Seeking Alpha
Long/short equity, deep value, value, special situations
Profile| Send Message| ()  

CenturyLink (CTL) was the unquestioned, undisputed King of the Mountain in the rural incumbent local telephone segment before it announced its shockingly deep and unexpected dividend cut on February 13th. We have been keeping our eyes out on Frontier Communications Corporation (FTR) because its dividend yield is 350bp higher than CenturyLink's. We were pleased to see that its rate of decline for revenues and wireline subscribers narrowed in Q3 2012. We also like that although Frontier's revenue trends aren't as good as CenturyLink's, its revenue trends have seen recent improvements and this will help it keep its dividend payout around 50% of its free cash flows.

Source: Bloomberg LP

Frontier recently reported adjusted EPS of $.06/share, which missed the consensus analyst estimates by $.01. Frontier's share price declined by 13% in the wake of CenturyLink announcing its dividend cut on February 13th before bouncing back after announcing that it was not cutting its dividend further. However, FTR's continued declines in revenue, operating income, EPS and free cash flows on a year-over-year basis is becoming such a recurring, obvious headline that we could probably write our research reports in advance of receiving the actual numbers from the earnings release.

We're disappointed that Frontier is no longer reporting its wireline access line metrics. Maybe everybody was sick and tired of seeing FTR's wireline customer base continue its steadily sagging performance. Even though it is the most extremely blatant example of an "obvious headline", we would prefer to see the numbers in detail. While we can see that its business customer base declined by 7.7% year-over-year in Q4 2012 and that its residential customer base declined by 7% during the same period. Frontier's customer decline was only partially offset by a 1.33% increase in the number of Broadband Internet customers served. But the real concern for this tepid growth in internet subscribers is it was slower than the 1.56% growth achieved in Q3 2012, 2.45% achieved in Q2 2012 and 2.6% achieved in Q1 2012. FTR's management said it was due to lower marketing promotions. We think that FTR should try to recruit some of CenturyLink's internet services leaders in order to get the 3.5% internet subscriber growth that CenturyLink has been generating.

Source: Frontier's Last 6 Earnings Releases

Although FTR's adjusted EPS showed incremental growth in 2012 versus 2011, its operating cash flows have declined slightly on a year-over-year basis. FTR's video subscribers increased by 43.6K in Q4 2012 versus Q4 2011 (excluding the impact of 203,100 DirecTV subscribers in Q3 2012 as Frontier no longer provides DirecTV as part of its bundled packages.. The company recently announced an agreement with Hughes to provide broadband satellite service and so far it has not helped stop Frontier's broadband internet growth from ebbing.

We were stunned that Frontier actually added 402 employees to its payrolls in Q2 2012 versus the Q2 2011 period even though revenues are dropping. We were pleased that Frontier reduced its employee headcount by 82 FTEs on a linked-quarter basis in Q3 2012 and by 591 FTEs in Q4 2012. FTR's year-over-year FTE decline of 4.75% in 2012 is comparable to the 4.4% revenue decline achieved in this past year. Frontier actually improved its year-over-year revenue decline trend during the quarter even though its wireline access line declines perked up. FTR's year-over-year revenue decline in Q4 2012 was 3.95% versus 3% in Q3 2012, 4.8% in Q2 2012 and 8% in Q3 2011. Frontier's revenue benefited from a 5.75% increase in its average revenue per business customer and a 1.84% increase in its average revenue per residential customer year-over-year during Q4 2012 versus Q4 2011.

Source: Frontier's Last 6 Earnings Releases

Frontier had a bit of good news during the period with regards to cash flows. FTR's operating cash flows declined by $112M on a year-over-year basis in YTD 2012 versus YTD 2011. However, its Q3 2012 OCFs only declined by $6M on a year-over-year basis versus Q3 2011. On a year-over-year basis for the first nine months of 2012, the company reduced its total CapEx by $128.6M but and this resulted in FTR's free cash flows increasing by $16M. The company raised $850M in debt in August and October in order to bolster its liquidity as well as refinancing existing indebtedness and pay down $561M in debt that is maturing in 2013. Included in the 2013 debt maturities is a $508M bond issue that was due in January 2013 and was recently retired due to FTR's $1.3B cash holdings as of Q4 2012.

Source: Frontier's Q3 2012 10-Q

We believe that Frontier's shareholders are relieved that its dividend payout ratio in 2012 was less than 50%. We believe that investors in FTR can't be blamed for being a little jumpy with regards to FTR's dividend considering that Frontier cut its annual dividend from $1/share in 2009 to $.40/share in 2012 thanks to the Verizon (VZ) purchase in 2010. We believe that Frontier's shareholders should keep their heads up because we don't believe it can get any worse since Frontier's payout ratio is now at 50% and its revenues and FCFs are starting to stabilize. At the same time, Frontier is paying a significantly higher cost on its debt that its rural telecom peers.

Another green shoot for Frontier shareholders is the fact that Frontier is making progress with its AT&T Wireless (T) reseller agreement. The company signed a three year agreement with AT&T last year in order to resell AT&T Wireless services to its customer footprint. Frontier shareholders should be pleased that it kicked off this partnership in Q4 2012 with trial markets in Upstate New York, Washington State and Minnesota. Frontier's management expects the trial to last until Q2 2013 and then it will decide to expand it further or not. We tip our hat to Frontier for reducing its revenue declines, launching the AT&T Wireless partnership and stabilizing its cash flow generation.

Source: Bloomberg LP

In conclusion, we are warming up to Frontier because it is making progress in narrowing its revenue declines. While we would like to see more growth out of its Broadband Internet customer base than we have seen recently, we are pleased that it is steadily improving its average monthly revenue per user. We also liked that Frontier's 2012 dividend cut and stabilizing cash flows have resulted in its 2012 dividend payout ratio being less than 50% of its free cash flows. Because Frontier is targeting a $75M-$125M reduction in its capital expenditures for 2013 versus 2012, we are expecting its free cash flows to increase by a similar amount for FY 2013.

Source: Frontier's Last 11 Earnings Releases

Source: Frontier Offers 10% Dividend Yield And Improving Cash Flow Trends

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.