Time to Say Goodbye to Fairpoint Communications?

Fairpoint Communications (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 (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

FRP 1-yr chart

Comments

[topicviewer:]

Here is a "potential" flaw in the model. You ought reference a Winstream/Valor like transaction where a larger higher payout rural landline company (VLR) is acquired by a newly created smaller rural landline spinout (WIN out of AT). Poof goes the high payout issue, and Windstream is known to be hunting this style of bolt on.

Buy the way, a large part of the VZ rural assets that FRP is acquiring come from the old GTEacquisition, which AT & VZ always swapped for Justice & FCC settlement, so yes I believe that something on scale is always possible.

Discl: Long WIN FRP VZ ALSK IWA CZN

2007 Jun 19 11:35 AM

[Winston Kotzan:]

Good point. When I did the spreadsheet, I kept the assumption that they will maintain the dividend. It would be smart if they dropped the dividend because it would give them plenty of cash flow to reinvest.

2007 Jun 19 12:11 PM

[publius:]

The closest GTE acquisition properties are about 1500 miles away from Northern New England. You are mixing up your states. All of the properties in Vermont, New Hampshire, and Maine were Verizon owned an long before the GTE acquistion

2007 Sep 12 04:06 PM

[sunrises:]

What is your opinion now for FRP on it's lows?

2008 Feb 25 02:39 PM

[User 394256:]

I just tried to reactivate my seasonal ( six months a year) account in Boothbay Harbor, Maine. What miserable service! I had to wait for 28 minutes on hold, then got some smart-aleck in what is generously called "Customer Service"...Donny, my rep, had a chip on his shoulder, and told me I was being sarcastic, when I had the brass to complain about the long hold time, then hung up on me. These people have no business operating a public utility. I'll chat with the puco when I get to Maine, but there's monkey business afoot here. These folks can't handle this job, and I am curious as to how they obtained the contract. There's more here than meets the eye....I suspect that there's a monetary explanation, don't you?

Apr 13 03:57 PM

[User 404512:]

I personally think that Fairpoint Communication compay if horrible. I am seriouly comtemplating going to wireless. We live on a island in Lake Winnipesaukee and have no other choice -- so far.

Apr 29 07:02 PM

[KaranB:]

On April 24, 2009 we discontinued our service with Fairpoint Communication and asked that a referral be left directing callers to our cell phone. Simple request, right? Not for FC. They have directed at least five other phone numbers to our cell phone making it nearly impossible to get any work done because we must answer the phone for fear that one caller will actually be correctly directed to us. FC has left referral numbers that are incorrect. This resulted in directing our callers to unknown numbers. The people at Fairpoint Communications can't get it right! After I requested that I be reimbursed for my time when making the dozen plus calls during the last month to correct the problem (and as of today, our callers are still being directed to an incorrect number) as well as the time it took to answer unwanted misdirected callers, I was told the best they could offer was a $20 credit by Amanda in Customer Service who said "I will not deny that mistakes have been made". I wouldn't recommend Fairpoint Communications to anyone. If there is no other land line option, just use your cell phone and save yourself a lot of time, grief, and a bundle of cash each month.

May 20 11:28 AM