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My series of articles examining the influence that Porter's Five Forces have on Frontier Communications (FTR) and the telecom operator industry has reached the last force - which is the "Intensity of Rivalry". The previous installments discussed how the "Threat of New Entrants" or "Barriers to Entry", the "Power of Suppliers", the "Power of Buyers, and the "Threat of Substitutes" impact the telecom operator industry and the strategies employed by the competitors in the industry, including Frontier.

An analysis of the "Intensity of Rivalry" attempts to describe how intense the competition is within the telecom operator segment of the telecommunications industry. The greater the intensity of rivalry, the more difficult it is for any single company within the industry to garner excess profits relative to its competitors and relative to the overall market. There are 8 aspects or sub-components to this force that go into assessing its significance. Some of these sub-components are exclusive to the "Intensity of Rivalry" force, while some have been discussed previously as they pertain to the other four forces.

The first sub-component in Porter's model of the "Intensity of Rivalry" is the presence or absence of numerous or equally balanced competitors. The model also indicates that in relation to the competitors, government regulations, subsidies, or other forms of influence have a direct bearing on industry structure. Currently, the "Threat of New Entrants" is low to moderate for a variety of reasons that I described in a previous installment of the series, but in the early 1990s, there was a rush of new entrants into telecom as a result of deregulation.

Now in 2012, there is a glut of competitors in the industry, which makes competition very sharp. These competitors are not necessarily equally balanced and represent a wide range from the very small, like FairPoint Communications (FRP) with revenue of about $963 million and a market capitalization of about $109 million, to the extremely large like AT&T (T), which has revenue of about $127 billion and a market capitalization of about $187 billion.

Frontier, with revenue of about $5.2 billion and a market capitalization of about $4.4 billion, occupies an industry position similar to Windstream (WIN), which has revenue of about $4.3 billion and a market capitalization of about $7.1 billion. This sub-component significantly increases the "Intensity of Rivalry."

Slow industry growth is the second aspect of the "Intensity of Rivalry" that investors must consider. This sub-component is important because a slowly growing industry turns competition into a market share game where competition is primarily on price, and a "race to the bottom" can ensue, which hurts all the players. The telecom operator segment is a slow growth industry. In fact, as it relates to "plain old telephone service" or POTS, the industry is a negative growth industry where prices have become so competitive that the players can not compete on it. In response, Frontier and its competitors have undertaken various strategies to move away from POTS and to compete on terms other than price. This has led to a wave of acquisitions, divestitures, and other maneuvers as companies position themselves to seize upon new opportunities.

Another factor that contributes to the "Intensity of Rivalry" is the degree to which fixed or storage costs are high relative to total costs. Fixed costs should be measured against the value added by incurring these costs, while storage costs are high if the industry's product is perishable. The reason that high fixed or storage costs are a sub-component of the "Intensity of Rivalry" is that high cost ratios pressure all firms to fill capacity which then leads to price cutting.

Telecom operators' products and services are not perishable, so storage costs are not a consideration, but the significance of infrastructure networks to the industry makes fixed costs a relevant issue for investors to consider. One way to measure the value added by fixed costs is to look at free cash flow as a percentage of revenue, also called average free cash margin.

Defined as free cash flow (cash flow from operations less capital expenditures) as a percentage of revenue, average free cash margin as of the third quarter of 2011 was about 4.4% for the trailing twelve months for all industries, while the communications sector was at about 8.9% and Frontier was at about 19.3%. This indicates that the fixed costs of the telecommunications industry do add value and do generate substantial cash flow and that Frontier is a leader in the industry.

The fourth sub-component of the "Intensity of Rivalry" is switching costs to the competitors in the industry. Switching costs were discussed previously in the "Barriers to Entry", "Power of Suppliers", "Power of Buyers and "Threat of Substitutes" analyses. This concept has slightly different implications for each of these forces and has yet another set of implications related to the "Intensity of Rivalry".

One-time costs related to a company's suppliers, employees, PP&E (property, plant and equipment), and operations are the principal sources of high switching costs that increase the "Intensity of Rivalry" and drive down industry profits. Examples of one-time costs include things like employee retraining, new ancillary equipment, testing or qualifying new sources, technical help, product redesign, or the psychic or emotional cost of severing a long-term relationship. When gauged against the number and balance of competitors, industry growth rate, and fixed & storage costs, switching costs for Frontier and the telecom operators in general are not a vital sub-component of the "Intensity of Rivalry".

The next installment of the series will continue to break down Porter's Five Forces when the focus will be turned to the last four sub-components of the "Intensity of Rivalry". These include the degree of product or service differentiation, exit barriers, diversity of competitors' strategic goals, and size of required fixed asset additions.

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

Source: Rivals Can't Touch Frontier's Cash Flow Margins