Will Frontier Sink This Year?

Maxwell is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Have you ever seen one of those videos where a youth sits atop his bike above a stairway all set to perform some spectacular stunt? His cohorts cheer him on, and you cringe because you ‘know’ what is going to happen; epic failure. You’ve seen it happen before, with similar circumstances ending the exact same way. It’s inevitable.

Sadly, we wait expectantly for our beloved Frontier Communications (NASDAQ: FTR) to complete its headlong down the stairway of disappointment, and for some benevolent company to absorb its wounded pieces into their successful operations. 

What Has Happened

Frontier is one of the largest rural local exchange carriers in the United States. Specializing in serving rural areas and smaller communities, it offers local and long-distance telephone service, broadband Internet, digital television, and computer technical support to residential and business customers.

First known as Citizens Communications, after its acquisition of Frontier ILEC companies in New York as well as Frontier Subsidiary Telco, it adopted the name Frontier in 1998. For the next 10 years, relatively little effort was put forth into securing a future position, even with the market obviously trending toward bundling services, and wireless exchanges.

It wasn’t until 2009, Frontier decided it was time to make a move toward profitability. That year, it struck an $8.6 billion agreement with Verizon (NYSE: VZ) to acquire Verizon's 4.8 million landlines leased to residential and small business customers. The deal meant Frontier would acquire all wireline assets in 14 states, making them the fifth largest local exchange carrier with over 7 million access lines and over 1 million high speed internet subscribers.

The move was equivalent to getting a good deal on a tape cassette player; it will hold for a while, but the market has moved beyond it. It also forced Frontier to announce a 25% reduction in the dividend in order to fund the purchase and align the service platforms.

In little over a year, the company realized the purchase was not a dream come true as originally thought. Loss of customers forced it to reduce its 7 million access lines down to just under 5.3 million. The declining access lines mean a further inability to service its customer base, and the cycle of hemorrhaging continues. Currently, Frontier services about 5.1 million access lines, representing 3 million residential customers and 300,000 businesses.

What Is Happening

Telecommunications companies must stay on the frontlines of innovation and service in order to remain competitive.  CenturyLink (NYSE: CTL) has proven more adaptable than Frontier based on its growth the last few years. Starting in 2007 with Embarq, the company swiftly moved to acquire Qwest in a stock-for-stock transaction. This merger made CenturyLink the third largest telecommunications company right behind Verizon and AT&T (T)

Another clear indication of CenturyLink’s competitiveness is its branching out into expanded managed hosting and cloud services. Last July, CenturyLink acquired Savvis, Inc., a global provider of cloud infrastructure and hosted IT solutions.

Compare this to Frontiers buying up old landlines. Where does it see that going? Based on the numbers, it has been losing about 2.5% of its residential access lines and 1.5% of its business lines every quarter. Not only this, the company’s financial outlook is bleak. In addition to its massive debt, it has seen shrinking revenue each quarter since the acquisition. Last year’s revenue was around $5.3 billion, a 13.6% drop from the stated $6.1 billion for 2009.

This ever declining revenue also pushed the company to follow another negative trend: cutting the dividend. The most recent cut was more than 46% from $0.75 to $0.40. At the current prices the dividend yield is about 9%. I submit an assessment by Jim Pyke on the dividend reduction:

In 2011, FTR had $748 million in capital expenditures as well as some additional expenses for integration of about $143 million. In 2009, FTR had $256 million of capital expenditures with $25 million related to the acquisition. So the incremental outflow is $635 million, which is almost completely offset by the $594 million dividend reduction, suggesting that the acquisition is still contributing very little. Presumably, with the claim of the acquisition being cash flow accretive in year 2, we would be seeing a dividend increase. My expectation is that this is not the last dividend reduction.

What Will Happen

It would not be fair to say that Frontier leadership is asleep at the wheel, or is locked into a ‘landlines only!’ strategy. There does seem to be some movement to enter the wireless age, as evidenced by its deal with AT&T to resell some wireless voice and data products. Even so, this move seems to be only in response to CenturyLink striking a similar deal with Verizon, and I remain dubious that it will help fuel subscriber growth – or even retention.

When watching the video of youth on the bike plummet downward to sure injury, there is one thing you never see; an amazing turnaround that allows him to miraculously gain control and begin going back up. At such high speeds, along with other forces, it is impossible. Regrettably, it is the same with Frontier. With its foolish purchase of outdated (or quickly becoming so) equipment, its frustrating investors by slashing dividends in order to pay for the equipment, and the cycle of ‘lose-lines-lose-customers’ that it seems locked into, I see no hope for a turnaround.

Summary

Even at the current share price of around $4 per share, more than 70% below the five-year high of $16, I predict shareholders will suffer negative returns as the company flounders. On the other hand, forward thinking companies such as CenturyLink, currently around $39 per share, continues to show itself as a viable and secure investment. I believe this company makes strategic moves to stay competitive, proven by its third place ranking in the telecommunications industry.

 


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