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Frontier Communications (NYSE: FTR) was founded in 1935 as Citizens Utilities and became a pure-play telecom network operator in 2004.

Frontier announced a deal with Verizon Communications (NYSE:VZ) in May 2009. Frontier acquired approximately 4.8 million access lines from Verizon, tripling the size of the company. The Verizon properties were packaged into an entity called SpinCo and merged with FTR. The all-stock transaction was valued at approximately $8.6 billion and closed July 1, 2010. The transaction created the nations fifth largest incumbent local exchange carrier (ILEC) operating in 27 states. The dividend was cut from $1.00 to $0.75 upon closing.

The yield is 9% based on the February 24, 2011 closing price. So is the dividend safe? Well look at what management envisioned when they announced the SpinCo acquisition and where they are today. Then well discuss how this relates to the dividend going forward.

When Frontier announced the acquisition in May 2009, expectations were based on the following pro forma numbers:

2008 Statistics 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
% EBITDA Margin 54.30% 44.70% 48.00% 55.70%
Bridge to Free Cash Flow:
Interest Expense (363) (290) (653) 0 (653)
Cash Taxes (79) (285) (364) (190) (554)
Capital Expenditures (288) (413) (701) 0 (701)
Other 9 0 9 0 9
Free Cash Flow $493 $930 $1,423 $310 $1,733
FCF/Share $1.58 $1.37 $1.44 $1.75 (c)
Net Debt/EBITDA 3.8x 1.7x 2.6x 2.2x
Dividends ($0.75/share) --- --- $742 --- $742 (c)
Dividend Payout Ratio --- --- 52% --- 43% (c)

(a) Adjusted to exclude Severance and Early Retirement Costs and Legal Settlement Costs.

(b) 2008 audited financial statements adjusted for certain matters
(c) Assuming Frontier issues share at the mid-point of the collar
(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 is used for comparisons going forward. The dividend payout ratio of 52% indicates the dividend was very safe when the deal was announced. In addition, Net Debt to EBIDTA was expected to substantially improve from 3.8x to 2.6x, indicating a stronger balance sheet.

FTR announced fourth quarter and year-end earnings on February 23 and management issued guidance for 2011. The question is: are the original expectations being realized? Below we extrapolated 2011 numbers based on guidance and past SEC filings.

Pro Forma Numbers

2008

2010

(actual)

2011

(proj.)

Range provided by FTR

Revenue

$6,524

$5,652

$5,453

EBITDA

3,132

2,752

2,672

% EBITDA Margin

48.00%

48.69%

49.00%

Bridge to Free Cash Flow:

Interest Expense

(653)

(666)

(672)

Cash Taxes

(364)

(108)

(60)

50-75

Capital Expenditures

(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

Dividend Payout Ratio

52%

62%

64%

The dividend payout ratio projection is 64% in 2011. There is still a comfortable margin of safety, but the percentage was rising when the market 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 go before all the synergies are realized. Management also raised their synergy 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 committed and bullish on $550 million in total synergies through 2013.... The fourth quarter results represent another sequential improvement in many areas of the business, which puts us on the path to deliver on our commitment to provide investors with growth in cash 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] annual dividend and/or reaching our leverage target of 2.5x or below. We believe this is achievable through a combination of EBITDA improvements and/or debt reduction. At this time, we expect residual free cash flow after any debt maturities to build on the balance sheet, and we're not contemplating any near-term changes to our dividend policy or any share buyback programs.

Management appears cautiously optimistic, and for now the dividend is safe. However, if the payout ratio continues to rise, it would be cause for 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.

Source: Frontier Communications - Is the Dividend Safe?