Distressed Debt Analysis - Fairpoint

Every few months, I post a recent idea from the distressed debt investors club. As a reference to readers, there are about 150 members on the site with over 2000 guests (guests see the ideas on a 50 day delay). In addition, over the past month, over 20 ideas have been submitted to the site. I really could not be happier with the success and encourage all those able to apply. Remember, at 250 members, I will close the application process. With that in mind, here is a recent distressed debt idea on Fairpoint Communications.

Fairpoint Communications: Distressed Debt Analysis

FairPoint ("Company") is a rural telephone company with over 1.2M access line equivalents (ALE). Company is based in Charlotte, NC and operates 33 Local Exchange Carriers (LECs) in 18 states. Company offers telephony, high speed and video services to its customers. Approximately 63% of access lines provide service to residential customers, 29% serve business customers and the rest are wholesale lines.

Prior to acquisition of the Verizon New England lines in March 2008, Company was a public company with a little over 300K lines. FairPoint acquired 1.6M lines from Verizon which were located in Maine, New Hampshire and Vermont. The $2.7B acquisition was funded with $1.8B term loan, $551M of bonds and 54M of Fairpoint shares (pro-forma, Verizon owned 60% of Fairpoint). The agreement with Verizon allowed Fairpoint to use Verizon systems for operating functions (including IT, accounting, HR, billing etc) under a Transition Services Agreement (TSA) while the Company built new systems to accommodate the acquisition. Capgemini was hired to build the new systems under a $160M contract.

The original transition date was September 2008. The new systems were not ready for transition in September and the cut-over date was pushed out to January 2009. Fairpoint started experiencing problems following the January cut-over. Processing times for new orders spiked and billing and collection systems experienced serious issues. Customer service call volumes increased and Company was overwhelmed. Customer frustration translated to increased churn and attracted regulatory attention. As quality of service slipped, the Public Utility Commissions (PUC) (regulate the telecom companies) in Maine, New Hampshire and Vermont imposed penalties on Fairpoint. FairPoint started incurring large incremental expenses as it threw all resources it could to deal with cutover issues. Bad debt due to poor collection, additional expenses to solve the transition issues and penalties caused the Company’s EBITDA margins to drop meaningfully below its peers.

Fairpoint had approximately $2.5bn of pro forma debt outstanding. Financial leverage issues coupled with the problems it incurred in its transition process are the primary reasons Fairpoint found itself in financial distress. The Company exchanged a portion of its bonds for PIK bonds to comply with financial covenants in the bank debt. But increased costs and transition problems made a bankruptcy filing inevitable. The Company filed for Chapter 11 on October 26, 2009 in the Southern District of New York. In the initial plan proposed by the Company, the bank debt holders were to receive 98% of the equity and the bond holders were to receive the remaining 2%. The bond holders started throwing roadblocks into the bankruptcy process, including a request to appoint an examiner. The company filed a new plan on Feb, 08 2010 which has the support of bank debt holders and bond holders. Under the new plan bank debt holders and bond holders received 92% and 8% of the equity respectively ( In addition the bank debt holders will receive excess cash at emergence and bond holders will receive warrants for an additional 12% of the Company at a strike price implied by $2.3B enterprise value). Further, the company renegotiated the union deal to freeze wages until 2013 and reached a deal with the state PUCs on revised capital investments and penalties. On March 11, 2010, the Bankruptcy Court approved the adequacy of the Disclosure Statement and the Company was expected to emerge from bankruptcy in summer of 2010. The plan confirmation required approvals from the PUCs of Maine, New Hampshire, Vermont and other 15 states. Vermont rejected the plan even as the other 17 states approved it. Vermont acknowledged that the Company had made material improvement in its service but believes that the projections were too rosy, inconsistent with Fairpoint’s recent performance and that the Company will overleveraged post-emergence. New Hampshire in its order of approval also noted that while the Company had resolved a number of issues and improved customer satisfaction since the cutover issue, its projections appeared optimistic. Fairpoint does not want to make any changes to the plan at this late stage and is exploring all possible options to address this late surprise. In early August Fairpoint indicated it was going back to Vermont with new information to try and get the board’s approval. The lingering uncertainty and a chance that the whole plan might blow up caused the bank debt to trade down to mid 60s from 80s in early May (it was around 73-74 in late June before the Vermont order came out).

At the current price you are basically creating the company at 4.8x 2009 EBITDA where the average comparable Rural LEC (RLEC) trades for 5.7x EBITDA. Moreover, Company’s EBITDA is loaded with extra costs due to cutover issues and penalties as evidenced by its margin of 26.9% (as opposed to average industry margin of 42.8%). Hence, it trades at half the valuation of the comparables on an access line and revenue multiple basis (see comparables table in the valuation section for details). While the number of RLEC voice lines is declining, Companies have replaced some of the lost voice line revenue with growth in broadband subscriptions and created value through acquisition of other RLECs and cost reduction. Windstream’s recent acquisition of Iowa telecom and CenturyLink’s pending acquisition of Qwest fit this pattern. Fairpoint is unlikely to remain an independent company for long after it emerges from bankruptcy. The current discounted multiple and opportunity to realize higher EBITDA margin presents an opportunity to buy the Fairpoint pre-petition bank debt. Whether the Company emerges with lower than currently proposed debt or a slightly different plan, there is enough margin of safety to realize value once it emerges from bankruptcy. If the plan falls apart and the assets are sold in the bankruptcy, a strategic acquirer should be able to pay more than the value implied by the current price of the bank debt.

Highlights

• Fairpoint’s footprint quality is not very different from other RLECs. From the company's annual reports you can see that the Company’s access line density and the cable telephony competition it faces are comparable to other RLECs. Fairpoint’s larger than average line losses and EBITDA decline has been largely a result of poor management of the systems and the transition problems
• Fairpoint has lower DSL penetration of its access lines compared to the industry. This is mainly because Verizon did not upgrade the New England systems to provide data services. Company has invested in upgrades and started selling data product in region since the middle of last year and has an upside revenue opportunity from increasing data penetration.
• Company’s EBITDA margin is significantly lower than peers due to inefficiencies and additional costs resulting from transition problems. Fairpoint’s EBITDA margin was about 40% pre-cutover but has declined dramatically in the last year indicating that Company has an opportunity to increase its margins meaningfully as it resolves its systems transition issues.
• The plan calls for a recovery of 88 points to the term loan holders (48 pts in new bank debt and the rest in equity) based on 5.4x multiple of 2009 estimated EBITDA of $362. Peers on an average trade at 5.7x EBITDA (see comparables in valuation section). However the pre-petition debt trades around 66 implying a 4.8x multiple of projected 2010 EBITDA. The recovery should be 90 pts based on a normalized EBITDA of $350M and multiple of 5.7x.
• This is a consolidating industry and Fairpoint will likely be acquired by one of the other RLECs. Windstream recently acquired two companies in 2009 and CenturyLink has announced a merger with Qwest (see Appendix for transaction comparables)

Risks

• Company’s recent performance has been worse than industry – access lines declined 12.4% YOY in 1Q10 vs. 6.8% decline for the industry. Anecdotal information from the New England PUCs indicates that the Company has meaningfully improved its service metrics as system issues have been resolved over the past year. This should improve churn metrics and stabilize revenue. Current valuation is already pricing in significantly more deterioration so investors are getting paid to wait for a turnaround.
• Industry has been losing retail lines due to competition from cable and wireless. There were meaningful losses to wireless and cable telephony when the competing products were first introduced to the market and access line loss metric has improved as the competitive landscape has stabilized. Verizon did not market aggressively to business customers in the assets acquired by Fairpoint, which presents an upside revenue opportunity. Other RLECs have been making up for line losses by selling data services. Companies generate a significant amount of free cash flow allowing them to pay large dividends, which has kept the EBTIDA multiple around 6x for a number of years.
• Stock will initially trade without dividends due to restrictions from exit facility (leverage has to be below 2x to pay any dividend and starting leverage should be around 3.0x)
• Plan projections were put together in the summer/fall of 2009. Company’s performance since has been worse than projections. Fairpoint has not updated its projections and actual 2009 performance is below initial projections. It is hard to figure out the precise proforma 2009 EBITDA since one time costs are not all disclosed in the filings. We have revised the projections with an estimate of 2009 EBITDA and modest turn-around expectations going forward. With some EBITDA margin expansion, Company should be able reach about $350M in EBITDA and generate cumulative FCF of $300M+ within three years.
• Vermont’s rejection of the plan creates additional uncertainty in timing and threatens to blow up the deal. It is not exactly clear whether Vermont wants leverage reduced or if they want payment or penalties or something else. But the state realizes (acknowledged clearly in the PUC order) that a Fairpoint stuck in bankruptcy court creates a lot of risk and potentially more problems for telecom customers in its state so Vermont is incentivized to cut a deal.

Valuation

The valuation put forth by the Company’s advisor, Rothschild values the company based on 2009 projected EBITDA and multiple slightly below the trading and transaction multiples for comparable companies. Comparable public companies trade at an average EBITDA multiple of 5.7x. Recent transaction comps support an EBITDA multiple of 6.0x and above