Burying my head in the sand

Lessons learned from holding FTR

Published on:
June 1, 2019
Last Update:

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Noam Ganel is the voice behind Pen & Paper, a value-oriented stock research publication. He  serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Analyst Credential (CFA).

In Where the Financial Statements Reveal Little Economist Reality , I bragged that buying Frontier Communication was effortless. All one had to do, I proclaimed, was to compare the prior years price, which was in the triple digits, to the 2018 stock price of $5.

A year passed and the stock price more than halved - which issues a few lessons. In this essay I describe these lessons and explain why I am still holding the stock nonetheless.

The four lessons

The first lesson is that not all equity is created equal. What I failed to see last year was that the reported 2017 equity of $2,274 million consisted of $5,035 million in additional paid-in capital which was offset by $2,263 million in accumulated deficit (The remaining $497 million was related to treasury stock and OCI). What this means is that the equity balance consisted of proceeds from past stock issuances - not from profits.

The reported equity should have embarrassed management. But instead management had no problem diluting common shareholders by issuing additional shares. There were 66 million outstanding common shares five years ago. There were 78 million outstanding shares a year ago. There are now over 90 million outstanding shares. This 6% annual growth in common shares, likely to continue, is worrisome.   

The value of reported goodwill and intangibles assets is always questionable. But in FTR's case, these two accounts were no assets at all. In 2016 goodwill and intangibles were $12,336 million. Management had written down these assets to $7,877 million by 2018, a whopping $4,459 million loss that was fully recognized in the income statement.

FTR's goodwill and intangibles are over a third of the value of the reported assets. And if we are to remove these accounts, as any bidder for the company surely would, we would be left with exactly nil - zero, nadir, nothing, zilch - in common equity. FTR's tangible assets, which exclude the goodwill and intangibles accounts are $15,782 million or $17 per share. FTR's liabilities are $22,059 million or $24 per share. Since the liabilities are worth more than the assets, the common equity is worthless. The omission of thought related to the intangibles is lesson number two.

The third lesson was the lack of margin of safety. Even at $5 per share, which was historically low, FTR had too many concerns. To name a few: (a) the fixed coverage ratio was deteriorating. The ratio was over three times in prior years and is now less than two times; (b) leverage, defined as total liabilities divided by total assets, was historically at 75% but is now at 93%; (c) pension liability increased from $1,055 million in 2012 to $1,750 in 2018. And there is no sign of this liability but to grow; (d) the percentage of employees under labor agreement increased from 23% to 64% and (e) the wireline telecommunication industry is doing bad.

Practically all telecommunication companies’ stock prices dropped. Anixter (AXE on Nyse) now trades at $57 compared to $99 five years ago. Centurylink (CTL on Nyse) now trades at $10 compared to $37 five years ago. See the table below for more examples.  

How telecommunications companies are trading nowadays

That I bought too much stock is the fourth lesson. I started to buy FTR in March of last year, when the stock traded at $7.76 per share. Then I bought twice as much stock, at $4 per share in November. I finished 2018 with 8,000 shares at a weighted average cost of $5 per share. The FTR position represents 8% of my portfolio while no stock represents more than 2% in comparison.

Why I still hold FTR

Admittedly, I bought too much stock and was careless, too. Reviewing FTR's latest public filing, I was ready to sell the entire position and to recognize the loss. But I found enough reasons (or excuses) to keep it.

There is - and I project will be continued - a reasonable pre-tax cash flow. FTR gathered $3,752 million in after-tax cash flow, after capital expenditures that is, since 2011. In two years the company showed a cash flow deficit: in 2016 the deficit was $227 million, and in 2015 the deficit was $31. But in 2018 the pre-tax cash flow was $687, and the 7-year pre-tax cash flow was $525 million.

The pre-tax cash flow matters. It allows management to change the capital structure by reducing the total liabilities (indeed, management reduced total liabilities by $551 million over the year and is planning to sell asset according to Barron's.) The pre-tax cash flow will allow the company to  compete better as well.

Plus the operating data improved over the past decade. FTR now has more customers in both the consumer and the business segments. For example it had no broadband or video subscribers ten years ago and now reports on 4.7 million broadband and video subscribers. In addition, the churn rate, the annual percentage rate at which customers stop subscribing to a service, is at normal levels.

FTR's Growth in customer base over the past decade


So FTR still meets the cheap, distressed criteria of a stock that trades at less than 50% of the net asset value and of less than 10 times the adjusted earnings per share. The reported book value per share today is $18 and the adjusted pre-tax cash flow is $7.  

***
My brother asked if I had a stop loss in place. Stop loss means that if a stock drops below a certain price, say a drop by 40%, then it is automatically sold to prevent the investor from future losses.

No, I said. Investors, especially investors who target distressed companies, expect - and should be ready - to see much volatility in market prices of their  holdings. May the case of FTR serve as a case in point a year from today.