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Investors in Frontier Communications (FTR) reacted positively to the acquisition of AT&T's activities in Connecticut, as announced in the past trading week. The deal is more or less of the same and continues to add to the company's sizable debt position.

As management continues to spend too much cash on acquisitions and dividends, and dilution is always a very real risk, I remain on the sidelines.

The Deal

Frontier Communications announced that it has acquired AT&T's (T) wireline business and statewide fiber network which provides services to residential, commercial and wholesale customers in Connecticut.

As part of the deal, Frontier will also acquire AT&T's U-verse video and satellite TV customers in Connecticut, in a $2 billion cash deal.

With the acquisition, Frontier will operate in 28 states, complementing Frontier's existing operations. As a result of the deal, Frontier will also welcome 2,700 new employees.

Frontier will furthermore acquire 415,000 data, 900,000 voice and 180,000 video residential connections in Connecticut as well as local business and wholesale relationships. CEO and Chairman Maggie Wilderotter commented on the rationale behind the deal;

"This is a great opportunity to bring to Connecticut Frontier's portfolio of products and services, such as Frontier Secure, our industry leading digital security offering that gives customers top-rated online computer protection and premium technical support."

The deal is expected to be accretive to Frontier's adjusted free cash flow per share in the first year after closure. Frontier will leverage its network and back-end costs, expecting total cost synergies of $200 million once the integration has been completed.

The deal is subject to review and approval by the US department of Justice, the Federal Communications Commission, as well as local and state regulatory authorities. The deal is expected to be closed in the second half of 2014.

Valuation

Back in November, Frontier Communications released its third quarter results. The company operates with $661.0 million in cash and equivalents. Yet Frontier's debt position is sizable at $8.15 billion, resulting in a net debt position of $7.5 billion. Despite the sizable debt position, Frontier has already lined up committed financing from J.P. Morgan (NYSE:JPM) for the deal.

Revenues for the first nine months of the year came in at $3.58 billion, down 5.2% on the year before. The company posted net earnings of $47.7 million compared to a $124.1 million profit in the comparable period last year. Note that earnings are heavily impacted by the debt position, with interest payments totaling $501.8 million in the first nine months of the year.

At this pace, annual revenues are seen around $4.8 billion, as earnings could come in anywhere between $50 and $100 million.

Trading around $4.70 per share, the market values Frontier Communications at $4.7 billion. This values the equity in the company at 1.0 times annual revenues and roughly 60 times GAAP earnings.

Despite the sizable debt position, Frontier Communications still pays a quarterly dividend of $0.10 per share, for a very high dividend yield of 8.5%.

Some Historical Perspective

Long term holders in Frontier Communications have seen very poor returns despite the high dividend payments. Shares fell from levels around $15 in 2007 to lows of $4 this year. The high debt position remains the key worry among investors, even as the company continues to pay out steep dividends to the tune of $400 million per year. Shareholders have seen a great deal of dilution in recent times, with the outstanding share base tripling between 2009 and currently.

The dilution, increased debt position and growing operations has been the result of the 2009 acquisition of 4.8 million landlines from Verizon Communications (NYSE:VZ) in a $8.6 billion deal. Ever since, it has only been downhill for Frontier's share price and dividend.

On the back of acquisition, Frontier managed to grow its revenues by nearly 150% between the calendar year of 2009 and 2012. The company has posted modest earnings in recent years.

Investment Thesis

So basically, Frontier already has a ton of debt, while paying out out excessive dividends given its earnings and financial position. On top of that the latest deal will boost the net debt position towards $10 billion.

With estimated annual interest payments of around $670 million, Frontier is paying a very high 9% effective interest rate on its debt, making deleveraging probably much more interesting compared to acquiring.

According to Frontier's presentation related to the acquisition, the company is paying 4.8 times 2014 expected EBITDA for AT&T's assets. The unit is expected to generate revenues of $1.25 billion next year, valuing the business at 1.6 times annual revenues. On top of that Frontier sees immediate cost savings of $75 million, increasing towards $200 million, resulting in a lower deal/EBITDA multiple of 3.3 times.

Frontier notes that it will be required to make $225 to $275 million integration capital investments in the period 2014-2015.

On a pro-forma basis, Frontier will generate revenues of around $6 billion, while the deal will be accretive to earnings going forwards. The company furthermore notes that the deal which will be financed with cash, and thus cost about $180 million given 9% effective interest rates. Yet is stresses that debt financing over equity financing will avoid dilution.

The deal is more of the same. The acquired assets have little growth appeal, just like the general organic business of Frontier, yet investors acted with enthusiasm earlier this week. Tuesday's jump boosted the market value of the firm by a cool $350 million.

I am not convinced, as Frontier is repeating its historical miss-steps. The company operates with too much debt and simply pays out too high dividends. While the deal appears to be attractive in the short term, the long term investors have seen very poor returns combined with continued slashed dividends, as the payout ratios have consistently exceeded earnings.

For this reason alone, Frontier Communications is not an attractive investment in my opinion, as management continues to operate on a too risky manner.

Source: Frontier Communications - New Deal, More Debt, Continued Leverage Concerns