Frontier Green Shoots To Consider Approaching Q4 Earnings

Summary

• Starting in October, the infrastructure fee doubled from $1.99 to $3.99 across 4.2M customers.
• Q4 and Q1 are the quarters where Frontier makes the majority of its annual cash flow due to lower CapEx.
• There's a lot of low hanging fruit that the new marketing guy from Bain can circle the wagons around and target as part of the rebrand.
• Having a larger fiber footprint allows for marketing and delivering services that would have previously not been possible.
• The market is not appreciating the quality of their asset base. It is assigning a runoff multiple when it should be growth.

Frontier Communications (FTR) offers the most leveraged speculative investment that I think money can buy right now, and to scale too. The net debt is around $17B par and the equity trades at around $200B. The market value of the debt trades at less than $17B because a lot of it is subpar, especially the debt with expirations after 2022, which is the year when most forecasts say that more debt will come due than cash flow is available to pay down. The stock price forecasts crash and burn in a blaze of glory, but I think things aren't so bad. In my last article, I gave an overview primarily surrounding the reasons why I thought revenue and EBITDA may actually increase. I wanted to talk about a few more reasons I think that this may be near term.

Investment Thesis

The market is basically saying that as part of the capital structure, the equity is worthless as evidenced by its call option style pricing. Equity is $200M. Debt is $17000M. That's a tiny fraction and that's what happens when you get a distressed capital structure. The reason is that the market is forecasting more of the same ice cube melting revenue and EBITDA that we've seen for years. I think that the market is wrong and this affords the opportunity of a lifetime for anyone willing to place a speculative bet on the equity. The purpose of this article is to point out a few things that you may not know about that will possibly lead to a blowout fourth quarter. The stock by my calculations on a forward basis in 2019 produces $7 a share of levered free cash flow. Considering this trades at less than 1x LFCF, upside could be explosive if the company announces that they grew revenue in February along with pretty solid guidance for the year.

Infrastructure Fee

The infrastructure fee was doubled around October. This went from $1.99 to $3.99 and should increase revenue $25M/quarter. That's consumer only, may have to add commercial.

Verizon 3 Year Bundles Roll Off

When Frontier bought its CTF fiber network, it inherited 3 year bundle details. These are already a tailwind and roll off completely in the middle of 2019. This should reduce churn on the go forward.

Fiber ROI

The network ROI is a factor of homes passed and sell-through rate. The ROI exceeds Frontier's debt interest expense. Hanging fiber costs 5 grand per mile. You assume that there are 10 homes possible per mile and the average industry sell-through rate is 30% and gross margin of about 40-45%. Plus, Frontier can borrow against a small fraction of that as secured debt. The market is punishing Frontier for its CapEx, saying that they should be paying down debt instead but given that we are still a few years out from the major debt wall, building out CapEx should drastically improve the Debt/EBITDA by bringing it lower. My understanding is that the company had a 10-year plan when it bought from Verizon to build out the FiOS and has accelerated it significantly after fully integrating its network.

At the 46th annual UBS conference, Dan said in 2019 the entire network would be fully capable ubiquitously at 1 gig. Having more fiber should reduce churn on the go forward.

New Marketing Guy From Bain

Robert Curtis is the Senior Vice President and Chief Marketing Officer. I think he is responsible for the rebranding that's going on. He comes from Bain:

It seems to me that he's responsible for the client segmentation aspect of the rebrand and this is all possible because Frontier has been overspending CapEx to build out its fiber making new marketing channels possible.

In Season

Q4 and Q1 are the quarters where CapEx goes down because of the weather, so these next two reported quarters should print big cash flow numbers, destroying the theory that this company's cash flow is in secular decline.

Over Under on EBITDA for Q4

I figure management is wrong on its EBITDA estimates for Q4. Downside is about $10M max while upside could be $20M. Downside would be because of a spike in churn.

$94M/Year In Revenue Potential CAF

According to the CEO, if the penetration rate increases to what he expects for the CAF opportunity, the company's top line should get boosted by $94M/year:

15%*$760,000*60%*115*12 = $94M. As you can see, the low hanging fruit here to boost revenue adds up fast. If you look at what they expect to build out in just the fourth quarter it should add $7M a quarter to the top line on the go forward.

Historical VZ Churn

Churn used to be at 12%. Now it's 1.9%. Things actually have been getting better over the past few years. Churn for Fiber is lower than for Copper.

Frontier Raised $80M

Frontier sold their 100 towers to Everest for $80M.

Paid down $150M On Revolver by Nov. 6th

This is a very bright sign roughly 1 month into the fourth quarter. Cash can't go to zero, and with the ebb and flow of AR and AP you need cash to operate. It's likely that $150M was cash from operations.

Hurricanes/Storms

Storms in late 2017 caused damage to Frontier's insured network. These things are fixed as quickly as possible and require immediate CapEx expenditures that show up in accounts receivable as the insurance claims are processed. When processed, those A/R turn to cash. In this case, the company says that some of 2018's above trend CapEx is due to 2017's storms resulting in above normalized CapEx into early 2018:

There haven't been any major storms in 2018, so this is another Frontier tailwind heading into 2019 and closing out 2018.

SD-WAN - Pure Upside

This would apply to large companies who have a WAN:

It's basically Wide Area Networks As A Service. From what I can tell, the real upside here would be part of the re-brand. This could be some seriously low hanging fruit on the commercial side of the business. It seems like Frontier has the superior network in its locations and eventually enterprise clients should figure this out since it saves them money.

Stable EBITDA to Growth EBITDA

From the UBS Call:

Dan says it will be slower than what they've done historically. That said, the changes seem to largely be seen as cumulative and compounding in certain cases. The main point here is watching to see how it changes the trends. If it becomes apparent that these changes are sticking, the debt should begin to trade higher.

Summary and Conclusion

This company is a binary outcome. Either they grow revenue and EBITDA or the company melts like an ice cube and the debt ends up taking over the equity in Chapter 11. From what I can see, this company is still years away from having to make those calls and is in much better health with a much brighter future than the market price suggests. Above I have listed some key reasons why the fourth quarter could blow earnings out of the water. The stock price projects declining everything so the bar is pretty low, but for all the reasons listed above, I'm long. This is a speculative position. Because they have 5.0x Debt/EBITDA and the debt is subpar, the market's perception has to improve enough so that the company can refinance its debt by 2022.

It's true that Frontier has lost some market share over time in its CTF markets, but that's just low hanging fruit if you ask me because it should gain that market share back because its network is superior to its competitors in those markets. I just don't think they've marketed it very well and that's what this whole rebranding is about, taking market share because they have the superior fiber network. The market doesn't seem to understand the quality of the asset base at Frontier and that's really the investment thesis. It treats it like a melting ice cube when I think it's really about to really start flexing its network potential.

A whole lot of work has gone into the future of Frontier and the market is fixated on historical results, and this all makes for Frontier being my top pick for 2019. In fact, this may end up being the best pick of my entire life. $7/share of LFCF when the stock is at $2 is a testament to the market's confidence that this is a melting ice cube. I just don't think it is. I think the company has come a long way in stabilizing EBITDA and has been strategically investing into high ROI fiber to begin to grow it. The market is not valuing CapEx in the slightest. It looks at it like the company is lighting any money that it doesn't use to pay down credit as money lit on fire. Growth initiatives compromised 75% of CapEx according to the Q3 2018 presentation. That $710M spent in CapEx for growth initiatives for 2018 has stabilized EBITDA and I think we're getting ready to turn the corner and turn up the heat.

Analyst’s Disclosure: I am/we are long FTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.