Late last year, Frontier Communications (NASDAQ:FTR) announced plans to acquire the Connecticut wireline business of AT&T (NYSE:T) for $2 billion in an all-cash transaction. In late February, Frontier received notice that it had cleared one of the regulatory hurdles for the merger from the Justice Department when the HSR waiting period expired. Then, on Friday, the company announced that it had received approval from the Federal Communications Commission. According to the company, the merger remains on track for a fourth-quarter closing.
At this point, all that remains is approval by the Connecticut Public Utilities Regulatory Authority ("PURA"). This particular review process was expected to begin last month. Frontier CFO John Jureller spoke about this in mid-June at the Morgan Stanley Leveraged Finance Conference.
So we have obviously gotten a lot of interrogatories from the Connecticut Public Utility Regulatory Authority, the PURA. And they're going to be holding hearings. Those hearings start at the end of June. So there would be a number of us participating in those, but we don't anticipate anything unusual that's coming out of this, they ask the usual questions about to take over a telecom utility in the state to make sure that we're good actors and good providers, but we clearly have a track record here of having done this in so many other different places with a great outcome that we don't think that this should be an issue I mean again…
... Obviously the regulatory authorities need to do their work they need to do their diligence around this and we have been accommodating all of the questions they have had and we will be sitting down with them again towards the end of [June].
Getting approval in Connecticut should be a relatively straightforward process. As part of a merger with Verizon's (NYSE:VZ) rural assets in 2010, Frontier took over operations across 14 states. Certain of those states required that Frontier put up performance bonds, and while that process took quite some time to fully integrate all systems, the performance was met and the bonds were satisfied.
The Benefits of the Connecticut Acquisition
Frontier management believes that the acquisition will improve the sustainability and coverage of the company's dividend. It appears that the market has bought into the idea as well. At the time of the announcement in mid-December, Frontier was trading at $4.40. The next day, the shares moved sharply higher, trading as high as $4.94 before closing at $4.78, up almost 9%. Since then, the shares have continued to move even higher, closing at $5.94 on Monday, up $0.07 or 1.1%. (For purposes of this particular article, I have separately and only briefly addressed the spike on Tuesday tied to the Windstream (NASDAQ:WIN) announcement about placing some of its assets into a REIT to reduce taxes.)
Aside from the improved dividend coverage, there are other benefits from the business acquired from AT&T. Unlike other telcos that have diversified into hosted solutions, data centers and cellular, Frontier has chosen to acquire a business that is similar to the rest of its business. The experiences gained from the Verizon transaction ensure there will be a short learning curve, and new programs used to compete in the broadband space should work well in Connecticut.
The purchase will require some additional cap-ex to improve certain parts of the network and further expand broadband coverage in the state, and there are going to be integration expenses - some of which have already occurred. Also, the company is expected to take on $1.9 billion of new debt to finance the acquisition. Despite this, the acquisition is expected to improve free cash flow in the first full year following the acquisition. Jureller spoke at length about the leverage and capital allocation strategy at Frontier and the dividend:
... at the end of Q1 is our net debt to EBITDA was just over 3.2 times. So, level that we feel really comfortable about, we've talked about on a pro forma basis, once we complete the entirety of the financing [for the acquisition] we'd be up at about 0.4 turns and even at that level we're still very comfortable about that level of leverage, our ability to comfortably to service debt.
But our capital allocation strategy... really guides, our guiding principles on how we think about, what to do with the cash flow. And the first is we wanted to continue invest appropriately in our network...
... The second thing is that we know that our shareholders really appreciate our dividend. We have a strong dividend payout ratio. We want to make sure that we continue to provide for that dividend. The good news as part of the Connecticut transaction with to respect to both of those two elements is we're going to be adding incremental cash flow, incremental EBITDA and free cash flow. And there is going to no share insurance attached to that. So, our share count doesn't increase, our dividend obligation doesn't increase as well.
The third part then after investing in our network, protecting our dividend is paying down our debt in the ordinary course. We have a lot of capital on our balance sheet. We're very comfortable even absent Connecticut that we didn't have to be on the capital markets until 2016 or 2017. So for example, the beginning of May this year, we had a $200 million maturing and in this year and we just paid it off in cash from our balance sheet. We got a lot of cash still to be able to do it to support our Connecticut integration cost to support our business in the ordinary course. And so even over the next couple of years despite where we are going is, we don't have to be back out in the capital markets, and adding Connecticut perhaps could even lengthen that.
Obviously, the company has to prove that it can meet all those objectives, but the key for me is protecting the dividend.
While the 35% increase [through Monday] in the share price since the merger announcement is good news for longs, those looking for high yield have seen the yield decline significantly. When the share price was at $4.40, the $0.40 dividend provided a yield of 9.1%. As the share price had risen to $5.94 on Monday, that yield was down to 6.7%. Still attractive in today's low rate environment, but the market has decided that much of the risk has been removed.
The reduction to the risk of a dividend cut is also reflected in the decline of the short interest in the stock. In early February, I wrote that investors might want to know that:
short interest in Frontier hasn't changed much since the announcement of Frontier's purchase from AT&T on December 17th.
Avg. Daily Share Volume
Days To Cover
One way to interpret this is that the shorts aren't buying into the premise that the dividend is more sustainable.
This also seems to have changed somewhat, as the short interest had since declined to as low as 160.7 million by mid-May. As the share price rose, short interest has increased to 173 million by mid-July (still about 10% below the short position back in December) and low volume increased the days to cover to more than 30.
Much of the company's dividend "protection" will be driven by continued reductions in customer losses and will depend on its broadband success. Again, a comment by Jureller:
You have seen us really had great success in our broadband net adds. In 2013, it was over 112,000 broadband net adds; in Q1, it was 37,000 broadband net adds. We continue at a good pace. We've said that we got some real positive momentum into this second quarter, we've also said generally our second quarter is seasonally a little less than Q1, but nevertheless we're still seeing good things.
Note that total broadband net adds in the first quarter of 2013 were 28,200, and that figure represented more than all of the broadband net adds for 2012. The 37,000 net adds in Q1 of 2014 represents a year-on-year increase of more than 30%.
Disclosure and Recent Events
I have been long Frontier for several years, and have also traded it extensively along the way. It has always been about the dividend, and I have frequently used covered calls to further enhance the yield.
Yesterday, Windstream caused a great deal of excitement with a press release and conference call that announced, "Windstream to Spin Off Assets Into Publicly Traded REIT". The purpose was ultimately about reducing taxes, and the impact was startling. Not only was Windstream up more than 12% on the day, but it carried other telcos along with it. Frontier rose 14.3%, CenturyLink (NYSE:CTL) rose 5.8% and even AT&T rose 2.6% on a down day for the market. Verizon was also up, although only 0.8%.
The implications of a possible REIT spin-off by Frontier and the other telcos have been ignored for this particular article. I suspect that the analysts will raise the issue in the upcoming conference call. Yesterday's jump in the share price will be addressed in a future article.
Frontier continues to move closer to closing on its acquisition of Connecticut's wireline business from AT&T, and it remains on track to close by the end of the year. That business should help to improve the coverage and "protect" the company's dividend. It will also be important for investors to follow how well the company is able to bring its broadband strategy to Connecticut. These two factors were reasons that I have remained a long-term investor in Frontier.
However, this could change after assessing the potential of Frontier following Windstream's lead. With yesterday's jump in the share price and the yield falling to 5.9%, it may make sense to move funds to one of the other telcos that has a history of increasing dividends. Stay tuned!
Disclosure: The author is long FTR, T, VZ, WIN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I have covered calls written against a portion of my Frontier holdings and no positions (or plans to trade) in any of the other company's mentioned in this article.