Time to Say Goodbye to Fairpoint Communications?

Fairpoint Communications (NASDAQ:FRP) is a rural local telecommunications company. Early this year, they agreed to purchase Verizon’s land line service area in rural New Hampshire, Vermont, and Maine for $2.7 billion dollars. Considering that this huge deal would add an additional 1.48 million access lines to Fairpoint’s current 248,000, I decided to take a closer look at whether there could be some hidden value in this stock.

Strengths

Fairpoint holds a virtual monopoly in rural areas. It provides high speed DSL and only 13% of its customers have the option of cable internet service. Fairpoint has been gradually expanding through the acquisition of smaller companies. In February 2005, the company restructured its debt, improving its ability to pay interest.

Weaknesses

The heavy dividend has been an unnecessary burden on the company’s cash flow. Rather than reinvesting excess cash in the business, every free penny of profit is being used to fund the dividend. The company has even issued additional debt. Unless something changes quickly, this dividend policy cannot be sustained.

Valuation

To determine whether the Verizon acquisition would be a significant catalyst to drive the stock price, I built a discounted cash flow spreadsheet model to compare value before and after the deal.

The DCF used a WACC of 7.75%. (Equity required return was determined by adding a risk premium to the bond yields, and not CAPM.) To account for inaccuracy in the assumptions, I included optimistic growth and slow growth scenarios into the model.

Based on the current capital structure and excluding the merger, my model valued Fairpoint between 6 and 12 per share. After adjusting the model to include the post-merger capital structure and revenues, the model valued Fairpoint between 13 and 22 per share.

This indicates that while the deal will be beneficial, it will not generate a substantial change in value. The stock currently trades near 18 per share.

Opposition to Verizon (NYSE:VZ) Deal

In order for the merger to pass governmental regulators, it must be approved by the Public Utilities Commission in all three states. Already, the citizens and unions of these states have generated a notable lobbying campaign against Fairpoint (see here and here.)

Even if the deal passes, it will be difficult for Fairpoint to smoothly integrate its systems. Its massive dividend will prevent the necessary capital expenditures to upgrade the new lines. Fairpoint currently has enough difficulty maintaining its own network. According to the Department of Public Service, Fairpoint's rate of consumer complaints in 2006 was 2.4 per 1,000 access lines and Verizon's was 0.46 complaints per 1,000 lines.

Conclusion

On the surface, Fairpoint seems to have a strong competitive position in the rural market. However, this position seems to be offset by poor financial management. The beneficial deal from Verizon offers little upside to the stock and an uncertain fate.

Disclosure: Author has a long position in FRP

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