Frontier Communications (NYSE: FTR) was founded in 1935 as CitizensUtilities and became a pure-play telecom network operator in 2004.
Frontier announced a deal with Verizon Communications (VZ) in May2009. Frontier acquired approximately 4.8 million access lines fromVerizon, tripling the size of the company. The Verizon properties werepackaged into an entity called SpinCo and merged with FTR. Theall-stock transaction was valued at approximately $8.6 billion and closedJuly 1, 2010. The transaction created the nation’s fifth largest incumbentlocal exchange carrier (ILEC) operating in 27 states. The dividend wascut from $1.00 to $0.75 upon closing.
The yield is 9% based on the February 24, 2011 closing price. So is thedividend safe? We’ll look at what management envisioned when theyannounced the SpinCo acquisition and where they are today. Then we’lldiscuss how this relates to the dividend going forward.
When Frontier announced the acquisition in May 2009, expectations werebased on the following pro forma numbers:
| 2008Statistics | Frontier | SpinCo(b) | Sub-Total | Synergies(d) | Total | |
| Revenue | $2,237 | $4,287 | $6,524 | --- | $6,524 | |
| EBITDA | 1,214 | 1,918 | 3,132 | $500 | 3,632 | |
| % EBITDAMargin | 54.30% | 44.70% | 48.00% | 55.70% | ||
| Bridge to FreeCash Flow: | ||||||
| InterestExpense | (363) | (290) | (653) | 0 | (653) | |
| Cash Taxes | (79) | (285) | (364) | (190) | (554) | |
| CapitalExpenditures | (288) | (413) | (701) | 0 | (701) | |
| Other | 9 | 0 | 9 | 0 | 9 | |
| Free CashFlow | $493 | $930 | $1,423 | $310 | $1,733 | |
| FCF/Share | $1.58 | $1.37 | $1.44 | $1.75 | (c) | |
| NetDebt/EBITDA | 3.8x | 1.7x | 2.6x | 2.2x | ||
| Dividends($0.75/share) | --- | --- | $742 | --- | $742 | (c) |
| DividendPayout Ratio | --- | --- | 52% | --- | 43% | (c) |
(a) Adjusted to exclude Severance and Early Retirement Costsand Legal Settlement Costs. | ||||||
| (b) 2008 audited financial statements adjusted for certainmatters | ||||||
| (c) Assuming Frontier issues share at the mid-point of thecollar | ||||||
| (d) All Synergies will not be realized until the end of 2013. | ||||||
All synergies will not be realized until 2013 so the "Sub-Total" column isused for comparisons going forward. The dividend payout ratio of 52%indicates the dividend was very safe when the deal was announced. Inaddition, Net Debt to EBIDTA was expected to substantially improve from3.8x to 2.6x, indicating a stronger balance sheet.
FTR announced fourth quarter and year-end earnings on February 23 andmanagement issued guidance for 2011. The question is: are the originalexpectations being realized? Below we extrapolated 2011 numbers basedon guidance and past SEC filings.
Pro FormaNumbers | 2008 | 2010 (actual) | 2011 (proj.) | Rangeprovidedby FTR |
Revenue | $6,524 | $5,652 | $5,453 | |
EBITDA | 3,132 | 2,752 | 2,672 | |
% EBITDAMargin | 48.00% | 48.69% | 49.00% | |
Bridge to FreeCash Flow: | ||||
Interest Expense | (653) | (666) | (672) | |
Cash Taxes | (364) | (108) | (60) | 50-75 |
CapitalExpenditures | (701) | (784) | (775) | 750-780 |
Other | 9 | 0 | 0 | |
Free Cash Flow | $1,423 | $1,194 | $1,165 | 1150-1200 |
FCF/Share | $1.44 | $1.21 | $1.18 | |
Net Debt/EBITDA | 2.6x | 3.0x | 3.1x | |
Dividends($0.75/share) | $742 | $744 | $746 | |
DividendPayout Ratio | 52% | 62% | 64% |
The dividend payout ratio projection is 64% in 2011. There is still acomfortable margin of safety, but the percentage was rising when themarket was expecting a downward trend based on original expectations(including synergies).
In fairness, the deal closed in July 2010, so there is a long way to gobefore all the synergies are realized. Management also raised theirsynergy guidance to 550 million from 500 million.
Maggie Wilderotter, Chairman and CEO, commented on the conference call:
Our synergy programs are on track, and we remain committedand bullish on $550 million in total synergies through 2013.... Thefourth quarter results represent another sequential improvementin many areas of the business, which puts us on the path todeliver on our commitment to provide investors with growth incash flow and improved balance sheet and a secured dividend.
Donald Shassian, CFO made the following comments:
We remain committed to maintaining both our 75 [cent] annualdividend and/or reaching our leverage target of 2.5x or below.We believe this is achievable through a combination of EBITDAimprovements and/or debt reduction. At this time, we expectresidual free cash flow after any debt maturities to build on thebalance sheet, and we're not contemplating any near-termchanges to our dividend policy or any share buyback programs.
Management appears cautiously optimistic, and for now the dividend issafe. However, if the payout ratio continues to rise, it would be causefor concern. Another concern is the Net Debt to EBITDA ratio. Given guidance, we calculate this ratio to be 3.1 in 2011 vs their 2.5 target. When asked about it, the response was:
Gray Powell - Wells Fargo Securities, LLC
Just one of the goals you mentioned for 2011 is reducing leverage to around 2.5x. How should we think about you getting there? Is it paying down debt with your excess free cash flow? Or is it driving synergies and improving EBITDA?Donald Shassian
Yes, yes and yes. It's all of the above. It's key for us to be able to improve our EBITDA, and to grow our EBITDA and to drive that ratio in the right direction, that's going to come from activities in the revenue side. It's getting the expenses out. It's also going to be using some excess cash that we have to pay down debt if we need to. We have about $280 million of debt comes up this year. We've got sufficient cash on hand to be able to pay that down. We may look at refinancing on term loans, if it's very attractive. But our view is we'll probably use cash to pay that down. So it's a yes, yes and yes in all fronts. It's not one versus any other. Fundamentally, we've got to grow the EBITDA. We've got to improve the EBITDA.
If they cannot lower this ratio, one option would be to cut the dividend and use the cash to pay down debt. Based on their guidance, EBITDA will be flat in 2011 unless guidance proves to be conservative.
The dividend is safe in the near term. Longer term depends on how successful they are at integrating the remaining parts of SpinCo and whether they fall short of their 2011 guidance.
Disclosure: I am long FTR.
"Longer term depends on how successful they are at integrating the remaining parts of SpinCo and whether they fall short of their 2011 guidance."
I am also long FTR. What key metrics would you be focusing on in the future? Also, do you feel any shortfall (top line or bottom line) would trigger a dividend cut? They seem to have been fairly protective of the dividend in the past.
Obviously the lower the ratio the more cash available to help drive the leverage number closer to 2.5 through debt reduction.
Also if the payout ratio is rising EBITDA is probably declining, so I'd hope they can improve here. As Donald said: It's key for us to be able to improve our EBITDA.
Thanks for the reply. I don't know whether you are up on the details of the merger (I certainly am not), but I seem to remember seeing some stuff about how the pension burden of the added Verizon employees would be handled. Late last year Business week had an article about how both AT&T and VZ may have underestimated pension obligations Even more recently there have been articles about changes in the way VZ and T would account for changes in pension liabilities, indicating that they would add volatility to earnings,as they hit the income statement immediately rather than be spread out. Would you know if any of this has an impact on FTR?
I don't know if the pension cash obligations could be spread, but it seems like there might be some significant changes to EBITDA without impacting FCF. (I'm really not trying to put you on the spot, but it seems you have done quite a bit of work here, so I was hoping... thanks)
I have FTR as a significant piece of my high-yielding dividend stocks in my IRAs as well as some other accounts. Bought some on my own, and acquired more in the Verizon deal. It is also in several Roth IRA accounts I manage for my kids who are all in their 20's (I just leave it there and watch it grow through a DRIP). I came to the conclusion a while ago that a lot of the growth in my portfolio came from re-investing dividends. This was especially true for those companies that regularly grew their dividends (PEP and PG) as well as certain utilities that were able to maintain high dividends.
Although I am relatively new to FTR, having made my first purchase about a year ago, it has turned out very well for me. The stock price has been far more erratic than I would have expected, but with re-investing dividends, it is similar to dollar cost averaging. And, with the recent weakness in price I have been considering buying more. It's far safer than some of the REITs I have for dividends.
Good luck with your decision.