Prospects Brighten For This High Yield Teleco

| About: Frontier Communications (FTR)

When Frontier Communications (NYSE:FTR) reported earnings after the first quarter, investors were rewarded with the first evidence that its investments in upgrading its network might just pay off. Its high speed Internet [HSI] additions totaled 28,200, its largest quarterly increase since acquiring portions of Verizon Communications (NYSE:VZ) telephone business in 14 states. Even more significant, the total exceeded the increase for all of 2012, and although this growth was aided by an Apple gift card promotion, it was critical for a number of reasons.

Frontier has been investing more than half a billion dollars per year to improve the speed and reliability of the network since the Verizon acquisition. Not only were the upgrades a condition of the acquisition, but the improvements were also considered critical to reducing the loss of customers and improving customer retention. President and COO Daniel McCarthy discussing a new HSI offering, stated:

Simply Broadband, while it does have a lower monthly price point, enables us to retain customers that would have otherwise been lost. Furthermore, keeping customers who would have gone to the competitor for a broadband-only solution not only enables us to retain a portion of their monthly recurring revenue, but it provides us additional selling opportunities. Simply Broadband helps us improve customer retention and also drove a significant increase in new customers that shifted to Frontier in Q1.

And it wasn't just the first quarter that had strong broadband increases. The second quarter was even stronger with more than 29,500 net additions despite the expiration of the Apple promotion, and the third quarter added another 26,800. The slightly lower net adds in the third quarter were probably a result of seasonality and continued clean-up of out-dated pricing plans for some customers acquired from Verizon.

I'm certain that I am not the only one to receive promotions in the mail to sign up for triple plays from the local phone company or cable provider. Or the only one bombarded with television ads featuring Tony Dungy to sign up for Comcast (NASDAQ:CMCSA). These discounted offers are designed to lure customers with low introductory rates in return for one or two-year commitments. The hope is that when the introductory rate expires, most consumers will continue to subscribe rather than cancel or switch to an alternate provider.

Frontier does not have a true one-stop solution, and instead partners with satellite television providers. Still, the objective is the same - to increase the stickiness of the solution and improve customer retention levels. The latest quarterly report indicates that, while improving, it is still a work in progress. Chairman Maggie Wilderotter noted:

Keeping customers is key to revenue growth and profitability. Residential retention improved in Q3 by more than 56% year-over-year. Q3 retention results are the second best quarter we have had since 2010, right behind our Q2 results. The slight increase in deactivations in Q3 are attributable to the expected vacation home disconnects that we experience every September, and to a customer migration we completed in the quarter to move customers off all of legacy packages.

McCarthy later added:

It was really divided on the sequence of two components; the first one was associated with migration that Maggie touched on that in her opening remarks.

If you think about it, we had identified a number of customers that were below what we felt was market based pricing for broadband services and we went ahead and we made some price increases. Those price increases were actually very good for us from a net revenue perspective and we expected to have some churns occur as a result of those increases and about half of the up-tick was really caused by that. The other half of the up-tick is really around seasonality and the reason you may not have seen it in the past is simply that as we've grown our broadband footprint, we are actually expanding into a lot of vacation communities that Verizon had never served before from a broadband perspective, and as a result, we are seeing some seasonality.

...So we will see those things occur in the third quarter of each year. So that's - it was equally divided between the two, but we're actually very happy with the results from the migration and it was expected on the seasonality.

Last May, after the first quarter broadband numbers came out, I wrote Frontier Communications - A Light At The End Of The Tunnel discussing the importance of increasing the HSI availability in Frontier's footprint. However, it was not only about increasing the availability of HSI, but demonstrating that the system conversions and unified call center activity would allow Frontier to halt the decline in revenue. The article ended with some questions and observations:

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?

...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.

When I had the temerity to suggest that Frontier might just be seeing a light at the end of the tunnel, Frontier critics took the opportunity to poke a little fun. One wrote:

The light at the end of the tunnel is a train coming.

And another wrote:

When I was in Vietnam, the Generals used to be fond of telling the troops that there is a light at the end of the tunnel. We troops used to say, exactly that--"yeah, you might be right, but that light is attached to the front of a locomotive."

Many critics are concerned about declining revenues, while others are concerned about a future dividend cut or competition and still others harbor a grudge against management for high pay packages and misleading investors about the safety of the dividend.

The Dividend

My reason for investing in Frontier is its dividend, and the future safety of that dividend is important. A recent article by David Klein examined the prospects for Frontier to stabilize the revenues and cash flow. He concluded:

  • Last but not least, the dividend is safe for the foreseeable future and still sporting a high yield.

Most of the telcos have attractive dividends. The following five - AT&T (NYSE:T), CenturyLink (NYSE:CTL), Frontier, Verizon, and Windstream (NASDAQ:WIN) - have a mixed track record. AT&T and Verizon are by far the largest of the group and have dominant wireless businesses in addition to their land lines. AT&T may be the most attractive of the group from a dividend perspective. It has a current yield of 5.1% and has been increasing the annual payout each year for almost 3 decades. While some of those increases have been quite small, the amount has doubled in the past 16 years.

Verizon has the lowest yield at 4.2%, and for quite some time its dividend had not been increased at all. Over the past 7 years, however, its quarterly dividend has increased just over 30%. Windstream has the highest yield of the group, and its $1 dividend, which has been in effect since late 2006, currently yields an eye-popping 12.2%. The yield certainly indicates that the market feels that the dividend is unsustainable.

CenturyLink has a current yield of 6.9% and surprised most investors when it cut its dividend more than 25% last Valentine's Day. That love note to investors sent the shares down by 23%. Frontier, now yielding 8.3% has had its own dividend issues, with two dividend cuts since 2010.

The first Frontier cut was well publicized and came as a result of the acquisition from Verizon and a dramatic increase in the number of shares outstanding. The second one that occurred in early 2012 was a surprise to this investor as management and the board had repeatedly issued statements about the sustainability of the dividend.

The sustainability of the Frontier dividend at the current level will depend on the company's ability to stem the revenue declines and customer losses. And, key to the company's plans to accomplish these objectives has been the improvement of the network and increased availability of HSI access to the homes in its territories.

Broadband Growth

These improvements, along with a unified computer system, has resulted in significant increases in broadband subscribers each of the past three quarters. The future increase in broadband buildout will also be aided by a Federal program to bring HSI access to underserved areas. The program dollars are available through the Connect America Fund ["CAF"] and are provided as subsidies to companies like Frontier. On the call, McCarthy said:

We have several significant initiatives underway. We are completing our broadband expansion program and implementing a CAF 1 Phase 1 area build outs. Through the first nine-months of 2013 we have invested over $21 million of previously received CAF funding to expand our network. In Q3, we turned up 37,000 additional households in both categories and we expect to expand to more than 30,000 in Q4. We've applied for $71.5 million in CAF 1 Phase 2 and are awaiting the [FCC's] decision.

While the CAF dollars provide a low cost way for Frontier to bring HSI access past these homes, the company still has to close those sales. More importantly, the company also needs to maintain the new customers it has brought on board and continue to pick up market share where it goes head to head with the cable companies. Wilderotter noted:

Frontier's greatest opportunity is to drive broadband penetration and increase our share of that addressable market. We took share once again this quarter from our cable competitors. Our broadband market share on average is between 20% and 25% of total homes [passed]. So we know there is still a lot of runway to get our 40% minimum target share.


Broadband share growth will continue to be a key factor in Frontier's ability to grow revenue, retain customers and sustain the dividend. And, the good news for investors is that, according to Wilderotter, "Thus far, our Q4 momentum is solid on the broadband front based upon October results."

The increases in broadband customers in 2013, and the potential for add-on products and speed upgrades, bodes well for a brighter future for Frontier. And if that light at the end of the tunnel happens to be a locomotive, well, maybe it's time for investors to hop on that train.

Disclosure: I am long FTR, T, VZ, WIN, CMCSA. 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 written covered calls against portion of my FTR and WIN holdings