Rural telecom companies are mainly considered due to the high yields on offer - these companies tend to pay a substantial chunk of earnings in dividends. However, putting too much focus on yields sometimes can be harmful, and investors might ignore the valuation all together. It is true that fat dividends are an extremely attractive prospect for income investors. However, it is equally important to pick stocks with considerable upside potential - a mix of growth and dividends can beat mere accumulation of dividends and result in higher total return.
Frontier Communications (FTR) is one of the rural telecom operators, and currently offers one of the highest dividend yields in the sector. In my previous article, I assessed the dividend stability of the company. Two dividend cuts have helped the company bring its payout ratio to an easily manageable level. In this article, I have made an effort to come up with a fair value for the company based on future free cash flows. Let's first look at the assumptions of the model.
Just like any other valuation model, there are assumptions involved in this model. These assumptions are essential for valuation as a small change in any assumption can impact the estimate of fair value. I will list key assumptions for my model.
- Rural telecom companies are currently facing decline in revenues in their traditional landline business. As a result, I have assumed falling net revenues for the next two years. However, after the first two years, I have assumed revenue growth rate of 2% till the end of valuation period. I expect broadband and other products to make up for the fall in landline revenues. My terminal growth rate will also be 2% in this model.
- Operating expenses are at 80% of revenue at the moment. For the model, I have kept the current level operating expenses, and these expenses will remain at 80% for the whole valuation period.
- Frontier has high levels of debt and its interest expense is expected to remain high. As a result, I have estimated interest expense close to the current levels of interest expense.
- Finally, I will talk about income tax expense. Frontier expects its cash taxes to be between $125 and $150 million for 2013 - for my model, I have assumed cash taxes of $130 million during the current year, and 35% tax rate in the following years.
I have ignored extraordinary items in order to value the company based on its core operations. Now, let's look at the pro-forma earnings.
Earnings will start showing improvement for Frontier, and my model shows an upward trend in earnings throughout the valuation period. Rising sales and earnings will allow the company to record a substantial improvement in its net profit margin.
For my valuation purposes, I have used a discount rate of 14%, which I believe is appropriate taking into account the weak state of the sector and declining revenues of the company. Below table shows free cash flows, adjustments for different items and valuation.
For the free cash flow calculation, I have taken net income as the starting point. All of these net income figures represent projected net income based on above mentioned assumptions. To reach at free cash flows, I have made adjustments regarding, depreciation, amortization and other non-cash items such as gains/losses on equipment sale and taxes. Furthermore, investment in fixed and working capital has also been taken into account. Non-cash items include depreciation and amortization along with some other non-cash expenses - these items are added back to net income.
However, investment in fixed capital and working capital has been deducted from the net income to reach at the free cash flows. At the moment, investment in fixed capital is expected to remain below $700 million. However, for the following years, I have assumed fixed and working capital investment to be around 18% of total sales.
Free cash flows beyond 2022 have been projected at a constant growth rate of 2% and discounted at the discount rate of 14% (adjusted for growth rate) to calculate terminal year free cash flows. After calculating free cash flows for each year, I have discounted those free cash flows at 14% to reach at the present value, and added them to achieve about $5.08 billion in discounted free cash flows. According to my free cash flow model, Frontier has the potential to reach $5.09 per share. At the moment, the stock is trading at around $4.12 per share.
According to my valuation model, Frontier Communications can substantially reward its investors. However, it is difficult to predict when the stock will reach its fair value as the depressed state of the sector has negatively impacted the stock price. Nonetheless, Frontier Communications is the best investment in the rural telecom segment - the company offers a sumptuous yield with a chance of substantial upside potential.