In our last article we said Frontier Communications' (FTR) major challenge is to stop the continuous bleed in revenue. Frontier Communications released their 2013 first quarter results on May 6. Based on the revenue challenge ahead of them this article will limit the discussion to the following:
- Revenue trend
- Effects on FCF estimates
We'll start with the trends projected from our last article through the period ending December 2012 then compare this to recent results. The graph measures management's efforts to bend the curve upward.
Now that integration is behind them, it's reasonable to expect their performance to improve but how that will influence revenue performance beyond the current trend is yet to be known. We would not have expected one quarter to produce drastic changes but indicate whether the curve is being nudged up or down, however the first quarter produced a surprise. Residential revenue was trending as expected but the business revenue appears close to going off the rails by deviating far from the trend line:
Another surprise when comparing FTR's Q4 slide presentation with Q1 shows the business revenue was revised down $41 million in 2012. About $31 million was moved to regulatory revenue and the remainder moved into residential revenue. The only explanation is a footnote on the bottom of slide 12 stating:
Prior period revenue and certain operating statistics have been revised from the previously disclosed amounts to reflect the immaterial reclassification of certain revenues and the adjustment of certain operating statistics.
The residential trend has nudged up as illustrated when comparing the above graphs so they continue to improve this metric. Business R2 dropped significantly compared to Q4. R2 is a number between zero and one whose main purpose is the prediction of future outcomes on the basis of other related information, or in this case management's track record. It describes how well a regression line fits a set of data:
- R2 <.30 are considered to have no correlation and behavior is explained by chance
- R2 of .30 to .499 are considered to be a mild relationship
- R2 of .50 to .699% are considered to be a moderate relationship
- R2 of .70 to 1.0 are considered to be a strong relationship
Unfortunately the trend that now has a higher correlation to the recent business results which includes the reclassification of business revenue is:
Management has their work cut out to get back to this trend line for business revenue. Maggie Wilderotter (Chairman of the Board, Chief Executive Officer) said on the conference call they expect low single-digit revenue declines for 2013. The above trends results in a 2013 revenue decline of 4.2% over 2012.
We want to see business and residential losses as a percent approaching zero. Business is trending in the wrong direction (down 3% quarter-over-quarter) while residential, albeit slowly, is still moving toward zero.
EFFECTS ON FCF ESTIMATES
The falling revenue trend is one contributing factor for the high yield. This raises the question of how much time does management have to bend the curves upward before the dividend becomes endangered?
Using the above data we can forecast the sustainability of the dividend. We can then monitor and update the progress with each quarterly result.
The following, including 2013 guidance, was used to aim for conservative targets:
- 2013 Adjusted FCF: $825m - $925m; actual FCF will be lower.
- 2012 Capex: Used the high end of guidance ($675m) with no reductions going forward
- Targeted 2013 gross cost savings: net $100m
- No reduction in network expenses going forward
- Tax rate: 35%
- Up to 40% of FCF goes toward debt reduction.
- No reduction in "Other operating expenses" after 2013
- Acquisition & integration costs completed in 2012
- No benefit from Pension/OPEB to cash flows from operating activities as in past years
- Dilution of 4 million shares per year
- 2013 adjusted FCF payout ratio in a range of 40-50% (per management); actual FCF payout ratio will be higher.
Developing an income statement summary using annual revenue from the regression curves, the last two years' results and the targets listed above yields:
The following compares longer term EPS trends calculated above with the consensus data provided at nasdaq.com at the time of this writing.
Reading the tea leaves on the consensus EPS points to an abrupt reversal in 2016 but there is no evidence at this point to support this. The next step is the FCF analysis incorporating data from the income statement:
Given the debt combined with other risks beyond their control such as future storm impacts and/or pension returns, etc., any FCF payout ratio above 55% before they hit their targeted leverage ratio of 2.5 would be cause for concern. The above table shows this limit exceeded in 2015.
The Credit Agreement and the Revolving Credit Agreement each contain a maximum leverage ratio covenant of 4.50 to 1. FTR would be restricted under the Credit Agreements from declaring dividends in an event of default. 4.5 appears a long way off as shown in the income statement presented earlier but the dividend would probably be reduced long before they let the leverage ratio approach 4.5 or come to the realization they cannot reduce the ratio without a dividend cut. A high FCF payout ratio is the more immediate threat over the next few years although a stagnating leverage ratio is a close second.
Based on the current trends and no additional revenue reclassifications FTR has a few years to turn this ship around. Q1 results were inconclusive although good enough to maintain the stock price above $4… so far. There is also no chance to achieve their targeted leverage ratio without improving the trends.
Even though they used "improve" 26 times in the conference call they have yet to prove they can turn this ship around. They have a serious revenue problem. The good news is they have a few years to make a difference but the question remains, can they? The clock is ticking.
We'll continue to keep track of the data and make adjustments here. This link also provides the data reflected in this article.