Edited By Adam Isaac
Frontier Communications Corporation (FTR) offers telecom services to small communities and rural areas. The company is currently operating in twenty-seven states. Moreover, the firm provides local and long distance telephone service, digital television services, satellite video, wireless internet data access, entertainment services and broadband internet. Recently, the stock has experienced a period of resurgence and gained significantly from the levels of July, 2012, when the stock was trading at $3.93. In my previous articles, I have covered the dividend safety, financial strength and financial position of the company.
In this article, I have tried to come up with a fair value for Frontier Communications. For the analysis, I have used a two-stage dividend discount model. For the high growth period, I have assumed a revenue growth of 3.5% for Frontier. At the moment, Frontier revenue growth stands at -4.5%. However, I believe the transition period is over, and the firm is ready to take advantage of the merger.
There are significant growth prospects in the industry due to an increase in the use of smart phones and mobile devices. As a result, the demand for data services has increased significantly. Frontier has made a move to exploit this growing market and expanded its data services business. I expect the firm to grow its revenues at 3.5% per year for the next four years and then decline to a stable growth rate of 2.5% in 2017 and onwards.
The company will enjoy significant cost savings due to synergies from the Verizon Communications (VZ) assets acquisition. At the moment, the firm expects total cost synergies of $650 million for the year. Frontier operating costs are showing a declining trend, and I expect the firm to achieve further cost savings through synergies and expansion of the network. Frontier uses an accelerated method for depreciation and amortization accounting. The amortization expense for the firm arises from the customer base acquired in the transaction at the fair value of $2.5 billion.
However, the residential customer base will be amortized over nine years, while business customer base will be amortized over 12 years. In addition, the firm had one-time loss from the early retirement of debt in the year 2012, which accounts for lower earnings for the year. Furthermore, the firm will report integration cost for the last time in the annual report as all the integration costs will be covered in the year 2012.
I have also assumed future interest expense to be lower than the current levels. The firm is trying to shed its debt to achieve operational and financial flexibility, and I expect the firm to further reduce the debt. Based on these assumptions, I have determined the following ProForma Earnings statement.
ProForma Earnings
Reported Earnings | Projected Earnings | |||||||
2010 | 2011 | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | |
Revenue | $3,797,675 | $5,243,043 | $5,426,550 | $5,616,479 | $5,813,055 | $6,016,512 | $6,227,090 | $6,382,768 |
Operating Expenses: | ||||||||
Network Access expenses | $383,679 | $518,682 | $466,814 | $420,132 | $403,327 | $399,294 | $395,301 | $391,348 |
Other Operating expenses | $1,611,137 | $2,278,419 | $2,187,282 | $2,099,791 | $2,015,799 | $2,009,752 | $2,003,723 | $1,997,711 |
Depreciation and amortization | $893,719 | $1,403,175 | $1,245,685 | $1,026,984 | $996,825 | $990,859 | $980,589 | $975,298 |
Integration Costs | $137,142 | $143,146 | $126,353 | $0 | $0 | $0 | $0 | $0 |
Total Operating Expenses | $3,025,677 | $4,343,422 | $4,026,134 | $3,546,907 | $3,415,951 | $3,399,905 | $3,379,613 | $3,364,357 |
Operating Income | $771,998 | $899,621 | $1,400,415 | $2,069,571 | $2,397,104 | $2,616,608 | $2,847,478 | $3,018,410 |
Investment Income | $6,848 | $2,391 | $17,589 | $17,941 | $18,300 | $18,666 | $19,039 | $19,229 |
Losses on early extinguishment of debt | N/A | N/A | $70,818 | $0 | $0 | $0 | $0 | $0 |
Other Income (loss), net | $13,690 | $9,135 | $4,256 | $4,426 | $4,603 | $4,787 | $4,979 | $5,178 |
Interest Expense | $521,820 | $665,196 | $675,982 | $669,222 | $662,530 | $655,905 | $649,346 | $642,852 |
Income Before Taxes | $270,716 | $245,951 | $675,460 | $1,422,716 | $1,757,477 | $1,984,156 | $2,222,150 | $2,399,965 |
Income Tax Expense | $114,999 | $88,343 | $236,411 | $497,951 | $615,117 | $694,455 | $777,753 | $839,988 |
Tax Rate | 42.48% | 35.92% | 35% | 35% | 35% | 35% | 35% | 35% |
Net Income | $155,717 | $157,608 | $439,049 | $924,766 | $1,142,360 | $1,289,701 | $1,444,398 | $1,559,978 |
Income attributable to non-controlling interest in partnership | $3,044 | $7,994 | $14,569 | $16,589 | $19,856 | $21,359 | $22,589 | $25,698 |
Net Income attributable to Frontier shareholders | $152,673 | $149,614 | $424,480 | $908,177 | $1,122,504 | $1,268,342 | $1,421,809 | $1,534,280 |
EPS | $0.23 | $0.15 | $0.38 | $0.80 | $0.96 | $1.07 | $1.17 | $1.24 |
Shares used in computation of EPS | 663,796 | 997,427 | 1,118,925 | 1,141,304 | 1,164,130 | 1,187,412 | 1,211,160 | 1,235,384 |
Dividend Per Share | $0.85 | $0.75 | $0.40 | $0.40 | $0.40 | $0.64 | $0.70 | $0.75 |
Payout Ratio | 369.57% | 500.00% | 105.44% | 50.27% | 41.48% | 60.00% | 60.00% | 60.00% |
According to my estimates, the firm will be able to generate healthy EPS at the end of the year 2012 and by the end of the projection period the EPS should go up to $1.24. Frontier has had an extremely high payout ratio over the past two years, which is another reason that the firm was not able to keep high levels of dividends; it is impossible for a firm to keep paying more than it generates.
At the current levels of dividends, the payout ratio for the company should decline to around 41% by the end of 2014. However, I have assumed a payout ratio of 60% from 2015, as I believe the firm will be able to generate enough cash flows to increase the dividends. Frontier has most of its stock options between the strike price of $9 and $14.5; all of the options are anti-dilutive at the moment, however, in the projected period, the stocks in circulation are increased in order to take into account the exercise of stock options.
Valuation
Valuation | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 |
Dividends | $0.40 | $0.40 | $0.40 | $0.64 | $0.70 | $0.75 |
Discount rate | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% | 10.00% |
Present Value Factors | 0.95 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 |
Discounted Earnings | $0.38 | $0.36 | $0.33 | $0.48 | $0.48 | $0.47 |
Terminal year Value @2.5% constant growth | $7.66 | |||||
Discounted Terminal Value | $4.76 | |||||
Fair Value | $7.26 |
For valuation purposes, I have discounted the expected dividend payments at 10%. I decided to use dividends discount model, as the firm has a fine dividend history and I have taken the view of an income-oriented stock holder. In addition, constant growth model is used for terminal year value; the final year dividends are grown at 2.5% and then discounted to achieve the terminal year value. However, the terminal year value further discounted to bring it to the present value. According to my valuation model, the fair value for Frontier is $7.26.
Comparison with Peers:
Although Frontier is one of the most broadly followed telecommunication stocks, it is hard to compare with telecom giants. I think it would be fair to state Windstream Corporation (WIN), Alaska Communications (ALSK), and Consolidated Communications Holdings (CNSL) as related companies. There are also some regional competitors for Frontier, which are limited to smaller regions.
Frontier | Windstream | Alaska communications | Consolidated Communications | |
P/E | 42 | 34 | 55.3 | 27.3 |
P/B | 1.1 | 4.5 | N/A | 24.9 |
P/S | 0.9 | 1.1 | 0.3 | 1.3 |
Operating Margin | 17.40% | 16.40% | 14.60% | 15.00% |
Net Margin | 2.10% | 3.10% | .50% | 4.90% |
ROE TTM | 2.30% | 15.40% | N/A | 41.40% |
Debt to Equity | 1.8 | 6.6 | 23.2 | 43.4 |
Source: Morningstar.com
In comparison to its competitors; Frontier is cheaper based on P/B and P/S ratios, while it is a little expensive on the basis of P/E ratio. However, Frontier has stronger margins as compared to its competitors. On the other hand, some of its competitors offer attractive ROE at the cost of elevated debt and risk levels.
Summary
Frontier Communications has been a winner in the current year, and the stock is showing strong growth patterns. However, I believe the stock is still a far from its fair value and represents an attractive investment. My dividend discount model suggests a fair price of $7.26. Based on the current valuation, the stock has at least 55% upside potential.
I believe the firm has a dedicated management that swallowed a hard pill to ensure the long-term sustainability of the business. At the moment, management has its focus on the repayment of debt. Low levels of interest rate provide an opportunity to decrease the interest expense. As I have mentioned in my previous article, it is unlikely that the firm will implement anymore dividend cuts. At the current price levels, Frontier offers a solid capital gain potential and a strong dividend yield.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
