation of $1,430 per line needed to cover the Senior Debt vs. approximately $3,000 per line market value), and the predictable revenues and cash flow of this business, FairPoint should not have a problem completing its refinancing (although it will likely be done at a higher cost than the current package). The second possible catalyst is a buy back of the bonds (sponsored by TH Lee/Kelso). The third potential catalyst is that FairPoint in its entirety is rolled up into one of the larger RLECs. Any one of these catalysts coming to fruition (or simply market recognition of the value in the 12.5%s) should result in significant appreciation in the 12.5s%. Combined with the current yield, such appreciation should provide a 42% total return (18% x 9/12 months + .70/.90) over the next nine months (56% annualized).

One further thought, for those of you that are skeptical of the RLEC space in general, this trade can work in conjunction with a hedge to mitigate your RLEC exposure – i.e., go long the FairPoint 12.5s% and go short a basket of the more highly valued RLECs (e.g., CentureyTel, Citizens Communications).

Note: The market cap indicated at the top of this report is actually the enterprise value computed with the Subordinated Debt valued at 70 cents on the dollar. There is no public market for FairPoint’s equity. The ticker shown is the one used by Bloomberg for FairPoint.

Catalyst

See above.