By David D. Tawil
I can't even say that FairPoint Communications is
misunderstood. It's not even known.
Originally, FairPoint was a collection of local
telephone exchanges spread throughout the U.S. Now it's the
Charlotte, NC-based operator of the un-sexy business of
land-line telephone and data services to residential and
business customers in 18 states. But the company is a favorite
of short sellers. Unfortunately for them, FairPoint's relative
anonymity is going to be great for the bulls and absolutely
perilous for the shorts.
Despite an enterprise value of about $1.1 billion,
FairPoint's equity has traded near $7 per share, giving it a
total market-capitalization of only $180 million. How did the
stock become so depressed? Short-interest in the company's
stock is gigantic. By last count, shorts were 26% of the
outstanding float (5.1 million of 19.4 million shares, with 54
days to cover). Shares were shorted at prices as low as $3.50,
signaling a belief that FairPoint must be a candidate for a
default or bankruptcy. That couldn't be further from the
Our price target is $25/share. The company is
undervalued by a wide margin.
FairPoint is now valued at about four times its
past year's adjusted EBITDA ($260 million), while peers average
closer to six times, and FairPoint's EBITDA is expected to
grow. We expect EBITDA to grow to $280 million in 2012 and to
$300 million in 2013. In addition, the company's annual capital
expenditures (CapEx) will come down from $176 million in 2011
to $145 million in 2012 and $120 million in 2013.
Ultimately, for most investors in the equity of
telecom companies, it's all about free cash flow and dividends.
With EBITDA moving higher and CapEx coming down, free-cash-flow
will move from $7 million in 2011 to $50 million in 2012 and
$100 million in 2013. With a market capitalization of only $180
million, a 28% free cash flow yield for 2012 and a 55% free
cash flow yield for 2013 is extremely valuable.
So why are the shorts so confident? Partially, it
has to do with a mucked-up acquisition, which has been remedied
by the hard work of new management during the past 18
In 2007, using a lot of leverage, FairPoint
purchased Verizon's telephone network in Maine, New Hampshire
and Vermont (its Northern-New England, or NNE, network).
Through the NNE acquisition, FairPoint increased its revenue
base by six times (in 2007, NNE had revenue
$1.1 billion versus the FairPoint's telecom group revenue of
$283 million), and tripled its debt. Through the acquisition,
FairPoint became the 7th largest local telephone company in the
U.S. (with 1.2 million access lines).
Upon acquisition, FairPoint had difficulty assuming
the operational responsibilities (installation, service,
billing, etc.). The cutover from Verizon's systems took much
longer than expected and was problematic, leading to an
increased cost structure (head-count) and lost market share.
This led to a trip through Chapter 11 bankruptcy, which
concluded in January 2011 with the reduction of FairPoint's
debt load by 60% and the introduction of a new management
Then there's the issue of the company's earnings
margin, which has historically been lower than that of its
competitors as a result of a higher cost structure.
Specifically, FairPoint has higher-than-average capital
expenditures, which will end this year. And, FairPoint has
operated with a higher-than-average workforce, which has
started to be right-sized. With these changes, FairPoint's
EBITDA margin should come into line with the industry average,
leading to increased cash flow.
For the past few years, FairPoint has spent up to
40% of its annual CapEx on the buildout of its NNE network
(this was agreed to with regulators as part of the company's
exit from bankruptcy). That buildout will be completed in 2012
and annual CapEx is expected to fall by $50-60 million (in
2011, CapEx was $176 million; CapEx for the last 12 months is
And by industry measures, FairPoint is considerably
overstaffed. FairPoint's peers average about 340 lines per
employee; at 3,600 employees, FairPoint's staffing was 313
lines/employee (FairPoint, December 2011 investor
presentation). In 2011, FairPoint reduced its headcount from
about 4,000 to about 3,400. Those cuts are expected to save the
company $35 million per year, and FairPoint can continue to
reduce headcount. The 2011 reduction-in-force focused
exclusively on unionized workers among the International
Brotherhood of Electrical Workers; the Communications Workers
of America workforce can be similarly trimmed, leading to about
$70 million of total annual savings.
FairPoint's management has ambitiously predicted
that the second-half of 2012 will be the inflection point for
the company's revenue trend. That is an astounding possibility
for a fixed-line communications company, which, like the rest
of the ground-losing industry, faces competition from cellular
and cable. I know the management team well; they are a very
conservative bunch and they wouldn't set expectations beyond
what they think is achievable.
In NNE, FairPoint is the incumbent carrier (the
main telephone company in each state). On average, incumbent
carriers have greater than 40% market share. FairPoint is well
below the average market share. To address that deficiency,
FairPoint has made serious changes and progress toward greater
penetration. The company's primary focus is on the business
customer. FairPoint has recently hired a chief revenue officer
and, in early 2012, reached landmark legislation in all three
NNE states that allows the company to compete more successfully
with cable providers and competitive local exchange carriers.
Moreover, to date, the company has slowed its voice line loss
to industry-leading levels and has been gaining steam on its
It's not just that the shorts don't know the
fundamental story. They also don't appreciate the precarious
technical position they are in.
More than 50% of FairPoint's equity is concentrated
in a half-dozen investors whose shares are not available for
borrow. In addition, there are limited additional shares
available for borrow; the technical machinations are complete,
now the fundamentals will take over.
The short interest has been building over time.
More equity was shorted even when the share price was below $4.
The only justification for that position is that the company
will head into bankruptcy and the shares will be deemed
Contrary to the thesis necessary to support the
short position, since exiting bankruptcy, FairPoint has
increased its cash position by 400%, and at the end of its
2nd quarter, the company had total
liquidity greater than $100 million. In conclusion, there is no
chance that the company will violate its debt covenants.
Moreover, as a levered equity ($970 million secured debt at
Libor+450 due in 2016), any expansion in the company's
valuation multiple will have a particularly intense effect on
the share price.
Moreover, on September 4, 2012, FairPoint made a
voluntary payment of $25 million on its secured debt.
Management is basically saying they are comfortable with the
operations and cash flow generation and that the cash is better
utilized to pay down debt.
The company's path forward is clear. All of the
growth is in NNE. By contrast, the telecom group is mature and
ripe for divestiture. The company can and should monetize those
assets (which have been kept operationally separate from the
NNE assets) and use the proceeds to retire debt and
Next, the company will be able to refinance its
remaining debt (to allow for equity dividends, among other
things) and continue to optimize operations in NNE.
By the end of 2013, FairPoint can achieve $100
million of pro forma net free cash flow. A
50%+ equity dividend is stupendous. Shorts sellers: Watch
David D. Tawil is co-founder and
portfolio manager for Maglan Capital, a New York hedge fund
focused on distressed and event-driven investments.