|Shares Out. (in M):||27||P/E||0.0x||0.0x|
|Market Cap (in $M):||240||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||1,013||EBIT||0||0|
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Fairpoint Communications - Long - (COMP: FRP)July 2011 - $8.83
Fairpoint Communications ("Fairpoint", "FRP" or the "Company") is an attractive long at current levels, with asymmetric risk / reward characteristics. I think shares are worth at least $15 over the near-term and potentially closer to $20+ over the mid / long-term. FRP is a recently emerged post-reorg equity, which has sold off 65% since emergence, on legitimate concerns, but I believe an operational turnaround is much closer than the market believes. Customer service metrics have and will continue to improve, given FRP's recent broadband investments, improved processes and systems and upgraded management. The improved customer service is leading to reductions in churn, which will allow FRP to pursue cost saving initiatives, which have not yet been announced, but I believe are increasingly likely in the second half of 2011. The Company may never achieve peer-level profitability, nor receive a "market" multiple, but at these levels, the Company only needs to show a reasonable degree of operational stability to be re-rated. At 4.2x my base case 2012E EBITDA, and 30% free cash flow to equity, FRP is a long.
Company Background and History
Fairpoint is one the nation's largest local exchange carriers ("LEC"), with assets in mid-southeastern states and northern New England. The Company was founded in 1991, with the intent of rolling up RLEC assets in Virginia, North Carolina and other rural regions. The strategy worked well, with Fairpoint growing access lines organically and through acquisitions. The Company maintained excellent profitability levels, had sound financial management, and was well-regarded by the (admittedly small) investor community.
In early 2007, Fairpoint announced the purchase of Verizon's northern New England ("NNE") assets, consisting of incumbent properties in Maine, New Hampshire and Vermont. Verizon, at the time, had executed several divestitures which were designed to lower exposure to legacy assets (see Hawaii Telcom and Idearc, and the subsequent RLEC divestiture to Frontier). Verizon reached an agreement to sell the properties to Fairpoint for $2.7bn, via a reverse Morris trust, which achieved favorable tax benefits for VZ. This transaction, obviously sizable for Fairpoint given limited financial and operational scale, was reviewed for almost one year by the NNE public utility commissions ("PUCs"). The transaction was ultimately approved, although the purchase price was reduced and Fairpoint was forced to agree to several regulatory agreements with the PUCs. These agreements, amongst other things, mandated certain broadband availability levels, provided for recurring customer service checks, and laid the groundwork for what was ultimately a disastrous transaction.
Verizon mandated a "flash" cutover, meaning once the properties were sold and the back-office agreement terminated (FRP paid VZ ~$15mm monthly prior to the cutover), there would be no redundant operating systems or support to manage processes. As everyone now knows, the cutover was a disaster, and Fairpoint suffered tremendously. Customers received incorrect bills, were forced to wait weeks to address the errors and service times, and spiked to (previously) unimaginable levels. There were many other issues, all of which were related, but needless to say these issues created a tremendous amount of negative publicity with the NNE customer base. Making matters worse, cable companies (primarily Time Warner and Comcast, operating the old Adelphia plant) and CLECs were quick to take advantage of FRP's weakened state (the increased competition began during the regulatory review, and continued throughout the bankruptcy; e.g. FRP was an easy target). FRP spent almost ~$30mm in incremental expenses during 1H 2009, brought in CapGemini, and was forced to divert significant management attention towards these issues (nearly 800 additional employees were brought in to help manage the transition). As most know, between a combination of terrible operating performance, poor economic conditions, and a highly levered balance sheet, Fairpoint filed for bankruptcy protection in October 2009.
The Company emerged from bankruptcy in January 2011 with a $1bn exit term loan, and pre-petition secured creditors owning ~90% of the equity. Unsecured noteholders received warrants, along with the rights to a litigation trust (against Verizon). The CEO and CFO were replaced in 2H 2010, along with several middle managers in product development, sales and marketing, and NNE state-level presidents.
Fairpoint has 1.4mm access equivalents ("ALEs"), spread amongst across 33 individual LECs in 12 states. The majority (0.9mm) of ALEs reside in the NNE, down from ~1.4mm in September 2009 and ~2.0mm in March 2008. The balance reside in Virginia, North Carolina, Florida, and other southeastern states, referred to as the Telecom Group. The Telecom Group is generally well-managed, with fewer competitive threats relative to the NNE properties. These divisions are separately managed, and are not integrated from a systems perspective (I think they will divest Telecom Group in the next year). While FRP no longer breaks out details for each division, a large profitability gap exists between the two properties. I've heard that Telecom generates ~$250mm in revenue and ~$110mm in EBITDA, while NNE generates ~$775mm in revenue and ~$150mm in EBITDA. I think they could sell Telecom Group for at least 6x EBITDA.
Employee BaseFairpoint has ~4,000 employees, comprised of ~2,600 unionized employees (primarily in NNE). The vast majority of these unionized employees are represented by the International Brotherhood of Electrical Workers (IBEW) and the Communications Workers of America (CWA). 2,350 of these employees are "protected", meaning they are covered under collective bargaining agreements, which expire in August 2014. The other 250 unionized employees who are unprotected were brought in as temporary help to manage the transition. Now that Fairpoint's operational metrics are stabilizing and "almost there", I expect an announcement in the back half of 2011 regarding the layoff of these employees. The vast majority of these "un-protected" employees will flip into mandatory protection in September 2011, and given the current level of overstaffing, I do not expect management to allow this to happen (the reduction in costs is likely ~$20mm). I also expect an announcement later in 2011 regarding the protected employees, given the Company is significantly overstaffed, by almost any metric.
On this last point, I'd note that the ideal time for Fairpoint to shed these expenses was during bankruptcy. Unfortunately, this was not possible given the significant, ongoing operational issues during 2009 and 2010 (customer service does not typically improve with layoffs). Furthermore, contentious labor disputes are seldom viewed favorably in the local communities, and given the widespread, well-known customer service issues in NNE, workforce reductions were not practical. The re-instated agreements do provide for a joint committee between FRP and the unions, and while this committee is supposed to reduce expenses by ~$25mm annually, I am not optimistic that the joint committee will produce tangible results. The bulk of the workforce related savings will come from negotiated personnel reductions, likely through employee buyouts.
Financial DetailsFRP has struggled financially for many reasons, but from a high-level perspective they have (i) too few access lines per employee and (ii) their employees are overpaid and unproductive (on a relative basis). Consider (i) the numerator has suffered due to churn and customer service issues, while (ii) the denominator has actually grown due to the aforementioned operational issues. In short, I expect line-losses to moderate given the recent historical trends, and continued improvements in customer service and operating metrics. In thinking about the operating model, I'd note the following:
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