Frontier Communications (NASDAQ:FTR) offers data, voice and video services to rural areas and small-to-medium size towns across 27 states in the U.S. I'm bullish on the company, as it has managed to improve its declining rate of customers and has increased high speed broadband revenues. It also offers a high sustainable dividend yield, along with price appreciation of 9.4% (based on a discounted cash flow analysis).
The company offers a healthy dividend yield of 9.30%, which makes it a striking investment opportunity for income-seeking investors. However, poor economic conditions and increasing wireless substitution has raised several concerns about the safety of dividends. The company generates more than enough free cash flow to maintain its dividends, as shown in the table below. Furthermore, free cash flow after dividends are sufficient to pay off the $892 million in debt maturing till 2016. So, the company's dividends are not threatened for at least the next three to four years.
June 30, 2013
March 31, 2013
June 30, 2012
Free Cash Flows
Source: Company Data
I believe that FTR should focus on future growth prospects and cut down on its dividend yield (which is higher than the industry average of 3.26%) in order to increase its capital expenditures. This would in turn drive growth in the long run as the company operates in a capital intensive industry. Therefore, it is important for FTR to invest in new products and services to keep up with competitors.
However, recently, CEO Maggie Wilderotter is reported to have said in an interview with The Wall Street Journal, "We would do acquisitions in a way that preserve the dividend. We might take on more debt instead." This statement clearly shows that the management has decided not to cut dividends.
Financial performance of 2Q'13
Broadband penetration provides a significant upside potential for the company. With the help of marketing initiatives and bundled offerings, FTR has managed net broadband additions of around 29,511 in the recent second quarter. FTR is also keen on improving its network, as it is boosting its broadband speed with ADSL2 and VDSL2 technologies. Also, management is planning to cover 52% of its subscriber base with 20Mbps service by the end of 2013, which is currently available to 40% of its subscribers. This will also help the company boost its ARPC, as high speed subscribers will be paying premium prices.
Residential and business customer losses have been constantly declining for the last five quarters, as shown in the figure below. Another encouraging sign is the 1.8% YoY and 2.8% YoY improvement in the ARPC of both residential and business customers, respectively. It also has the highest operating margin among its competitors, which shows the strength of the company's operations.
Source: Company Data
One of the negative takeaways of the second quarter is that FTR experienced a 4.6% YoY decline in total revenues given that local and long distance revenues, which contribute around 44% to total revenues, fell by 8.7% YoY. Operating income was also down to $266 million, even though operating expenses have been down by 5.2% YoY. The company is also highly leveraged with a net debt to adjusted EBITDA of 3.34x. With falling revenues and operating income, FTR might not be able to reduce its leverage (net debt to adjusted EBITDA) to its desired level of 2.50x in the long term.
The company will announce third quarter's earnings next month. Analysts are expecting that the company will report an EPS of $0.06. Annual revenues will be around $1.18 billion, with a growth rate of -5.50% YoY.
Discounted free cash flow evaluation
I have used free cash flow estimates until 2016 and a 6.60% WACC (using cost of equity of 8.8% and after-tax cost of debt of 4.8%). Furthermore, I have used a terminal year growth rate of 0.5%.
Terminal Value of FCF
Estimated Free Cash Flow
Total Value to firm = $642+$660+$657+$10,815=$12,774 million
Total Debt= $8159 million
Total Value to firm - Total Debt = Total Equity value
Share Outstanding = 998 million
Target Price = Total Equity Value/Share Outstanding
$4.62 = $4,615/998
My price target is $4.62, which means that price appreciation comes out to be 9.4%. The company also offers a dividend yield of 9.30%, which gives a total return of 18.70%.
FTR's traditional voice revenues are constantly declining as customers are switching to wireless-featured products. The company is also facing serious competition from cable companies. Lastly, fragile economic conditions have caused revenues to decline, and additional spending by customers is dependent on an economic recovery.
Next 5 yr Growth rate (per annum)
Windstream Holdings, Inc. (NASDAQ:WIN)
Source: Yahoo Finance
The company offers the highest growth rate for the next five years among its competitors. Also, the company has an encouraging PEG ratio, which means it offers the cheapest growth rate. Its dividends are safe and income-seeking investors should buy the stock for hefty returns. The current stock price is depressed, so I believe the stock is currently trading at a discount and $4.22 is a strong entry point. However, I believe the company needs to increase its capital spending to extract growth for the long term.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.