Broad Telecom Industry: Focus on Frontier

Mar.25.12 | About: Frontier Communications (FTR)

The broad telecommunications industry currently encompasses:

  • Companies providing local and long distance voice services, sometimes referred to as plain old telephone service (or "POTS")
  • A plethora of new data and internet services for both residential and commercial customers
  • Switched access services that allow telecoms to complete calls on each other's networks
  • Equipment sales

Frontier Communications (NYSE:FTR), with revenue of about $5.2 billion and a market capitalization of about $4.4 billion, occupies an industry position between industry behemoth AT&T (NYSE:T), which has revenue of about $127 billion and a market capitalization of about $187 billion, and FairPoint Communications (NASDAQ:FRP), with revenue of about $963 million and a market capitalization of about $109 million. Two other companies that compete directly with Frontier in the space are CenturyLink (NYSE:CTL) and Windstream (NASDAQ:WIN). CenturyLink has revenue of about $15.4 billion and a market capitalization of about $24.1 billion while Windstream has revenue of about $4.3 billion and a market capitalization of about $7.1 billion.

These companies are each impacted significantly by the overriding industry trend of rapidly diminishing POTS and the value destruction it causes. To counteract this trend, each of these companies are using various business strategies that seek to seize upon new opportunities created by the changing telecom landscape. Other companies in the broad telecommunications space include cable companies such as Comcast (NASDAQ:CMCSA) and wireless phone service providers such as Verizon Communications (NYSE:VZ). The rapidly changing competitive landscape in the telecommunications industry has led to a flurry of acquisitions, divestitures, and other maneuvers as companies position themselves to capture market share and profits to generate cash flow and create value.

To make sense of this new telecom environment, I will use a well known model called "Porter's Five Forces" to analyze both the industry generally and Frontier specifically.

The Porter model was introduced by Michael E. Porter in 1980 and is a great tool for gaining insight into the forces that define the competitive structure of an industry. It is also useful for assessing an individual company's corporate strategy against the framework of this industry structure. Porter identified five broad themes or "forces" that serve to define the competitive arrangement in an industry.

These forces are:

  1. Threat of new entrants
  2. Bargaining power of suppliers
  3. Bargaining power of buyers
  4. Threat of substitutes
  5. Intensity of rivalry in the industry.

Within each of these forces are additional subcomponents that influence the relative strength of each specific force.

At the industry level, the "threat of new entrants" refers to how easy or difficult it is for companies to enter the market. For individual companies in an industry, this means how easy or difficult it is for other companies to enter their specific product, service or geographic territories or niches. The "bargaining power of suppliers" refers to the relative strength of price setting between the companies in an industry as a whole and the suppliers of raw materials, labor, parts, & services to the industry. Within an industry, each company will have unique bargaining power with each type of supplier. The "bargaining power of buyers" is the relative power that the consumers of an industry's products or services have to dictate prices and is typically uniform for all the players in an industry unless a company can differentiate itself in a particular way. In general, the more commoditized an industry's products or services, the more power consumers have to set the price they will pay. The "threat of substitutes" arises for an industry when products or services outside that industry are viable alternatives for customers. The companies within an industry can compete on the basis of providing substitutes if the industry's products or services are not highly commoditized. Finally, the "intensity of rivalry" is a measure of an industry's level of competition and is influenced primarily by the number of industry players, their relative sizes, and the growth rate of the industry. This force has a direct impact on the returns earned by the individual companies in an industry.

I will begin this analysis of Frontier by using the Porter framework to delve into the "threat of new entrants", giving a background for the telecommunications industry as a whole and Frontier's position in relation to its Peers. In forthcoming analyses, I will finish discussing the "threat of new entrants" and then cover each of the other five forces in turn.

There are nine specific subcomponents associated with the "threat of new entrants" which is also called "barriers to entry". I have included three other subcomponents that provide additional insight into the industry. Economies of scale is the ability of a company to improve operating efficiency by increasing the volume of business. This force is a key factor in the telecommunications industry as demonstrated by the drive to add spectrum, customers, and access lines through acquisitions in the hope that spreading the high fixed costs inherent in being a telecom provider over a broader base will bring down per unit costs. Frontier significantly increased its scale with the 2010 acquisition of Verizon's rural landlines which increased the number of access lines from about 2.2 million to more than 7 million. This transaction also improved Frontier's economies of scope, another subcomponent of the "threat of new entrants" that refers to a company's ability to gain efficiency through sharing of costs across various functions. When companies highlight possible synergies in a transaction, they are talking about improved economies of scope.

Another subcomponent that impacts the players in telecommunications is distribution cost which is the cost that a new entrant must pay to encroach on existing players' distribution channels. The significance of this force in the telecom industry is another driver of the recent acquisition trend because it makes more economic sense to purchase the assets and distribution channels of an existing player in a specific market than trying to develop a distribution channel from scratch.

Product differentiation, the fourth subcomponent of the "threat of new entrants", comes into play in the telecom industry when companies are building brand identification and customer loyalty through advertising, customer service, product bundles, and being the first to offer a service/product or first to capture a local market. Product bundles are a prime avenue for telecom companies to create product differentiation and generally consist of a mix of different internet, television, phone, data, and video services with varying emphasis on residential and commercial customers and to a lesser degree equipment sales.

So far I have covered only four of the twelve subcomponents that make up the "threat of new entrants" and have discussed them in terms of the competition between existing players in the telecom industry. These four areas, economies of scale, economies of scope, distribution costs, and product differentiation, are the primary points of competition when it comes to existing telecom companies facing the "threat of new entrants". Next time I will finish discussing the remaining subcomponents of the "threat of new entrants" that relate to individual telecom companies, particularly Frontier, and will discuss the other aspects of the "threat of new entrants" that pertain to the telecom industry as a whole as it defends itself against possible threats from companies and products or services outside the industry.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.