FAIRPOINT COMMUNICATIONS INC FRP
February 13, 2014 - 5:25pm EST by
jdr907
2014 2015
Price: 13.30 EPS $0.00 $0.00
Shares Out. (in M): 27 P/E 0.0x 0.0x
Market Cap (in $M): 352 P/FCF 9.9x 6.7x
Net Debt (in $M): 940 EBIT 0 0
TEV ($): 1,292 TEV/EBIT 0.0x 0.0x

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  • Technology
  • Telecommunications
  • M&A target
  • Deleveraging

Description

Fairpoint Communications, was written up in October, 2012 by dionis589.  Much of what he had forecasted to move the stock, has played out.  However, there are several catalyts ahead, which could lead to a significant re-rating of the stock, and provide upside of over 50%.  Stock currently trades with a 15% 2014 FCF yield and a 20% 2015 FCF yield, given conservative forecats.  
 
 
Price $13.30       2013 2014 2015
Shares Out 26.50   EV/EBITDA   4.9x 4.7x 4.4x
Market cap  $   352.5   FCF Yield   10.1% 14.8% 20.1%
Debt        965.0   P/FCF   9.9x 6.7x 5.0x
Cash         25.0            
   $ 1,292.5            
  • Fairpoint, a rural local exchange carrier (RLEC), which prior to 2008 operated in rural markets in 15 states, acquired the Northern New England (Vermont, New Hampshire & Maine) wireline business from Verizon in March, 2008.  The company levered up enormously, and utterly botched the integration of the company.  This culminated in a bankruptcy filing in October, 2009, with $2.5 billion in debt.  The company exited Chapter 11 in January, 2011 at $25/shr,  still over levered at 4x with $1 billion in debt. 
  • New management came in during the bankruptcy process, and worked to complete the integration of Northern New England, with the goal of stabilizing the operations. 
  • The company laid out a consistent 4 point strategy at that time, which it has effectively executed on:
    • Improve Operations
    • Execute HR Strategy
    • Change the Regulatory Environment
    • Transform and Grow Revenue
Taking each one of these: 
  • Improve Operations: The company has largely completed this - through system integration, improved product management, increased customer service, reduced churn which has manifested itself in a stabilized top line on a quarter over quarter basis, at a quarterly runrate of ~$234 million / quarter.  In Q3 it was slightly higher at $236, but this should ebb and flow in the near term. 
    • Recently, company has worked to strenghten the credit profile of customers, by increasing credit standards, and reducing the costs associated with collections.  These include taking deposits for lower quality customers, and taking collection actions sooner on delinquent customers. 
    • Exited a NECA DSL pool for regulatory settlement - which caused a drop of $1.6 mm in quarterly revenue - which came with a negative margin of 180k
     
  • Human Resource Strategy:  This is the operational category that offers huge potential upside   
    • Company has accomplished a 21% workforce reduction in the past 2 1/2 years, going from about 4,000 employees to 3,182 as of Sep 30, 2013.  Of those, 2,025 are represented by unions  (1,782 of those covered by collective bargaining agreements with the CWA, IBEW and NNE which expire August 2014.
    • The expiration of the collective bargaining agreement will allow FRP to deal with everything ranging from the Pension & OPEB plans, workplace rules and salaries.
    • The current CBA they are operating under, is a relic of the acquisition of NNE from Verizon - it was not restructured or amended during the bankruptcy process.  There is only potential upside from this negotiation (putting aside potential for near term disruptions). In the meantime, both Verizon, AT&T, Hawaii Telecom and Frontier (both own large chunks of legacy VZ wireline assets) have renegotiated and restructured their agreements. 
      • Current workforce rules are inconsistent with recent negotiations  - unlimited sick days, fully funded medical retirement, defined benefit plan
      • Current unfunded pension liability is ~$210 million (plan assets of $168 m vs. obligations of $378m, while OPEB is unfunded by $658 million.
      • GAAP valuation assumes current contract existing in perpetuity to all employees
      • Fairpoint is not responsible for anybody that retired from the NNE Verizon assets prior to the acquisition from Verizon.  
      • An increase in interest rates + 2013 return expectations should reduce the unfunded obligation under GAAP in 2014
      • Almost 50% of the company's expenses are personnel related. EBITDA margins now stand in the 27-29% range.  
        • Comparable EBITDA margins - FTR 46%, CTL 39%, WIN 38%, CNSL 46%, HCOM 30%
        • The company has indicated that it needs flexibility to fully rightsize its operations. On an employee per 1000 access lines metric, the company sits at 3.55, ahead of Frontier at 3, Centurylink at 3.4 and overall peer average of 3.3 - giving ample room to cut add'l costs from downsizing, once they gain union concessions.
        • 65% of bonus performance goals for management in 2014 are related to EBITDA or FCF margins - showing the motivation mgmt has
      • Recent Union negotiations & outcomes
        • Hawaii telecom negotiation finalized Dec, 2012 led to a) annual wage increases of 1% b) 401k matching but frozen pension c) 10% employee contribution to health insurance premiums d) sick leave limited to 8 weeks.  Appeals by the Unions to the NLRB were rejected
        • Frontier Telecom a) limited annual wage increases b) 401k matching but frozen pension c) increase in employee contribution to health insurance premiums d) limited sick leave.  
      • I model no opex benefit in 2014, and only operational improvements in 2015 that expand margins by 100 bps
        • Include stable cash pension contributions in 2014/2015
        • Risk of work stoppage in 2H 2014 - although they believe they have amply prepared the business to minimize any disruption to customers in the event of a strike.   
  • Change Regulatory Environment: This piece of the operational turnaround is also largely complete.
    • FRP has continued to work with state PUCs - to minimize the regulatory requirements, and potential penalties for regulatory breaches.  Many of these were conditions from the original acquisition from Verizon -but also led to the enormous market share loss in both the business and residential markets.   
      • In April 2011, FRP negotiated with Vermont to signifcantly reduce exposure to retail 'Service Quality Index' (SQI) penalties, and in March 2013 these penalties were completely eliminated.
      • In 2012, regulation was enacted by New Hampshire and Maine decreasing the scope of the retail telecom regulation - eliminating many of the meger conditions, and increasing flexiblity to compete in the marketplace.  These laws leveled the playing field vs. regulatory requirements of other competing carriers
      • In 2012 - SQI penalties were eliminated in New Hampshire, and the maximum exposure in Maine was reduced from $12.5 mm to $2 mm.  
  • Stabilize Transform & Grow Revenue:  The company has stabilized the top line - but there is still room to go here to grow revenues
    • The company is squarely focused on the enterprise and SMB market, operating almost as a competitive carrier given that it has under a 25% share of the business market - significantly below what an incumbent carrier typically would have.   FTTT, Ethernet & business penetration are helping drive revenue stabilization
    • Fiber to the Tower (FTTT) - A large focus in 2010-2013 that is now paying off.  1,600 wireless towers in their footprint, added 800 in 2011 which are now contributing 2x the revenue that the comparable T1 connection previously did.  By the end of 2013, they believe they will be at about 1,000 towers, with contracts to grow that to 1,300.  
    • New England Teleheatlh Consortium - working to connect over 400 healthcare facilties (from 200 currently) to hospitals/clinics and offer wholesale and enterprise services
    • Revenue mix is shifting within Northern New England - which represents 80% of the revenue. Currently, 31% of total revenue is residential, 24% wholesale (including FTTT) and 20% is business.  The residential is continuing to decline at decelerating rates, as broadband is growing at >20%, while legacy voice continues to decline.  Business and wholesale are also seeing mix shifts - that are seeing slight growth, offsetting consumer declines.   
    • Capex has been declining annually - from $198 million in 2010 to guidance of $130 million in 2013.  There should be one more step-down in revenue, before it normalizes in the low teens of revenue, with roughly 1/3 of capex being success based, 1/3 being network growth and 1/3 that is maintenance.  
    • Wholesale biz:  Recently built fiber footprint down to Boston/New York carrier hotels to offer interconnection to the company's 15,000 fiber network in New England - expect to see a pickup in wholesale revenue into 2014
    • Residential - 1.3 million access lines of a total of 2.1 mm that have been upgraded to speeds of 7+ mbps, with penetration south of 10% in those areas.  Seeing increasing penetration post network upgrades -as they take lost share back from cable operators. 
    • In Q3 - the company was able to institute selective price increases in legacy voice and long distance services, helping to mitigate continued declines in access lines (7.2% in Q3) 
    • Focused on having and training the right salespeople - enterprise bookings were up 25-30% q/q in Q3
 
Fairpoint Communications      
  2013 2014 2015
Revenue  $    942.0  $     947.3  $     959.6
y/y Growth   0.6% 1.3%
Adj EBITDA  $    265.1  $     274.7  $     290.8
 % Margin 28.1% 29.0% 30.3%
Capex  $    125.8  $     120.8  $     121.8
% of Sales  13.4% 12.8% 12.7%
Cash & OPEB Contribution         25.6           28.0          25.0
UFCF  $    113.7  $     125.9  $     144.0
Interest Expense  $      78.2  $       73.6  $       73.1
Free Cash Flow  $      35.5  $       52.3  $       70.9
FCF/Share $1.34 $1.97 $2.67
Net Debt / LTM EBITDA 3.4x            3.1x 2.7x
       
  • Asset Sales
    • The company operates in 14 other states, that have little synergy with the Northern New England assets.  They are quietly shopping these assets on an individual basis.  Likely buyers would be other small wireline operators with neighboring assets. The company does not have an formal sale process, but they have been open to transactions where they would get full value for the sale.  An acitivst investor (discussed below) is pushing for a sale of these properties. 
    • Sold Idaho asset for 6x EBITDA or $30 mm in cash in November, 2012.  
    • Company has roughly $85 million of EBITDA coming from these assets, that could be divested over time.  Assuming a valuation of 5-6x EBITDA, that could potentially garner $425-$510 million of proceeds, signficicantly higher than the current market cap of $350 million. 
     
  • Initiation of Dividend
    • The company has been hesitant to return any capital to shareholders, or change anything strategically until they have completed the union negotiation.  They want to eliminate any potential leverage points the union has done. This is the reason they refinanced their debt in 2013 - solely to push out maturities, and at pretty high rates - they didn't want the Union to have any ability to use refinancing their debt as a pain point.
    • The company understands that after moving past the union negotiation, they will be in a place - even if the status quo does not change where they have excess cash.  They are targeting leverage in the 3x area, and are at 3.5x currently. Based strictly on cash flow generation, and EBITDA growth, the company will be there by the end of 2014.  
    • Looking at the base case, which includes no benefits from successful employee negotiations, and consistent pension and OPEB cash contributions, and assuming a range of sustainable payout ratios of 50-60%, a dividend yield of 7.5% to 8% - consistent with CTL, CNSL - but lower than FTR/WIN - gets a price target of ~$20, or about 50% higher than the current stock price.


      Stock Price Based on Dividend Yield on Base Case
        Dividend Payout Ratio
        40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0%
    Dividend Yield 7.00%  $  15.28  $ 17.19  $  19.10  $  21.01  $  22.92  $  24.83  $  26.74
    7.25%  $  14.76  $ 16.60  $  18.44  $  20.29  $  22.13  $  23.98  $  25.82
    7.50%  $  14.26  $ 16.05  $  17.83  $  19.61  $  21.40  $  23.18  $  24.96
    7.75%  $  13.80  $ 15.53  $  17.25  $  18.98  $  20.71  $  22.43  $  24.16
    8.00%  $  13.37  $ 15.04  $  16.72  $  18.39  $  20.06  $  21.73  $  23.40
    8.25%  $  12.97  $ 14.59  $  16.21  $  17.83  $  19.45  $  21.07  $  22.69
    8.50%  $  12.59  $ 14.16  $  15.73  $  17.31  $  18.88  $  20.45  $  22.02
    8.75%  $  12.23  $ 13.75  $  15.28  $  16.81  $  18.34  $  19.87  $  21.40
                     
                     
      Upside to Stock Price Based on Dividend Yield on Base Case
        Dividend Payout Ratio
        40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0%
    Dividend Yield 7.00% 14.9% 29.3% 43.6% 58.0% 72.4% 86.7% 101.1%
    7.25% 10.9% 24.8% 38.7% 52.5% 66.4% 80.3% 94.2%
    7.50% 7.2% 20.7% 34.1% 47.5% 60.9% 74.3% 87.7%
    7.75% 3.8% 16.8% 29.7% 42.7% 55.7% 68.7% 81.6%
    8.00% 0.5% 13.1% 25.7% 38.2% 50.8% 63.4% 75.9%
    8.25% -2.5% 9.7% 21.9% 34.1% 46.2% 58.4% 70.6%
    8.50% -5.4% 6.5% 18.3% 30.1% 41.9% 53.8% 65.6%
    8.75% -8.1% 3.4% 14.9% 26.4% 37.9% 49.4% 60.9%
                     
     
  • Buyback?
    • Company could also announce a share buyback.  I am forecasting the company to have $136 million of cash by YE 2015 - initiating a $50 million buyback - would retire 15% of the float.  
  • Upside from Union Negotiation
    • Base case financials assume marginal growth on the top line, and ~100 bps margin improvement / yr from continued cost synergies, but don't assume any significant benefit to EBITDA margins, or reduction in cash Pension & OPEB contributions.  
    • Currently looking at $25 million in 2015 of pension contributions (2013 of $25, 2014 guidance of $28), and margins of about 30% in 2015.  This gets to a current 2015 Free Cash Flow Yield after Pension contributions of 19%.  
    • Upside from margin improvement, or lower annual pension contributions gets to Free Cash Flow yields between 20-30% - which also offers upside to the dividend analysis above. 
  Free Cash Flow Yield
    EBITDA Margin Change from Base Case
    -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0%
Annual Pension Contribution  $  10.0 21.6% 24.4% 27.1% 29.8% 32.5% 35.3% 38.0%
 $  12.5 20.9% 23.7% 26.4% 29.1% 31.8% 34.5% 37.3%
 $  15.0 20.2% 22.9% 25.7% 28.4% 31.1% 33.8% 36.6%
 $  17.5 19.5% 22.2% 25.0% 27.7% 30.4% 33.1% 35.8%
 $  20.0 18.8% 21.5% 24.2% 27.0% 29.7% 32.4% 35.1%
 $  22.5 18.1% 20.8% 23.5% 26.3% 29.0% 31.7% 34.4%
 $  25.0 17.4% 20.1% 22.8% 25.6% 28.3% 31.0% 33.7%
 $  27.5 16.7% 19.4% 22.1% 24.8% 27.6% 30.3% 33.0%
                 
                 

  • Debt Refinancing
    • The company refinanced its debt in 2013 - but the average cost of debt is 7.9%.  The $300 mm  of 8 3/4 Senior Secured Notes are currently trading at 107.375 or ~8%.  
      • They are callable now - but at a price of 107 until February, 2016
    • The $635 mm Term Loan yielding L+625 bps, with a Libor Floor of 125 bps is currently trading at 103.5
  • Activist Investor
    • Maglan Capital currently owns 6% of Fairpoint, and has been vocal in its interest in Fairpoint returning cash to shareholders.  While they have had conversations, the company has only pushed back, kneeling behind the view that they don't want to return any cash to shareholders ahead of the union negotiations
    • In a letter in November, 2013 - Maglan again reiterated that the Company should institute a recurring dividend and/or implement a substantial share repurchase.
    • Maglan proposes increasing the board to 9 from 8 directors, and electing 3 new directors.  They then comment that if the Board does not work with Maglan, they will look to elect their own directors at the 2014 annual meeting
    • Maglan filed its financial projections - which are significantly above my 2015 estimates with FCF of $88 mm or $3.33 per share  (vs. my $70mm or $2.67).   They are looking for a 65% dividend payout ratio. 
  • No Cash Taxes
    • Fairpoint has a $200 mm NOL - and will not pay cash taxes for the foreseeable future
 
  • Catalysts
    • Union negotiation leading to lower opex + lower pension obligations
    • Continued top line improvements.  Company will give inital 2014 guidance on its Q4 earnings call in a few weeks
    • Continued cash flow generation should bring about initiation of a dividend in late 2014 or 2015 or buyback - think dividend is more likley
    • Additional asset sales of the other 14 states
    • Activist investor who is looking for cash returns-  potential for new BoD
    • Results should continue to trend well
    • Debt refinancing
    • Sell side coverage - Only actively currently covered by 3 firms - Stifel, Jeffries and Drexel Hamilton.  Potential for some more interest from the sellside
  • Risks
    • Although they believe they are at a period of revenue stabilization and growth into the future, there are mix shifts going on with various revenue streams - timing of winning new enterprise wins vs. continued decline in residential could cause some lumpiness in quarterly trends
    • Unfavorable union negotation outcome
    • Strike by the unions - causing negative publicity.  Customer service issues etc. 
    • Poor execution in either enterprise segment or churn accelerating in residential business
    • 3% of revenues tied to USF/ICC and other regulatory schemes - the FCC is replacing these with other regulatory regimes like Connect America fund (CAF) which are supposed to subsidize broadband, rather than traditional voice lines.  But this high margin revenue could be at risk in the future. 
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 
  • Union negotiation leading to lower opex + lower pension obligations
  • Continued top line improvements.  Company will give inital 2014 guidance on its Q4 earnings call in a few weeks
  • Continued cash flow generation should bring about initiation of a dividend in late 2014 or 2015 or buyback - think dividend is more likely
  • Additional asset sales of the 14 states not in Norther New England
  • Activist investor who is looking for cash returns-  potential for new BoD
  • Results should continue to trend well
  • Debt refinancing
  • Sell side coverage - Only actively currently covered by 3 firms - Stifel, Jeffries and Drexel Hamilton.  Potential for some more interest from the sellside
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    Description

    Fairpoint Communications, was written up in October, 2012 by dionis589.  Much of what he had forecasted to move the stock, has played out.  However, there are several catalyts ahead, which could lead to a significant re-rating of the stock, and provide upside of over 50%.  Stock currently trades with a 15% 2014 FCF yield and a 20% 2015 FCF yield, given conservative forecats.  
     
     
    Price $13.30       2013 2014 2015
    Shares Out 26.50   EV/EBITDA   4.9x 4.7x 4.4x
    Market cap  $   352.5   FCF Yield   10.1% 14.8% 20.1%
    Debt        965.0   P/FCF   9.9x 6.7x 5.0x
    Cash         25.0            
       $ 1,292.5            
    • Fairpoint, a rural local exchange carrier (RLEC), which prior to 2008 operated in rural markets in 15 states, acquired the Northern New England (Vermont, New Hampshire & Maine) wireline business from Verizon in March, 2008.  The company levered up enormously, and utterly botched the integration of the company.  This culminated in a bankruptcy filing in October, 2009, with $2.5 billion in debt.  The company exited Chapter 11 in January, 2011 at $25/shr,  still over levered at 4x with $1 billion in debt. 
    • New management came in during the bankruptcy process, and worked to complete the integration of Northern New England, with the goal of stabilizing the operations. 
    • The company laid out a consistent 4 point strategy at that time, which it has effectively executed on:
      • Improve Operations
      • Execute HR Strategy
      • Change the Regulatory Environment
      • Transform and Grow Revenue
    Taking each one of these: 
    • Improve Operations: The company has largely completed this - through system integration, improved product management, increased customer service, reduced churn which has manifested itself in a stabilized top line on a quarter over quarter basis, at a quarterly runrate of ~$234 million / quarter.  In Q3 it was slightly higher at $236, but this should ebb and flow in the near term. 
      • Recently, company has worked to strenghten the credit profile of customers, by increasing credit standards, and reducing the costs associated with collections.  These include taking deposits for lower quality customers, and taking collection actions sooner on delinquent customers. 
      • Exited a NECA DSL pool for regulatory settlement - which caused a drop of $1.6 mm in quarterly revenue - which came with a negative margin of 180k
       
    • Human Resource Strategy:  This is the operational category that offers huge potential upside   
      • Company has accomplished a 21% workforce reduction in the past 2 1/2 years, going from about 4,000 employees to 3,182 as of Sep 30, 2013.  Of those, 2,025 are represented by unions  (1,782 of those covered by collective bargaining agreements with the CWA, IBEW and NNE which expire August 2014.
      • The expiration of the collective bargaining agreement will allow FRP to deal with everything ranging from the Pension & OPEB plans, workplace rules and salaries.
      • The current CBA they are operating under, is a relic of the acquisition of NNE from Verizon - it was not restructured or amended during the bankruptcy process.  There is only potential upside from this negotiation (putting aside potential for near term disruptions). In the meantime, both Verizon, AT&T, Hawaii Telecom and Frontier (both own large chunks of legacy VZ wireline assets) have renegotiated and restructured their agreements. 
        • Current workforce rules are inconsistent with recent negotiations  - unlimited sick days, fully funded medical retirement, defined benefit plan
        • Current unfunded pension liability is ~$210 million (plan assets of $168 m vs. obligations of $378m, while OPEB is unfunded by $658 million.
        • GAAP valuation assumes current contract existing in perpetuity to all employees
        • Fairpoint is not responsible for anybody that retired from the NNE Verizon assets prior to the acquisition from Verizon.  
        • An increase in interest rates + 2013 return expectations should reduce the unfunded obligation under GAAP in 2014
        • Almost 50% of the company's expenses are personnel related. EBITDA margins now stand in the 27-29% range.  
          • Comparable EBITDA margins - FTR 46%, CTL 39%, WIN 38%, CNSL 46%, HCOM 30%
          • The company has indicated that it needs flexibility to fully rightsize its operations. On an employee per 1000 access lines metric, the company sits at 3.55, ahead of Frontier at 3, Centurylink at 3.4 and overall peer average of 3.3 - giving ample room to cut add'l costs from downsizing, once they gain union concessions.
          • 65% of bonus performance goals for management in 2014 are related to EBITDA or FCF margins - showing the motivation mgmt has
        • Recent Union negotiations & outcomes
          • Hawaii telecom negotiation finalized Dec, 2012 led to a) annual wage increases of 1% b) 401k matching but frozen pension c) 10% employee contribution to health insurance premiums d) sick leave limited to 8 weeks.  Appeals by the Unions to the NLRB were rejected
          • Frontier Telecom a) limited annual wage increases b) 401k matching but frozen pension c) increase in employee contribution to health insurance premiums d) limited sick leave.  
        • I model no opex benefit in 2014, and only operational improvements in 2015 that expand margins by 100 bps
          • Include stable cash pension contributions in 2014/2015
          • Risk of work stoppage in 2H 2014 - although they believe they have amply prepared the business to minimize any disruption to customers in the event of a strike.   
    • Change Regulatory Environment: This piece of the operational turnaround is also largely complete.
      • FRP has continued to work with state PUCs - to minimize the regulatory requirements, and potential penalties for regulatory breaches.  Many of these were conditions from the original acquisition from Verizon -but also led to the enormous market share loss in both the business and residential markets.   
        • In April 2011, FRP negotiated with Vermont to signifcantly reduce exposure to retail 'Service Quality Index' (SQI) penalties, and in March 2013 these penalties were completely eliminated.
        • In 2012, regulation was enacted by New Hampshire and Maine decreasing the scope of the retail telecom regulation - eliminating many of the meger conditions, and increasing flexiblity to compete in the marketplace.  These laws leveled the playing field vs. regulatory requirements of other competing carriers
        • In 2012 - SQI penalties were eliminated in New Hampshire, and the maximum exposure in Maine was reduced from $12.5 mm to $2 mm.  
    • Stabilize Transform & Grow Revenue:  The company has stabilized the top line - but there is still room to go here to grow revenues
      • The company is squarely focused on the enterprise and SMB market, operating almost as a competitive carrier given that it has under a 25% share of the business market - significantly below what an incumbent carrier typically would have.   FTTT, Ethernet & business penetration are helping drive revenue stabilization
      • Fiber to the Tower (FTTT) - A large focus in 2010-2013 that is now paying off.  1,600 wireless towers in their footprint, added 800 in 2011 which are now contributing 2x the revenue that the comparable T1 connection previously did.  By the end of 2013, they believe they will be at about 1,000 towers, with contracts to grow that to 1,300.  
      • New England Teleheatlh Consortium - working to connect over 400 healthcare facilties (from 200 currently) to hospitals/clinics and offer wholesale and enterprise services
      • Revenue mix is shifting within Northern New England - which represents 80% of the revenue. Currently, 31% of total revenue is residential, 24% wholesale (including FTTT) and 20% is business.  The residential is continuing to decline at decelerating rates, as broadband is growing at >20%, while legacy voice continues to decline.  Business and wholesale are also seeing mix shifts - that are seeing slight growth, offsetting consumer declines.   
      • Capex has been declining annually - from $198 million in 2010 to guidance of $130 million in 2013.  There should be one more step-down in revenue, before it normalizes in the low teens of revenue, with roughly 1/3 of capex being success based, 1/3 being network growth and 1/3 that is maintenance.  
      • Wholesale biz:  Recently built fiber footprint down to Boston/New York carrier hotels to offer interconnection to the company's 15,000 fiber network in New England - expect to see a pickup in wholesale revenue into 2014
      • Residential - 1.3 million access lines of a total of 2.1 mm that have been upgraded to speeds of 7+ mbps, with penetration south of 10% in those areas.  Seeing increasing penetration post network upgrades -as they take lost share back from cable operators. 
      • In Q3 - the company was able to institute selective price increases in legacy voice and long distance services, helping to mitigate continued declines in access lines (7.2% in Q3) 
      • Focused on having and training the right salespeople - enterprise bookings were up 25-30% q/q in Q3
     
    Fairpoint Communications      
      2013 2014 2015
    Revenue  $    942.0  $     947.3  $     959.6
    y/y Growth   0.6% 1.3%
    Adj EBITDA  $    265.1  $     274.7  $     290.8
     % Margin 28.1% 29.0% 30.3%
    Capex  $    125.8  $     120.8  $     121.8
    % of Sales  13.4% 12.8% 12.7%
    Cash & OPEB Contribution         25.6           28.0          25.0
    UFCF  $    113.7  $     125.9  $     144.0
    Interest Expense  $      78.2  $       73.6  $       73.1
    Free Cash Flow  $      35.5  $       52.3  $       70.9
    FCF/Share $1.34 $1.97 $2.67
    Net Debt / LTM EBITDA 3.4x            3.1x 2.7x
           
    • Asset Sales
      • The company operates in 14 other states, that have little synergy with the Northern New England assets.  They are quietly shopping these assets on an individual basis.  Likely buyers would be other small wireline operators with neighboring assets. The company does not have an formal sale process, but they have been open to transactions where they would get full value for the sale.  An acitivst investor (discussed below) is pushing for a sale of these properties. 
      • Sold Idaho asset for 6x EBITDA or $30 mm in cash in November, 2012.  
      • Company has roughly $85 million of EBITDA coming from these assets, that could be divested over time.  Assuming a valuation of 5-6x EBITDA, that could potentially garner $425-$510 million of proceeds, signficicantly higher than the current market cap of $350 million. 
       
    • Initiation of Dividend
      • The company has been hesitant to return any capital to shareholders, or change anything strategically until they have completed the union negotiation.  They want to eliminate any potential leverage points the union has done. This is the reason they refinanced their debt in 2013 - solely to push out maturities, and at pretty high rates - they didn't want the Union to have any ability to use refinancing their debt as a pain point.
      • The company understands that after moving past the union negotiation, they will be in a place - even if the status quo does not change where they have excess cash.  They are targeting leverage in the 3x area, and are at 3.5x currently. Based strictly on cash flow generation, and EBITDA growth, the company will be there by the end of 2014.  
      • Looking at the base case, which includes no benefits from successful employee negotiations, and consistent pension and OPEB cash contributions, and assuming a range of sustainable payout ratios of 50-60%, a dividend yield of 7.5% to 8% - consistent with CTL, CNSL - but lower than FTR/WIN - gets a price target of ~$20, or about 50% higher than the current stock price.


        Stock Price Based on Dividend Yield on Base Case
          Dividend Payout Ratio
          40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0%
      Dividend Yield 7.00%  $  15.28  $ 17.19  $  19.10  $  21.01  $  22.92  $  24.83  $  26.74
      7.25%  $  14.76  $ 16.60  $  18.44  $  20.29  $  22.13  $  23.98  $  25.82
      7.50%  $  14.26  $ 16.05  $  17.83  $  19.61  $  21.40  $  23.18  $  24.96
      7.75%  $  13.80  $ 15.53  $  17.25  $  18.98  $  20.71  $  22.43  $  24.16
      8.00%  $  13.37  $ 15.04  $  16.72  $  18.39  $  20.06  $  21.73  $  23.40
      8.25%  $  12.97  $ 14.59  $  16.21  $  17.83  $  19.45  $  21.07  $  22.69
      8.50%  $  12.59  $ 14.16  $  15.73  $  17.31  $  18.88  $  20.45  $  22.02
      8.75%  $  12.23  $ 13.75  $  15.28  $  16.81  $  18.34  $  19.87  $  21.40
                       
                       
        Upside to Stock Price Based on Dividend Yield on Base Case
          Dividend Payout Ratio
          40.0% 45.0% 50.0% 55.0% 60.0% 65.0% 70.0%
      Dividend Yield 7.00% 14.9% 29.3% 43.6% 58.0% 72.4% 86.7% 101.1%
      7.25% 10.9% 24.8% 38.7% 52.5% 66.4% 80.3% 94.2%
      7.50% 7.2% 20.7% 34.1% 47.5% 60.9% 74.3% 87.7%
      7.75% 3.8% 16.8% 29.7% 42.7% 55.7% 68.7% 81.6%
      8.00% 0.5% 13.1% 25.7% 38.2% 50.8% 63.4% 75.9%
      8.25% -2.5% 9.7% 21.9% 34.1% 46.2% 58.4% 70.6%
      8.50% -5.4% 6.5% 18.3% 30.1% 41.9% 53.8% 65.6%
      8.75% -8.1% 3.4% 14.9% 26.4% 37.9% 49.4% 60.9%
                       
       
    • Buyback?
      • Company could also announce a share buyback.  I am forecasting the company to have $136 million of cash by YE 2015 - initiating a $50 million buyback - would retire 15% of the float.  
    • Upside from Union Negotiation
      • Base case financials assume marginal growth on the top line, and ~100 bps margin improvement / yr from continued cost synergies, but don't assume any significant benefit to EBITDA margins, or reduction in cash Pension & OPEB contributions.  
      • Currently looking at $25 million in 2015 of pension contributions (2013 of $25, 2014 guidance of $28), and margins of about 30% in 2015.  This gets to a current 2015 Free Cash Flow Yield after Pension contributions of 19%.  
      • Upside from margin improvement, or lower annual pension contributions gets to Free Cash Flow yields between 20-30% - which also offers upside to the dividend analysis above. 
      Free Cash Flow Yield
        EBITDA Margin Change from Base Case
        -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0%
    Annual Pension Contribution  $  10.0 21.6% 24.4% 27.1% 29.8% 32.5% 35.3% 38.0%
     $  12.5 20.9% 23.7% 26.4% 29.1% 31.8% 34.5% 37.3%
     $  15.0 20.2% 22.9% 25.7% 28.4% 31.1% 33.8% 36.6%
     $  17.5 19.5% 22.2% 25.0% 27.7% 30.4% 33.1% 35.8%
     $  20.0 18.8% 21.5% 24.2% 27.0% 29.7% 32.4% 35.1%
     $  22.5 18.1% 20.8% 23.5% 26.3% 29.0% 31.7% 34.4%
     $  25.0 17.4% 20.1% 22.8% 25.6% 28.3% 31.0% 33.7%
     $  27.5 16.7% 19.4% 22.1% 24.8% 27.6% 30.3% 33.0%
                     
                     

    • Debt Refinancing
      • The company refinanced its debt in 2013 - but the average cost of debt is 7.9%.  The $300 mm  of 8 3/4 Senior Secured Notes are currently trading at 107.375 or ~8%.  
        • They are callable now - but at a price of 107 until February, 2016
      • The $635 mm Term Loan yielding L+625 bps, with a Libor Floor of 125 bps is currently trading at 103.5
    • Activist Investor
      • Maglan Capital currently owns 6% of Fairpoint, and has been vocal in its interest in Fairpoint returning cash to shareholders.  While they have had conversations, the company has only pushed back, kneeling behind the view that they don't want to return any cash to shareholders ahead of the union negotiations
      • In a letter in November, 2013 - Maglan again reiterated that the Company should institute a recurring dividend and/or implement a substantial share repurchase.
      • Maglan proposes increasing the board to 9 from 8 directors, and electing 3 new directors.  They then comment that if the Board does not work with Maglan, they will look to elect their own directors at the 2014 annual meeting
      • Maglan filed its financial projections - which are significantly above my 2015 estimates with FCF of $88 mm or $3.33 per share  (vs. my $70mm or $2.67).   They are looking for a 65% dividend payout ratio. 
    • No Cash Taxes
      • Fairpoint has a $200 mm NOL - and will not pay cash taxes for the foreseeable future
     
    • Catalysts
      • Union negotiation leading to lower opex + lower pension obligations
      • Continued top line improvements.  Company will give inital 2014 guidance on its Q4 earnings call in a few weeks
      • Continued cash flow generation should bring about initiation of a dividend in late 2014 or 2015 or buyback - think dividend is more likley
      • Additional asset sales of the other 14 states
      • Activist investor who is looking for cash returns-  potential for new BoD
      • Results should continue to trend well
      • Debt refinancing
      • Sell side coverage - Only actively currently covered by 3 firms - Stifel, Jeffries and Drexel Hamilton.  Potential for some more interest from the sellside
    • Risks
      • Although they believe they are at a period of revenue stabilization and growth into the future, there are mix shifts going on with various revenue streams - timing of winning new enterprise wins vs. continued decline in residential could cause some lumpiness in quarterly trends
      • Unfavorable union negotation outcome
      • Strike by the unions - causing negative publicity.  Customer service issues etc. 
      • Poor execution in either enterprise segment or churn accelerating in residential business
      • 3% of revenues tied to USF/ICC and other regulatory schemes - the FCC is replacing these with other regulatory regimes like Connect America fund (CAF) which are supposed to subsidize broadband, rather than traditional voice lines.  But this high margin revenue could be at risk in the future. 
    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     
    • Union negotiation leading to lower opex + lower pension obligations
    • Continued top line improvements.  Company will give inital 2014 guidance on its Q4 earnings call in a few weeks
    • Continued cash flow generation should bring about initiation of a dividend in late 2014 or 2015 or buyback - think dividend is more likely
    • Additional asset sales of the 14 states not in Norther New England
    • Activist investor who is looking for cash returns-  potential for new BoD
    • Results should continue to trend well
    • Debt refinancing
    • Sell side coverage - Only actively currently covered by 3 firms - Stifel, Jeffries and Drexel Hamilton.  Potential for some more interest from the sellside
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