FYBR | CHASING A POT OF GOLD

overview

While 1Q23 was far from a clean quarter – our bullish thesis on FYBR is anchored in a tail duration, and we are not changing our position. We recognize that we are in a difficult period. New fiber build capex is elevated, and opex/capex to connect is accelerating along with new fiber customers before incremental EBITDA from these customers is fully realized. But that is typically how investments in capital projects work, and we anticipate these pressures will ease significantly 2H23 into 2024.

FYBR maintained passing/build guidance of at least 1.3M (339K new fiber locations 1Q23 vs 211K 1Q22); Capex continues to be front-end loaded in 2023, but concerns linger around the higher cost to connect + pass and IRR impact. However, higher penetration rates and rising ARPU (sell-through basis) give us confidence in our IRR projections as it stands (mid-teens). Frontier is also monetizing value-add services and adjusting pricing – implementing multi-year contracts (SMBs), shifting mix to higher bandwidth sales (+1Gbps 55% Gross New), and passing through inflationary costs via inflation-linked price escalators. 

Key Takeaways Adjusted EBITDA grew YoY for the first quarter in over 5 years (incl. subsidy revenue), up +1.9% from -9.7% in Q4. Excluding subsidy revenue, Adjusted EBITDA growth decelerated to -1.2% YoY in 1Q23 (from +2.4% YoY in 4Q22). While the quality of 1Q23 AEBITDA growth was low, the trend is clearing improving. See Exhibit A and Exhibit B. FCF came in worse than expected at -$757M versus the FactSet consensus of -$737.7M. Losses accelerated from -$518M in Q4. Capex of $1.15B came in higher than $863.8M consensus and management also updated their FY range by $200-400M, to $3B-3.2B from $2.8B (see below). Management reaffirmed full-year build guidance of 1.3M homes despite the rising cost to pass, which is now expected to be in the range of $1,000-1,100, up from prior guidance of $900-1,000. The company noted in late 2022 they were approaching the high end of their prior guidance range; management believes they can still achieve mid-high teens IRR on total build given faster than anticipated penetration rates and higher ARPU assumptions given recent pricing actions; AND no change to overall conversion opportunity between 10-12M passings. <- In our April 2023 Black Book, we had already contemplated a higher cost to pass + connect in our IRR analysis. Also, it is important to note that Frontier was early in securing resources / contractors for their fiber build in 2021 – and because of this timing, they did not see the same inflationary pressures as peers (net benefit to Frontier). However, now those contracts are renewing at a higher labor and material costs (market rates). The point is, it is important to keep the entire build cost in perspective. Frontier is still on pace to hit their build goal, both 1.3M passings 2023 and 10M by 2025. They’ve built 2M passings in the last 2 years that we still haven’t seen meaningful EBITDA contribution from but will start seeing in the back half of 2023 and over the course of the next 1.5 years. The copper segment continues to decline while fiber becomes an increasingly larger share of the revenue pie. We said in April that we are comfortable underwriting near-term leverage and capital intensity given our confidence in long-term fiber economics. Capex growth and FCF deterioration this quarter may not look pretty, but we inherently believe fiber will win in the long run and Frontier will manage short-term cost pressures in labor and inventory. Exhibit J shows a valuation table on a per-passing basis. You will see that FYBR in the high teens is trading at near the same valuation that CNSL just got taken out at by private equity despite superior business mix and network characteristics.

EBITDA and Business Mix

• Adjusted EBITDA of $519M was light relative to consensus of $522.5M but it grew 1.9% YoY and marked the company's first time back to LSD growth. Fiber AEBITDA growth of 17.5% YoY in 1Q23 (vs 4Q22 19.4%), more than offset declines in copper AEBITDA of -23.5% in 1Q23 YoY (4Q22 YoY -17.98%). Overall, Fiber represented 62.0% of consolidated EBITDA in 1Q23, an increase of 821bps versus 53.8% in 1Q22.
• The slight EBITDA shortfall in 1Q23 was due to higher gross connects as fiber penetration rates have increased. The higher level of expenses were partially offset by the ongoing cost savings program, where targeted savings were increased by $100M this past quarter to $500M by 2025. We expect EBITDA growth to improve for the remainder of 2023 and into 2024 as newer cohorts of fiber builds come online. Management anticipates an additional $230M of EBITDA over the next 2 years from the 2M homes they passed over the last 2 years (versus the $10M generated in the trailing twelve months), which is consistent with the expected timing/ramp in penetration rates. See Exhibits A and B

broadband trends

On a consolidated basis, Frontier added 24K new broadband customers across residential and SMB. This is the 6th quarter of positive net additions on subs and represents growth of 2.1% YoY. Despite the losses in the copper segment, Frontier has stabilized its customer base thanks to strong fiber gains – increasing the favorable mix towards a more profitable product and a more monetizable customer base. Fiber now accounts for 62.7% of total broadband customers, up from 60.2% in Q4. See Exhibits C and D

• Net fiber broadband additions were 87k, which was higher than 76K in Q4 and 54K in 1Q22. Accelerating net additions resulted in higher expenses in Q1. Including video, Frontier now has 2.01M fiber customers across their consumer and business segments, representing 1Q23 growth of 12.6% YoY (from 11.1% in 4Q22). Excluding video, Frontier now has 1.77M fiber customers across their consumer and business segments, representing 1Q23 growth of 19.5% YoY (from 17.5% in 4Q22). See Exhibit E
• Fiber churn declined QoQ to 1.2% from 1.3% in Q4 - almost down to a “New Frontier” low churn of 1.19% in 1Q22. 
• Fiber ARPU (as reported) declined -1.06% YoY, but the rate of decline improved from 4Q22 of -1.62%.
• The positive impact from recent pricing actions both on existing and sell-through ($65-$70/ mo on new subs) won’t show up until Q2 results, so we should see ARPU improve steadily to LSD % by 2H23. Consumer Fiber ARPU adjusted for the gift card decline -0.14% on a YoY basis versus 4Q22 of 0.9%.
• Copper broadband churn remained elevated at 1.71% (down from 1.88% in Q4). Consumer broadband copper lost 56K subs, down from a loss of 62K in Q4 but above the 30K losses in 1Q22. Frontier now has 1.09M copper subs compared to 1.33M a year ago, representing 41.2% of total subscribers and a YoY decline of 17.9%.

Capital Expenditures + Free Cash Flow

Negative $757M FCF in 1Q23 was communicated in advance, but the magnitude combined with the increase in cost per passing probably caught some by surprise. Consensus estimates called for -$737.7M into the print. Down sequentially from -$518M in Q4.

• Capex came in higher than expected at $1.15B in 1Q23, again communicated in advance and partly due to timing and prepayments. Full-year capex guided higher by $200M - $400M to $3.0 - $3.2B (from $2.8B). Capex growth accelerated from 57% YoY in Q4 to 158% in Q1, but comping against a muted capex quarter of 1Q22 when growth was only 16.4%. Management cited a higher cost to build due to inflationary pressures and that Q2 capex will be similar to Q1, with 2H23 to be a lighter capex load than 1H23.
• Guiding 2Q23 capex in-line with 1Q23 on absolute terms puts 1H23 capex in the range of $2.3B, leaving $700-900M in capex to be deployed in 3Q23 and 4Q23 before Frontier exceeds their guidance. However, street estimates currently have Q2 capex lower than management guidance, at $883.9M, and they have Q3 and Q4 at $546M and $520M, respectively. Therefore, consensus numbers need to come up for Q2 and go down for 2H. See Exhibit G
• Current guidance implies Capex declines YoY in 2H23, which makes sense if a large portion of capex upside has been driven by opportunistic additions to inventory for equipment in anticipation of accelerating gross connects. See Exhibits G and H 

“So we said about half of the increase in the CapEx related to inventory. Part of that was the really strong operational momentum that we had. Q4 was the biggest build quarter ever. Q1 was not far behind it. But part of that was opportunistic as others have pulled back, we were able to secure equipment at a discount. So that's about half of the CapEx. And then the other half was a combination of new markets and higher labor costs in those new markets and some legacy markets as we reset those. Yes, I think it's -- we're seeing some headwinds and tailwinds related to potential labor costs in the future.” - 1Q23 Earnings Call

Exhibit A

Exhibit B

Exhibit C

Exhibit D

Exhibit E

Exhibit F

Exhibit G

Exhibit H

Exhibit I

Exhibit J