Frontier Communications - A Light At The End Of The Tunnel

| About: Frontier Communications (FTR)

Investing in Frontier Communications (NYSE:FTR) is all about the risk associated with its $0.40 annual dividend and if the nearly 10% yield is sustainable. That risk, in turn, will be based on whether an investor believes that the revenue declines can be stopped and/or reversed. It is an issue that has been unfolding ever since Frontier's acquisition of a significant portion of Verizon Communications' (NYSE:VZ) rural telecom business nearly three years ago.

Investors in Frontier have been hearing management discussing the need to invest in the network to increase the availability of High Speed Internet ("HSI") and to integrate the disparate computer systems. (Part of this investment was required by the Federal government as a condition for the acquisition from Verizon.) Once accomplished, the company would have the ability to market bundled offerings, run company-wide promotions, use a unified call center and would hopefully reduce customer losses.

Frontier had pointed to their success in West Virginia - the first of the 14 states where Frontier had focused its efforts to upgrade the broadband infrastructure and convert the financial systems.

Broadband availability in West Virginia was 78% at the end of September [2011], up from 62% at closing [of the acquired properties from Verizon]. Our capital spending to improve the network and expand broadband in the last mile and middle mile, plus the ability to sell with local engagement on our own systems has driven a strong turnaround in the state.

The 9-month period ending September 30, 2011, compared to the 9-month period ending September 30, 2010, we've seen residential customer losses decrease by 25%, with churn falling 60 basis points. High-speed net additions turned from a net loss of 1,600 to a net gain of 6,800. Video net additions increased from 5,200 to 15,342 and commercial competitive win-backs of 1,000 customers.

Frontier's high-speed penetration of newly available homes was 18% at the end of Q3 2011, which is 4 points higher than we reported to you last quarter. We expect increasing broadband penetration to continue, improving customer metrics as we sold double and triple play bundles.

Those results had looked promising, but residential access line losses were taking place so quickly in the remaining states that Frontier was forced to slash its dividend as it worked to integrate the systems while continuing to invest in HSI "in the last mile and middle mile." And, even though the upgrades were proceeding ahead of the announced plans, it wasn't until the second quarter of 2012 that the company reported it had completed converting the last nine states to Frontier's legacy systems. Did it help or are more dividend cuts in the future?

The Dividend

The dividend would seem secure throughout the remainder of 2013. As noted above, it is the reason that many investors hold Frontier stock. That dividend compares favorably to other major wireline telecom providers, including AT&T (NYSE:T) at 4.8%, CenturyLink (NYSE:CTL) at 5.7%, Windstream (NASDAQ:WIN) at 11.5% and Verizon at 3.9%. However, not all these dividends are comparable. Both AT&T (for 15 years) and Verizon (6 years) have regularly increased their annual payouts, while Windstream's dividend hasn't changed since 2007 and CenturyLink cut its dividend earlier this year.

Many analysts believe that the Frontier dividend is safe for the near term. Goldman Sachs, which late last year put out a $3.50 price target, noted:

Though we see little near-term risk to the dividend, EBITDA declines limit the ability to delever the balance sheet. We forecast FCF/share declines of 15-17% in 2013/2014.

On a more positive note, earlier this month following the earnings release, Jeffries maintained a buy rating on Frontier, although it lowered its price target to $5 from $6. However, longer term, the company needs to demonstrate that it can stem the revenue declines.

Customer Losses and Revenue

Until the most recent quarter, the impact on stemming customer losses or increasing HSI customers didn't appear to be particularly useful from an improved revenue perspective. Then, during the most recent conference call, investors received the following news:

    • broadband subscriber growth of 28,200 (strongest since the Verizon acquisition and greater than full year 2012)
    • residential customer retention improved by 38% quarter over quarter and 57% year-over-year

Much of the increase in broadband customers was the result of an Apple Computer (NASDAQ:AAPL) gift card promotion. And while this promotion expired during the first quarter, Frontier Chairman and CEO Maggie Wilderotter noted:

...our customer retention and sales efforts substantially improved our residential net customer losses by 17,300 from Q4 2012, which improved our rate of loss from 1.5% in Q4 2012 to 1.0% in Q1 2013. We are maintaining this strong broadband and customer retention momentum into this second quarter through strong sales, continued investments in our network and exceptional customer service.

While the number of HSI customers showed strong growth and while the customer retention metrics improved, overall revenue was still down. The decrease was 4.9% year-over-year and 2.2% sequentially from the fourth quarter of 2012. During a May 14th presentation at the J.P. Morgan 41st Annual Technology, Media and Telecom Conference, Phil Cusick questioned Frontier's executives about how the company was going to increase revenue.

Cusick: As you look out - I don't know whether it's 2Q, or 3Q, or 4Q - is there a point at which you can see that revenue flattening and then starting to grow on the residential side?

John Jureller - Frontier EVP and CFO - I think so. I think we see that opportunity. I mean, no doubt for us as well as for our peers, is that voice will continue to be a challenge but I think balanced with our growth in broadband and our video services as well, is those are really great offsetting balances in the number of gross customers that we are adding every quarter continues to increase and we think so at a point in the not too distant future we will be at that point of inflection on our residential revenue side. Whether it's this quarter, next quarter, whatever it is... I think it's early days to tell but I think we've got a good sight line on that one. We're cautiously optimistic on our residential revenue profile.

There were additional questions about the business side at Frontier and wireless backhaul revenue, but the key question asked was:

Cusick: Back to where I started. We started talking about growth. And, I think with where the revenue's been showing, people are very skeptical. As you look out, can you give us some confidence in the potential to really flatten the total revenue in this business. And then, and then start to grow and is the growth organic or does there need to be some M&A to get there.

Wilderotter answered that the focus was on organic growth, noting that the Verizon acquisition tripled the size of the company, and that the goal had been to build out HSI availability in the acquired properties. Discussing broadband, she noted there wasn't "even the buildout in 60% of those markets."


Today, the broadband buildout for Frontier is at 88% and expected to grow to 90% by the end of the year. And, Frontier has finally shown the ability to add a significant number of HSI customers, but many questions remain. Can the momentum be maintained or will there be a fall-off with the expiration of the Apple promotion? Will the churn rate continue to improve? Will the company be successful in retaining new customers after the promotions expire and will it be successful in selling add-ons and upgrades to higher speeds?

Whether the HSI momentum generated in the first quarter continues throughout the second quarter and for the remainder of 2013 will be extremely important. Wilderotter noted that the company's long-term goal is to increase broadband market share from 25% to 40%. She also pointed out that each point of market share is worth $50 million of revenue. It's a number that is large enough to stem the revenue declines.

Cusick closed the interview with the following:

You mentioned inflection point a few minutes ago. So, for investors who have been watching the company for a long time, we have been sort of hoping to see that inflection point for quite a while. Help us get a little bit more confident... Why is it now? And as we look at the next couple of quarters, what should we be looking for to be sure that it's actually happening?

As to why now, Wilderotter replied that the fundamentals are in place - the system conversion, the common platforms and the infrastructure. As to what to look for, she replied:

If I were you, I'd think about where does revenue come from? It comes from market share growth. It comes from broadband 'cause broadband is the future platform for voice, video and data in our industry. And it comes from the fundamentals of add-on products and services that add values to customers that we can really start to change that revenue trajectory.

So it's broadband metrics and customer churn metrics.

The initial market reaction to the company's first quarter earnings release and conference call was initially negative, as the shares traded down nearly 3% to $3.97 the next day. The price subsequently rose more than 11% to $4.42 through the end of last week, and the yield of the $0.40 annual dividend had declined to less than 9% from just over 10%.

The revenue decline has been a long dark tunnel for many years. Is there finally a light becoming visible at the end of that tunnel? The first quarter broadband growth was encouraging, but I will continue to look at the broadband and churn metrics since they are key to halting the revenue deterioration and will be critical to sustaining the attractive dividend.

Disclosure: I am long FTR, VZ, AAPL, T, WIN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have covered calls at a variety of strike prices sold against portions of my long positions in FTR and WIN. I may open new positions or unwind current positions at any time.