In an article written last week, the recent debt offerings of Frontier Communications (FTR) were discussed in some detail along with how the interest rates on the new debt represented an improvement in the outlook for the company. While that is still valid, as the fourth quarter begins, it is probably a good idea for investors to take a look at the unusual events that took place at Frontier during the third quarter. These items were disclosed by the company when it issued an 8K on September 20th, and were subsequently discussed during its participation at the Goldman Sachs Communications Conference. It is also important for investors to recognize that many of these are one-time items, and since the market prices stocks by looking forward, these are probably already priced into the shares. However, if analysts have not appropriately updated EPS estimates, there is the risk - specifically headline risk - of a short-term sell-off when earnings and related data are released.
Among the items discussed in the 8K and at the Goldman Sachs conference were:
- Significant storm damage and related expenses
- Pension contributions
- Impact of intercarrier regulatory reform
- Impact of the recent debt issue on operating expenses
The 8K also discussed two other items - 2013 cash taxes and access lines. Frontier CFO Donald Shassian stated that most sell side analysts had projected $200-$300 million for cash taxes. After filing their tax returns for 2011 in August, Frontier is now projecting a figure of only $125-$150 million. The tax savings are the result of taking advantage of accelerated depreciation from investments made by in prior years.
With respect to access lines, Frontier wrote:
...in late second quarter, Frontier began selling Simply Broadband, which is a true standalone high speed product without an associated access line. We are seeing success in attracting and retaining customers with this product and it is having a positive impact on our Q3 Residential customer counts. However, as this is the first time we are adding residential customers without access lines, our external reported unit counts will reflect a change in residential customer count without an associated change in residential access lines.
Many investors focus on the loss of access lines as a gauge of how well Frontier is performing. This is not surprising, since it is also one of the metrics that Frontier also has focused on during its quarterly conference calls. The loss rates - or churn - increased substantially after the company acquired a large portion of Verizon Communications' (VZ) rural business, and Frontier has claimed that once all of the Verizon-acquired properties were converted to Frontier's legacy systems, there would be an improvement in this metric. This conversion occurred in Q2.
The statement continued:
As we discussed in our annual report, we continue to believe that customer counts are a more important metric than access lines in measuring our performance and revenues. We also measure and set employee performance goals based on Residential and Business customer counts, and not on access lines.
Unfortunately, the management of Frontier has a history of misleading investors. This history suggests that investors should be skeptical about the change. Why is Frontier management so anxious to divert focus away from access line losses now that the company finally has all of their customers converted to the legacy financial systems? If that conversion is succeeding in reducing the losses, one would think management has a good reason to pat itself on the back.
On the surface, it appears to be a reasonable position; focus on customers rather than access lines. But, as a result of management being less than completely honest in the past, it is probably advisable for investors to continue to focus on access line losses despite what management would like us to do.
Storm Related Costs
While storms that damage telephone company infrastructure are not all that uncommon, it was somewhat surprising that Frontier management felt that it was necessary to draw special attention to damage caused by hurricanes in West Virginia, Pennsylvania, Indiana and the Carolinas in late June and early July. Shassian stated that the storms had a "severe impact on our operations" and affected 277 central offices. The company had to purchase 203 generators, replace 167,000 feet of cable, and incur millions of dollars of incremental overtime and contractor expenses. (The overtime/contractor expenses were $15 million dollars higher than Q2 and $3 million more than Q3 2011 storm costs). While only the overtime and contractor costs would show up as expenses in the quarter, the generators and cable costs would likely be capitalized and have an impact on cash flow.
The description of the storms as having a severe impact on operations might suggest that revenue could also have been adversely affected.
Frontier had previously given guidance of $30-$40 million of net pension contributions. Recent IRS guidance has reduced the necessary contribution to the low end of guidance. Since no pension contributions were made in the first half of the year, Frontier will be contributing $20 million in Q3 and $10 million in Q4. The company noted:
As a reminder, cash pension contributions reduce our non-cash pension expense that we add back to Adjusted EBITDA.
Intercarrier Regulatory Reform
In order to provide universal telephone service at affordable rates, the cost to provide service to remote and rural areas has been subsidized by a set of complex fees known as the Universal Service Fund and Intercarrier Compensation System. Earlier this year, the FCC began implementing a new fee structure as part of a program to provide broadband access to more Americans. During Q3, the net impact was a negative $1 million on Frontier's EBITDA. The components were a $10 million reduction in regulatory revenue, a $7 million increase in voice revenue and a $2 million reduction in cost of goods sold due to a reduction in the fees Frontier had to pay for originating long distance traffic.
Impact of New Debt
Frontier recently issued a total of $850 million of debt at favorable rates. At the time of the conference and release of the 8K, only $600 million of the debt had been issued. The statement in the 8K regarding that $600 million was, "we plan to use those funds exclusively to reduce outstanding indebtedness." Whether the same is true for the additional $250 million which was announced the week after the conference remains to be seen.
Regardless, despite the new debt carrying a favorable interest rate, until the old debt is actually retired, there will be an incremental interest expense from the new debt.
There would appear to be a variety of negative hits that investors should expect in the third quarter. The incremental interest expenses, incremental storm costs and lower revenue from regulatory reform are offset to some extent by savings in cost of sales and lower pension cash costs. There are two items that investors should be paying particular attention to when the third quarter earnings are released.
The first is access lines. The idea that investors should now focus more on customers rather than access lines is troubling. After having been told for 2 years that the conversion would result in improvements, or reductions in the churn rates, of the properties acquired from Verizon, I will be looking for any comments by management that indicate that the conversion may not be yielding expected improvements.
The second is more color on the impact of the storms. When Shassian stated that the storms had a "severe impact on our operations," a red flag went up. Was revenue impacted? How significant were the dollar costs for the generators, cables and other water related damage?
For those who have invested in Frontier for its dividend yield of more than 8%, I would expect that the major debt refinancing will provide a sufficient amount of safety for the dividend for at least the next year. That should provide ample time to find out if Frontier's new focus on customers rather than access lines provides a more stable revenue stream.
Additional disclosure: I have sold covered calls against a large portion of my FTR holdings in order to enhance the return. I may open new positions in FTR at any time, and could have positions closed at any time if certain shares are called early.