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Frontier (FTR) announced a reduction in its yearly dividend from $0.75 to $0.40 in February. The 47% dividend cut provides an additional $348 million a year. The dividend cut, while painful to many, was necessary. The reduction added flexibility to:

  • Meet pension obligations
  • Reduce and/or refinance debt

  • Lower leverage

  • Lower payout ratio

FTR_1yrThe stock has taken a beating over the last year as investors realized a dividend reduction was only a matter of time. The question now becomes, is FTR a good investment going forward?

Management projections for FCF have not inspired confidence. When Frontier announced the acquisition of the Verizon (NYSE:VZ) properties named SpinCo in May 2009, FCF on a pro forma basis was $1.73 billion, including expected synergies at the time. The deal was completed in July 2010. Once integration was underway, FTR issued 2011 FCF guidance on February 23, 2011, in a range of $1.15-1.2B. At the Goldman Sachs conference on September 20, 2011, FTR lowered the 2011 FCF projection from a midpoint of $1.175 billion to $1.1 billion. Now the midpoint for 2012 is $950 million. (Note: Management projections are non-GAAP; calculation details are found here) The problem is guidance continues to trend in the wrong direction.

We'll examine trends based on management's financial track record using GAAP results to highlight longer term trends. The raw data used in this article can be found here.

EPS TRENDS

The following graph for EPS trends are arrived at by calculating the statistics for a trend line using the "least squares" method. This determines the line that best fits the historical data and consensus estimates.

Click to enlarge:

There is nothing consistent about the historical data. EPS hit bottom in 2011 following the SpinCo acquisition in July 2010. The above chart represents the following trends:

Analysis Period

EPS Growth Trend

3 year

6.1%

5 year

(19.5%)

10 year

1.2%

Analysts are projecting a five-year growth rate of 0% as of this writing. (Source: Nasdaq.com)

OPERATING CASH TRENDS

The old saying "Cash is King" especially applies in the case of FTR. Why? FTR must generate enough cash flow to:

  • Service the $8.3 billion debt

  • Pay the dividend

  • Fund the pension

  • Cover the occasional unexpected event (past example: Hurricane Irene)

Generating cash is the critical metric for FTR. First we'll look at total operating cash measured in total dollars. The data was obtained directly from the company's financial filings.

Click to enlarge:

The above graph looks upbeat, showing an upward trend. Looks can be deceiving. The graph is distorted due to the SpinCo acquisition in July 2010 which tripled the size of the company. A better measure of performance would be cash per share, since there was heavy share dilution following the acquisition. The picture starts to look much different, as shown below:

The above chart represents the following trends:

Analysis Period

Operating Cash per share Growth Trend

3 year

2.69%

5 year

(4.93%)

10 year

(10.29%)

VALUATION

The stock is yielding close to 10%. The market is sending a message that their faith in management has taken a turn for the worse. Is the selling overdone?

This fair value analysis is based on management's longer term financial performance as measured by the previous data. Fair values are based, in part, on the following: Discounted cash flow, a modified Graham's intrinsic value formula and a P/E analysis. The valuation model consists of two parts.

  1. The discounted cash flow and the modified Graham's intrinsic value are blended to arrive at a fair value.

  2. A P/E analysis based on historical adjusted values.

Fair value used is the minimum value of the two parts.

Part 1: Discounted cash flow and the modified Graham's intrinsic value.

We set the bar low for both longer term earnings and cash trends. We've used a long-term EPS growth rate of 0% a and long-term cash per share growth rate of 2.7% from 2013 through 2017 in line with the data described above.

Running these projections through our pricing model, excluding the PE analysis, produces a fair value of $3.80. Needless to say, the result is sensitive to changes in the growth rates as illustrated below.

Part 2: P/E Analysis

The model looks at current and past periods to calculate a limiting PE value. The result is a maximum allowable PE of 22 yielding a fair value of $4.60. The result is sensitive to changes in the growth rates as illustrated below.

Final fair value is the minimum of the two methods or $3.80. Again, we should emphasize this analysis sets the bar low, based on extremely low long-term growth rates. Until there is more visibility, the high yield will limit the downside, partly reflected in the PE analysis. Where the stock trades from here depends on management's ability to meet or exceed current expectations.

Below is a sampling of analyst price targets, giving a wider view of market sentiment.

Source

Target

DA Davidson

$4.00

BAC

$4.00

RBC Capital

$6.00

Zacks

$4.50

UBS

$5.00

Yahoo Consensus

$5.00

COMPETITION

The following chart compares FTR's cash track record to CenturyLink (CTL), Windstream (WIN) and TW Telecom (TWTC) over the last three years to get a feel for FTR's performance in relation to other large players in the industry.

Click to enlarge:

Not only is FTR at the bottom of the heap but has continued its downtrend as others have started to recover. The continued downtrend triggered the previous dividend reduction and continues to pressure the stock since it is unclear when the trend will reverse. CTL might be worth investigating further as an alternative to FTR, considering its high yield and above chart.

RISKS

  • Managements free cash flow projections have been continuously revised down, raising questions about management's ability to execute.

  • Revenue and line losses have yet to stabilize since the Verizon SpinCo acquisition.

  • FY2011 pension return of approximately 1.9%, far below management's yearly assumption of 8%. Pension obligations could put additional downward pressure on free cash flow and by default, the dividend. Additional detail can be found here.

  • Deteriorating financials could trigger a future downgrade by the S&P ratings agency, making it harder to negotiate better terms on the debt. Or it could lead to the elimination of the dividend.

  • Integration costs exceeding current expectations and/or not accomplished in the expected time frame

CONCLUSION

Management's credibility has suffered due to the dividend and free cash flow issues as previously discussed here. Have they gotten the message? If yes, they have probably become more conservative with their projections and the dividend will continue to support the stock. If no, then management will continue to guide down, putting the safety of the dividend in question, i.e., today's price would represent a value trap. Unfortunately, the direction will not become apparent for several quarters.

Our take: Expect management to meet their pared down expectations, which would limit any downside. Unless expectations are exceeded, the upside is also limited. The current attraction is the high yield, although this is dependent on positive cash growth going forward using 2012 projections as the starting point. FTR should be viewed as speculative pending additional visibility.

Source: Frontier Communications: Opportunity Or Value Trap?