Late last year I recommended Frontier Communications (FTR) when I wrote an article titled Frontier Communications: A Top Income Idea For 2012. This article is a review of that strategy, how it worked out and what are the next steps for those that chose to follow it.
First, note that the title was about an income strategy, not capital appreciation. Second, the idea was to use covered calls to lower the net cost of the investment and increase yield. Third, I have delayed finishing this article in order to wait for the long term call expiration date - January 19th - to be reached. If I had used different share prices from various points during the past few months when the shares traded as low as $4.09 to as high as $4.88, the results would be vastly different.
The shares can trade in a narrow range and then make sudden moves. The week the options expired, the shares traded between $4.35 and $4.52. And, on the 18th, the shares traded as high as $4.52 before settling at $4.48. This was a moderately important price point because above $4.50, some of my shares would have been called. As it was, the calls expired worthless.
At the time of the recommendation, the shares were trading at $4.95, Frontier's annual dividend was $0.75 and $5.00 call options for January 2013 were trading at a bid price of $0.45. This would put the net cost at $4.50. As long term followers of Frontier know that dividend was cut from $0.75 to $0.40, and the yield on the net cost was reduced to 8.9%.
That is substantially below the hoped for 16.7% yield that a $0.75 dividend would bring. It is also below the yield of 11.1% that would have been realized if the hypothetical rate cut to $0.50 discussed in the article had been instituted. In the current low interest rate environment, it was still a rather high return, but nonetheless disappointing.
What is now important is for investors to reassess that position. Is it reasonable to continue to hold? Should investors that followed the covered call strategy write new calls? If so, at what strike price?
Standard & Poor's issued a report stating that it lowered Frontier's "corporate credit and senior unsecured debt ratings from 'BB' to 'BB-' ". (The full report can be found at the S&P web site. Although the site is password protected, any user can create a free account.) The downgrade was based largely on declining revenues caused by access line losses, and cited competitive pressures from both wireless and cable service providers as well as loss of regulatory revenue. S&P believes the revenue losses would put pressure on EBITDA and constrain Frontier's ability to reduce leverage below 4x.
After the debt downgrade, Frontier announced that it had paid off its 6.25% debt that had matured on January 15th with "cash available on hand," most likely coming from the debt offerings made during the Summer of 2012. This debt repayment news was received favorably by Nomura Securities which "reiterated their Buy rating and $5.50 price target..." Nomura estimated that the dividend payout ratio at Frontier was 53% compared to 92% at both CenturyLink (CTL) and Windstream (WIN).
This view differs from that of Goldman Sachs (GS), which, in November, had downgraded Frontier from neutral to sell with a price target of $3.50. Although it downgraded Frontier, Goldman had this to say about the dividend:
Though we see little near-term risk to the dividend, EBITDA declines limit the ability to delever the balance sheet. We forecast FCF/share declines of 15-17% in 2013/2014.
The current dividend yield of 8.8% is still the main attraction for investors in Frontier. It compares favorably to both CenturyLink (7.2%) and Windstream (10.3%). All three have yields that are substantially higher than the two domestic telecom behemoths, Verizon (VZ) and AT&T (T) with dividend yields of 4.8% and 5.2%, respectively.
Both AT&T and Verizon have dividends that are considered much safer than the other three. Also, AT&T has been increasing its dividend for nearly thirty years, and Verizon has increased its dividend by 25% over the past five years.
The position was originally opened to generate income, and that will continue to be the plan. At the time the initial position was opened, a call was sold to lower the cost of the investment and reduce risk. That call has since expired. Going forward, it now makes sense to write another call option to enhance the return on the net investment.
Today, because the calls expired earlier this month when the shares closed at $4.48, the investor has two attractive alternatives with the January 2014 calls (or LEAPs). The first is to simply write another call at the $5 strike price. Although the premium is only $0.15, it has two potential benefits. First, the $0.15 increases the current yield on the original net cost of $4.50 from 8.8% to 12.2%. Second, if the shares reach the Nomura price target of $5.50, there would be an additional $0.50 of "income," and the total return would be significantly higher.
The second alternative would be to write a $4.50 call expiring January 2014. The premium would be $0.30, but there is a substantially greater risk that the shares would get called away prior to expiration. Is that bad? It depends on one's objective. If the shares are called prior to the next dividend payment (and based on today's closing price $4.57, a very distinct possibility), the investor still gets 75% of the expected annual dividend, and does so in a much shorter time period. That gives the investor the rest of the year to place the funds into a similar investment, or even re-open a new position in Frontier using an in the money call option.
How does that work? Using today's prices as an example, if the shares are called away, the investor could re-open a position with the $4.50 January 2014 call with a net cash outlay of $4.27 - the $4.57 price minus the $0.30 premium. And, if the shares are again called away before the next dividend payment, the investor winds up with a $0.23 capital gain, or the equivalent of more than two dividend payments. It is likely that similar transactions could be repeated throughout the year.
The recommendation of Frontier at the end of 2011 resulted in significantly lower than expected performance, although in the end, the goal of generating above average current income was achieved. Investing in Frontier still carries risk due to its high debt load and high leverage ratio. It is also a risk that can continue to be mitigated with the use of covered calls.
There is obviously a difference of opinion on the level of risk. Goldman has a sell rating and sees a lower price, while Nomura has a buy rating and sees a higher one in the future. And, of course, there is the S&P downgrade of the corporate debt.
I believe the dividend is safe, at least for the rest of 2013, but I will be closely monitoring Frontier's revenue. That revenue will be dependent on the success of its new DSL initiatives, bringing down the rate of residential customer access line losses, maintaining business customer retention, and the new resale arrangements with AT&T Wireless and Hugh's Satellite. And, since the purpose of placing Frontier in my portfolio is to generate current income, I believe the risk is acceptable.
Additional disclosure: I currently have no positions in other companies mentioned in this article. Also, I have used the covered call strategy outlined in this article, with much of my Frontier and Windstream positions having covered calls written against them. I may open new positions in Frontier using the strategies outlined in this article, or write additional covered calls against my current positions in Frontier at any time.