Frontier Communications (FTR) is not a glamorous company, but its dividend is big (8.0%) and its shares are cheap. It’s not hard for the naysayers to decry this company as an archaic 20th century landline business that is dying a slow death. However its recent $10.5 billion acquisition of Verizon assets, combined with its 6% price decline this week, may be providing an excellent entry point for long-term investors. More specifically, we like Frontier because it has carved out a niche for its business, it has been easily covering its dividend payments, its current valuation is attractive, and its recent big acquisition of Verizon assets will give the company the cash flow to pay down debt and ultimately position itself for continued long-term success.
What is Frontier’s Niche?
Frontier provides phone, Internet and other data services to three million residential and 300,000 business customers across 28 states.
The company has carved out a niche for itself by operating in small markets and rural areas where competition is less intense and often non-existent. The economics of operating in these markets is often unattractive to bigger players (e.g. Verizon and AT&T) however Frontier’s existing infrastructure combined with government subsidies (more on this later) has allowed Frontier to operate successfully while paying a big dividend to its shareholders.
About Frontier’s Dividend
Frontier’s dividend yield has recently climbed to 8.1% as the stock price has fallen nearly 25% in the last year and roughly 10% in the last several weeks following its deal to acquire Verizon assets for $10.5 billion and its May 3rd earnings announcement. For reference, here is a chart of Frontier’s historical dividend payments.
As the chart shows, the Frontier has cut its dividend payments in the past (largely the result of a poor integration of a previous acquisition). However, Frontier has recently raised it’s dividend (as the chart shows) demonstrating strength and confidence in the dividend payment going forward. Additionally, Frontier currently only pays out around 56% of its free cash flows as dividends as shown in the following chart.
This relatively low payout ratio demonstrates strength in the dividend while still retaining cash flows to grow the business. And the amount of free cash flow is expected to grow significantly following the recent acquisition of assets from Verizon.
About the Verizon Asset Acquisition
On April 1, Frontier completed it $10.5 billion acquisition of Verizon assets. According to Frontier’s CEO Daniel J. McCarthy:
"This is a transformative acquisition for Frontier that delivers first-rate assets and important new opportunities given our dramatically expanded scale. It significantly expands our presence in three high-growth, high-density states, and improves our revenue mix by increasing the percentage of our revenues coming from segments with the most promising growth potential."
Worth noting, Frontier management has provided full-year 2016 free cash flow guidance (including the Verizon acquisition) of $800 to $925 million. This represents a significant increase over previous years (i.e. free cash flow was $438 billion and $582 billiion in 2014 and 2015, respectively). And this increased free cash flow will allow Frontier to pay down debt (more on debt later) and improve the business via needed upgrades and expansion beyond landlines.
What is Frontier Worth?
A basic dividend discount model suggests Frontier is worth significantly more than its current stock price. Specifically, if we discount Frontier’s annual dividend payment amount ($0.42 per share) by its cost of equity (6.67% using the reasonable assumptions at GuruFocus) and we assume a 0% growth rate, then Frontier is worth $6.30 per share, or roughly 22% more than its current share price. Said differently, we have to assume a negative 1.5% growth rate to back into Frontiers current market price which seems unreasonable considering Frontier's low dividend payout ratio (see previous chart) and the new growth opportunities created by the Verizon asset acquisition.
Similarly, if we discounted Frontier management’s $800 million of expected 2016 free cash flow by Frontier’s 6.16% weighted average cost of capital (again using the reasonable assumptions at Guru Focus to calculate weighted average cost of capital) and we assume a 0% growth rate, then Frontier is worth nearly $13 billion, or roughly twice it current market capitalization.
What are the risks?
Despite Frontier’s big dividend and its attractive valuation, the company faces a variety of significant risk factors as we have highlighted below.
For starters, Frontier’s effort to combine their business and the business acquired from Verizon may not be successful. Specifically, Frontier may not realize the cost synergies that are anticipated from the Verizon transaction.
Another big risk is that customers will continue to “cut the cord” on wireline connections. The following table from Frontier's annual report shows the declining trend in voice services revenues, and much of the decline comes from customers terminating their landlines. According to the Risk Factors section of Frontier’s annual report, “we may be unable to stabilize or grow our revenues and cash flows despite the initiatives we have implemented.”
Competition is another risk for Frontier. Even though Frontier is the leading provider in many of the markets it serves, some of Frontier’s competitors have superior resources, which may place Frontier at a cost and price disadvantage. Further, Frontier acknowledges in their annual report that “some of our competitors have market presence, engineering, technical, marketing and financial capabilities, substantially greater than ours. In addition, some of these competitors are able to raise capital at a lower cost than we are able to.”
Debt load is another risk factor for Frontier. The company took on more debt to fund the Verizon asset acquisition, and as the following chart shows, the debt level has been increasing.
However, following the acquisition of Verizon assets, Frontier has more free cash flow which they may use to pay down some of the debt. According to Frontier’s annual report “we currently have a significant amount of indebtedness and we may still be able to incur substantially more debt in the future. Such debt and debt service obligations may adversely affect us.”
Another big risk for Frontier is that they are reliant on support funds provided under federal and state laws. A portion of Frontier’s total revenues ($500 million, or 9%, in 2015 and $319 million, or 7%, in 2014) are derived from federal and state subsidies for rural and high-cost support, commonly referred to as USF. (annual report, p.22). Significant changes to these laws could result in a significant reduction to Frontier’s revenues and profits.
Conclusion
We like Frontier. Its dividend is big and its price is cheap. Last week’s 6% price decline has also provided some additional margin of safety for would be buyers. If you’re looking for a lower-volatility telecom stock with a big dividend yield and the potential for price appreciation, Frontier may be worth considering for your diversified, long-term, income-focused, investment portfolio.
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