The Street is currently bearish about Windstream (WIN) and Frontier Communications (FTR), rating both a "hold." This contrasts with the near "strong buy" rating for CenturyLink (CTL). With sector-wide consolidation likely to continue in telecom at a time when companies are trading at high multiples, takeover activity should be viewed with much caution. Based on my review of the fundamentals and multiples, I find limited upside for these companies.
From a multiples perspective, all three are trading at high levels. CenturyLink is the cheapest at a respective 21.1x and 14.6x past and forward earnings. But, even still, the current PE multiple is 165% higher than the five-year year average. Frontier trades at a respective 28.7x and 15.9x past and forward earnings while Windstream trades at a respective 24.4x and 14.6x past and forward earnings. Frontier may offer the highest dividend yield at 17.4%, but investors are rightfully skeptical about the sustainability here.
At the third-quarter earnings call, Windstream's CEO, Jeff Gardner, noted solid momentum in several areas:
First, I am very pleased with the top line improvements we have accomplished this year. Our goal over the past few years was to transform our business to achieve revenue and cash flow growth.
Given our shifting revenue mix, success-based capital investments and expected deal synergies, we are on the verge of showing growth in both of these areas.
Our activity level is high, and we have made progress on a number of fronts, including business sales momentum, data center expansion, fiber-to-the-tower builds and integration. Importantly, we are seeing the benefits of this transformation and have created the unique opportunity to provide our investors with a combination of both growth and yield.
The merger with PAETEC will unlock around a 200 bps improvement in margins, mainly through reducing unnecessary cost overlap. For example, Windstream is aiming to slash around 980 jobs, which will add greater efficiency. PAETEC dramatically expanded the company's revenue in broadband while diversifying product offerings. With its high degree of leverage at this point, Windstream is unlikely to slow down takeover activity, if not outright halt it.
Consensus estimates for Windstream's EPS forecast that it will grow by 15.2% to $0.76 in 2011 and then by 11.8% and 7.1% in the following two years. Modeling a CAGR of 11.3% for EPS over the next three years and then discounting backward by a WACC of 9% yields a fair value figure of $11.57, implying 7% downside.
Frontier has turned off investors through continued losses in access line. At the same time, the company is being weaned from Federal Universal Service Fund subsidy payments. Challenges in integrating the Verizon (VZ) assets further raise questions concerning the sustainability of the dividend yield. Furthermore, the expiration of bonus depreciation rules will result in greater taxes. With Frontier's underperformance, the earnings release February 23, is gearing up to be an inflection point.