Frontier Communications: What To Look For In Q2

| About: Frontier Communications (FTR)

Investors in Frontier Communications (NYSE:FTR) are probably focusing on the dividend, which currently yields more than 10.5%, and how long the company will continue to make payments. Since acquiring rural assets from Verizon Communications (NYSE:VZ) in 2010, Frontier has cut its dividend twice. As the end of the second quarter approaches, there will be a large list of important items where investors should be focusing, all of which can impact the sustainability of the dividend. These include the continued loss of access lines, build-out of high speed Internet ("HSI") lines, success of the recently completed nine state conversion and its impact on guidance for revenue and cash flow, any changes to cap-ex and status updates on the company's debt.

High Speed Internet Service

The HSI build-out has been a focal point of the company's capital spending programs. Providing broadband to consumers in attractively-priced bundled services has been shown to reduce customer defections. In addition to broadband-local/long distance bundles, the company also markets Dish Network's (NASDAQ:DISH) satellite TV service and more recently announced an agreement with AT&T (NYSE:T) where Frontier will market AT&T's wireless services.

The company spent more than $750 million on cap-ex in 2011, and according to a recent 8K, will spend a similar amount in 2012 before declining in 2013:

Our capital expenditure spending will decrease in 2013 as the geographic broadband expansion of our network concludes. Our guidance for capex spending in 2012 is unchanged: $725 million to $775 million. Investment in VDSL and other key initiatives are included in this guidance. We expect capital expenditures to drop by approximately $100 million in 2013.

The HSI build-out is critical to the company's bundled service offerings and its ability to compete with similar offerings by cable companies.

The Nine State Conversion

The nine state conversion, completed earlier this year, refers to moving the remaining Verizon-acquired properties to Frontier's legacy financial and provisioning system, enabling the company to save nearly $100 million per year in software licensing fees, improve customer service and run unified promotions. It is likely to be the focal point of the company's conference call.

For the past year, management has been pointing to the success achieved in West Virginia - the first state to be converted - as an example of what can occur after conversion. On the 2011 Q2 conference call, CEO Maggie Wilderotter said the following about West Virginia:

First, we converted all of the operational, billing and financial systems to our legacy Frontier platform. We enhanced the middle mile fiber optic network extensively, providing 100-fold capacity improvements to carry traffic throughout the entire state. We increased broadband availability from 62% to 76%. By the end of 2012, West Virginia will go from 1 of the bottom 5 states in the country in broadband connectivity and capacity to 1 of the top 5 in the nation. We have achieved 14% market share of the new households with broadband service, experienced a 53% reduction in customer complaints and a 16% decrease in trouble tickets. Our new service orders are up, call center close ratios have improved and the Customer Satisfaction Index is the highest in the country. As we bring the remaining 13 states onto our systems and continue to enhance the network in all of these states, we expect to replicate these same results throughout the acquired property.

At the end of the Q1, the company continued with reporting on the success in West Virginia:

You can see the continued progress in West Virginia, where a significant broadband expansion has enabled line losses to improve from 11.2% to 5.6%, which is better than legacy overall.

West Virginia churn also continues to step down.

She continued discussing the next 4 states that were converted in Q4 2011:

What we call Frontier 4, North and South Carolina, Indiana and Michigan, converted on October 1, 2011, and have already shown a reduction in line loss rates from 11.9% at 2Q '10 to 9.7% at 3Q '10 to 9.2% in first quarter of '12. Frontier 4 churn has also come down from 2.23% to 1.94% over the same period. These positive changes are driven by both broadband expansion, which you can see in the slide and from systems conversion and local engagement. Having 100% of the systems running these states on the legacy Frontier platform means we can now manage, serve and sell the same way we always have done.

While the conversion of the final nine states earlier this year is certainly good news for investors, the company still has a mountain of debt.

The Debt

As of the end of last year, Frontier had more than $8.3 billion in long term debt. This included $0.6 billion at 6.25% due in January 2013, $0.6 billion at 8.25% due in May 2014, and $0.8 billion in 2015. During Q2 the company issued $0.5 billion of new debt at 9.25% due in 2021, and used the proceeds for a tender offer for $400 million of the 2014 debt and $49.5 million of the 2015 debt.

The completion of the tender offer will result in a slight increase in the long term debt, a slight increase in the annual interest payments and a charge of $0.04 per share in Q2 (due to the debt being redeemed at a premium to par). The positive is that the debt maturities have been stretched out, giving the company increased financial flexibility over the next few years.

Summary

Frontier continues to struggle with residential customers "cutting the cord." Access line losses still remain an issue and revenue continues to decline. It will be important for investors to find out whether there is continued performance improvement in the Frontier 4 and the early indications of the nine state conversion.

While waiting for these results to become apparent, extending out the average debt maturities has given the company additional breathing room. And, both the reduction in cap-ex and the conversion of the remaining nine states with the resulting savings in software license fees should be enough to cover the dividend through 2013.

Disclosure: I am long FTR, VZ, T. I also have covered calls at strike prices of $4 and $5 written against a portion of my position with expiration dates of August 2012 and January 2013. I have no positions in DISH.