A New Reason Frontier Is A Winning Stock

Apr.11.12 | About: Frontier Communications (FTR)

In this article, I examine a new reason I believe Frontier Communications (FTR) is a winning long-term dividend stock. So far in my series, looking at the influence of Porter's Five Forces on Frontier and the telecom operator industry, I have reviewed the "Threat of New Entrants," also referred to as "Barriers to Entry," the "Power of Suppliers" and the "Power of Buyers." The fourth of these forces that determine the structure of the telecom operator industry and the effectiveness of competitors' strategies is the "Threat of Substitutes." When examining this force, investors attempt to understand how easy it is for customers to buy a competing product or service. The easier it is for customers to find substitutes, the weaker the competitive position of the industry and the companies in it.

Porter's model indicates that the first factor or subcomponent of the "Threat of Substitutes" is the buyer's cost of switching to substitute products or services. Cost of switching is a factor that also previously impacted the analyses of "Barriers to Entry," the "Power of Suppliers," and the "Power of Buyers." This concept is simple to grasp, but has slightly different implications for each of these forces. Cost of switching as it pertains to "Barriers to Entry" refers to the costs customers incur to switch from one company, product or service, or industry to another. Relative to the "Power of Suppliers" and "Power of Buyers", cost of switching is the same concept looked at in opposite ways, so that whichever player has higher costs of switching is in the weaker position. In general, the greater the cost, whether it is monetary, psychological, extra time, or increased effort, the greater the power a company or industry has over its customers.

Now that recent legal actions have potentially diminished the effectiveness of early termination fees, product differentiation is essentially the only way companies in the telecom industry can favorably impact switching costs. If a company is able to differentiate its product or service from its competitors, the psychological cost of switching can be increased. Monetary costs, time, and effort costs are not significant aspects of switching costs for the telecom companies, because of the commoditization of service. Frontier, like many of its competitors, has undertaken significant network upgrades to differentiate its offerings and move away from commoditization to boost the cost of switching and diminish the "Threat of Substitutes." Another consideration that telecom industry investors need to beware of is government influence or involvement in promoting substitute industries by making the substitute less costly to buyers.

The second subcomponent of the "Threat of Substitutes" is the number of substitute products or services. Investors must be aware that evaluating the number of substitutes is not simply a matter of counting the number of competitors' offerings or the number of similar industries. It is crucial that the product or service being offered by a specific company or industry be accurately defined. This means identifying those products or services that can perform the same function as the industry's product or service. Products and services from non-traditional telecom industries pose serious substitution threats. Cable television and satellite companies now compete with the telecom operators for customers by offering offer broadband internet services and high-speed business networking, while railway and energy utility companies are laying miles of high-capacity telecom networks alongside their track and pipeline assets.

Also, internet service providers offer cut-rate land line telephone service, which is one reason telecom operators have seen an erosion of their POTS (Plain Old Telephone Service) over the past several years. Frontier and the other telecom operators have responded to this growing number of substitutes by redefining the products and services they offer. By bundling their services and upgrading their networks, the telecom operators are bringing distinct offerings to market in an attempt to reduce the number of direct substitutes.

The similarity of substitutes is the last factor or subcomponent of the "Threat of Substitutes" and is straightforward in its implications. The more alike a substitute is to a company's or industry's product or service, the weaker that company or industry is and the greater the likelihood that price will be the primary point of competition. This is extremely relevant with the telecom operators where POTS is now essentially a commodity and the companies have begun to embrace product differentiation to break out of price only competition.

One new development that will surely affect the telecom operators as they try to compete with substitutes from cable, satellite, internet service, and wireless providers is the emergence of LTE technology. LTE, or long term evolution, is a kind of 4th generation service that is significantly faster than current standards, and that lets telecom operators transmit more data per unit of spectrum. For now, the winners appear to be the companies with large installed customer bases such as AT&T (T) and Verizon (VZ). However, as networks reach full capacity, additional capital investment will be required which will allow more agile players like Frontier a chance to pick off customers. The residual impact that this new LTE technology will have on equipment suppliers like Cisco Systems (CSCO) will also need to be in an investor's analysis. And even WiFi network operators, such as Boingo Wireless (WIFI) will be part of the overall equation if the expected "WiFi offloading" phenomenon is meaningful.

The "Threat of Substitutes" force expresses the idea that the easier it is for customers to find substitutes, the weaker the competitive position of the industry and the companies in it. The weakness or strength of a company or an industry relative to substitutes depends on the cost of switching to a substitute product or service, the number of substitute products or services, and the similarity of substitutes. The telecom operator segment faces a very significant threat from substitutes because the industry has not been able to create effective or sustainable costs of switching and because there are a great number of competitors that offer very similar products and services. This force is even more crucial than the "Threat of New Entrants," "Power of Buyers," or "Power of Suppliers" in defining the structure of the telecom operator industry and the effectiveness of telecom companies' strategies. For that reason, investors must be vigilant in monitoring the broad telecom landscape to assess the severity of the "Threat of Substitutes" to the telecom operators.

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