Frontier Communications Displays Optimism Ahead Of Earnings

Aug. 5.13 | About: Frontier Communications (FTR)

Frontier Communications (NASDAQ:FTR) is a traditional wireline telecommunications company serving large portions of rural America. It is a company that will regularly pop up when investors screen the S&P 500 companies as they look for yield. This had been especially true as dividends received special tax treatment and interest rates remained pitifully low on much safer investments in bank CDs and US Treasury obligations.

The Dividend

That dividend has been cut twice in the past four years and took the share price down with it. The first cut which took place in the second half of 2010, from $1.00 to $0.75, was pre-announced. At the same time the company announced its acquisition of a significant portion of Verizon Communications (NYSE:VZ) rural business, the company notified investors that the dividend following the merger would be reduced:

New Dividend Policy: After the close of the transaction, the company will pay an annual dividend of $0.75 per share to its shareholders, representing an attractive and sustainable payout ratio. Based on Frontier's $7.57 closing stock price on May 12, 2009, this dividend represents an annual yield of approximately 9.9% to Frontier shareholders. This dividend policy will allow the company to invest in the acquired markets, offer new products and services, and extend and increase broadband capability to those markets over the next few years.

The second dividend cut announcement was more of a surprise to many investors since it followed a string of declarations by management and the board that the dividend was sustainable. The market had doubts as the yield of the $0.75 dividend was climbing towards the mid-teens. Is the dividend safe?

Market Perception

Earlier this year the wisdom of the market again had similar concerns, driving the share price down to a low of $3.71 and pushing the yield back up into double digits. The access line losses had continued, and up until the first quarter earnings were released, there had been little evidence that the company would succeed in gaining high speed Internet customers to replace the loss of its traditional voice customers.

Even after the first quarter earnings were released on May 6th, the market remained unimpressed. Not only did the share price continue to struggle, trading in the $3.80's during the last week in June, but the short interest continued at elevated levels. The most recent reporting period - July 15th - showed the short interest at 242 million shares (about one fourth of the shares outstanding). It also showed that it would take nearly five weeks to cover.

Business Continues to Erode

Frontier has had a significant loss of business in recent years as more and more customers "cut the cord" and migrated to cell phone service or bundled offerings from cable companies that combine phone, Internet and television. In fact, many of the younger generation have skipped any regular phone service and are also dropping cable television. Instead, they are opting for a combination of cell phones and high speed Internet service while taking advantage of lower cost services from Netflix or Hulu-plus, free alternatives or services that offer both free and pay-up for "premium" offerings (including Tum Tiki from Frontier).

In this environment, the decline of wire-line basic telephone service is likely to continue. From the most recent 10K:

During 2012, we lost 240,500 customers, as compared to a loss of 375,400 customers in 2011. We believe the improved customer retention in 2012 as compared to 2011 is principally due to our investments in our network, our local engagement strategy, improved customer service and the introduction of our Simply Broadband product. Also, during 2012, the average monthly total customer revenue per customer increased $5.18, or 5%, over 2011. We lost 216,700 residential customers and 23,800 business customers during the year ended December 31, 2012, or 7% on an annual basis, as compared to 341,400 residential customers and 33,900 business customers lost during the year ended December 31, 2011, or 10% on an annual basis.

The customer losses remained substantial, although the rate of decline improved and the average revenue per customer increased. This increase came from providing higher revenue Internet and video services.

Importance of Broadband Availability

Frontier has recognized the importance of broadband and has upgraded much of their system to support higher speed Internet service. That investment did not appear to be paying off with the company adding only 23,400 broadband customers during 2012 despite increasing availability to 318,000 new homes.

Frontier had been telling investors that the gradual integration of the Verizon acquisition had prevented the company from monetizing its investment in broadband infrastructure. The final nine state conversion of computer systems to a single platform during 2012 finally allowed the company to run unified promotions and it may be starting to pay off.

The Company's broadband customer net additions were approximately 28,200 during the first quarter of 2013, which was greater than the 23,400 broadband customer net additions for all of 2012. The Company had approximately 1,782,600 broadband customers at March 31, 2013. The Company added 18,300 video customers during the first quarter of 2013. The Company had approximately 365,000 video customers at March 31, 2013.

As a consumer, I am inundated with junk mail and TV ads from the various broadband and video service providers. Whether it is the low cost promotional offers from DirecTV (DTV) or Dish (NASDAQ:DISH), or bundled offerings of double, triple or quadruple plays from Verizon or Comcast (NASDAQ:CMCSA) or Cablevision (NYSE:CVC), the companies recognize the value in gaining - or at least not losing - customers.

Frontier used an Apple gift card promotion to gain broadband customers during the first quarter. And, although the promotion expired partway through the first quarter, Frontier chairman Maggie Wilderotter stated that the broadband sales had continued to be strong into the second quarter during the Frontier conference call on May 6th.

...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.

How important is broadband? As a parent, I have seen my adult children have cell phone service from one company and broadband from another. They need the Internet to keep in touch with friends and relatives but have found that they can do without cable television. Why? Because they use their computers to watch television or movies from Netflix or Hulu. Those services are dependent on higher speed broadband.

Bundled offerings tend to improve customer loyalty - the more services a customer takes from a single vendor, the less likely they are to switch. At least Frontier seems to think so. Not only is it providing video from third parties, but it is also testing out an agency agreement with AT&T's (NYSE:T) wireless to touch the customer in multiple ways. While these bundled offerings are likely to be important, reliable higher speed Internet access may be the critical component in retaining customers.

Why the Optimism?

Has Frontier continued to make improvements? The market seems to think so. The share price as of this writing reached an intra-day high of $4.58, its highest price since mid-February. It's difficult to know whether there is optimism about the forthcoming earnings release on Wednesday, August 7th, or whether the fear of a merely decent report is driving some short interest covering. Maybe the optimism has been fueled by the board declaring the regular quarterly dividend of $0.10 on July 31st, removing one additional area of doubt.

There were also other reasons for some optimism. The company had escrowed funds released for meeting performance criteria in Oregon and West Virginia. Washington's Utilities and Transportation Commission found "that Frontier faces effective competition with regard to basic residential and business local exchange services," paving the way for reduced regulatory burdens. Also, new products and services were added in support of the broadband offerings.

So, what should investors focus on in the upcoming call? My key will be the broadband activity. Numbers that come close to repeating the first quarter net adds would be a pleasant surprise. And while broadband is the key, I will also be looking for continued improvement in customer churn, growth in video, growth in average revenue per customer and an update on the AT&T Wireless program.

And, while revenue will remain a key, like other telephone companies with traditional defined benefit pension plans with medical coverage, there are expenses that aren't always quite as obvious. The stock market rally could provide a short term benefit to Frontier, although longer term, the pension funding level remains a concern.

Summary

Was the market right when it priced Frontier at $3.71 earlier this year? Is it correct to now price the shares above $4.50 - up more than 20% in just five weeks? I don't expect to see the customer loss trend reverse itself this quarter. In May, when questioned about revenue growth, CFO John Jureller said:

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 is no reason to think that trend suddenly reversed this quarter, and there is little reason to think that all those on the short side of the trade are fools. I suspect that Frontier will be somewhat volatile after earnings are released. Even if Broadband trends are positive, I expect that the shares will pull back from their current highs before moving higher.

Frontier remains a risky investment, although one that also provides investors with a large yield.

Disclosure: I am long T, CMCSA, FTR, VZ. 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: In addition to being long Frontier, I have also sold cover calls with various expirations and at various price levels. Some of these covered positions were opened with the expectation that the shares would be called away as part of an income strategy.