Frontier Communications (FTR) recently released fourth quarter and full year earnings. At the same time, the company slashed its annual dividend from $0.75 to $0.40. The dividend cut had been priced into the share price by the market for several months, as evidenced by a dividend yield in the high teens. However, during the entire time, management and the board steadfastly reiterated that the dividend was secure.
Furthermore, management also stated that the dividend coverage ratio was where management expected it to be when the company first acquired a significant amount of Verizon's (VZ) local business in 14 states more than a year and a half ago.
A somewhat lengthy chronological history of the board and management's statements follows. These statements addressed the payout ratio, sustainability and attractiveness of the dividend. Those less interested in the specifics can scroll down to the section "Why was the Dividend Cut?"
A press release discussing the benefits of the merger issued on May 13, 2009:
- New Dividend Policy: After the close of the transaction, the company will pay an annual dividend of $0.75 per share to its shareholders, representing an attractive and sustainable payout ratio. Based on Frontier's $7.57 closing stock price on May 12, 2009, this dividend represents an annual yield of approximately 9.9% to Frontier shareholders. This dividend policy will allow the company to invest in the acquired markets, offer new products and services, and extend and increase broadband capability to those markets over the next few years.
- Strong Financial Profile: Upon close of the transaction, Frontier will have significantly enhanced financial flexibility with decreased leverage of 2.6 times combined 2008 pro forma EBITDA, a very sustainable dividend payout, and a commitment to achieve an investment grade credit rating. The transaction is anticipated to be free cash flow accretive in the second full year of operation, growing to double-digit accretion in the third year and beyond.
Maggie Wilderotter, Frontier CEO, on February 24, 2010 during the company's earnings conference call.
The integration of these Verizon markets will give our investors a new Frontier with leverage approaching investment grade, more scale, and a great platform for improved product penetration, revenue growth, significant cost savings opportunities and an attractive and sustainable dividend.
Wilderotter on Q1 2010 earnings call May 6, 2010
Finally, we remain committed to an annual $0.75 dividend at close for our shareholders.
Wilderotter on Q3 2010 earnings call on November 8, 2010
Financially, we are in a solid position with a safe and attractive annual dividend of $0.75 per share. We remain committed to our investors and we are committed to improving our cash flow from the acquisition.
Don Shassian, Chief Financial Officer, on Q3 2010 earnings call on November 8, 2010
Please note that this CapEx increases in future quarters for our broadband expansion, specifically for example, in Q4, our payout ratio will increase. In the future, the capital expenditure decreased and our revenue initiatives and our cost saving are fully realized, our dividend payout ratio would significantly improve to at or below 50%.
As Maggie stated earlier, we are very committed to maintain your 75% [sic should read 75 cent] annual dividend. We are also committed to lowering our leverage to 2.5 times or below, which we continue to believe is achievable for the combination of EBITDA improvement and/or debt reduction. At this time, we expect residual free cash flow to build on a balance sheet and are not contemplating any near-term changes to share buyback or dividend policy.
Wilderotter, Q4 2010 earnings call on February 23, 2011
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.
Shassian, Q4 2010 earnings call on February 23, 2011
We remain committed to maintaining both our 75 to [sic] 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.
Fast forward to the fourth quarter of 2011. In an October 3, 2011 press release:
Frontier Communications Corporation paid its Third-Quarter dividend to shareholders on Friday, September 30, 2011 and announced today that its Board of Directors has reaffirmed its current intention to maintain the annual dividend of $0.75 per share of the Company's common stock.
"We remain committed to the return of capital to our shareholders at the dividend level announced in May 2009 and believe our ability to do so will be enhanced by delivering on the cost synergies of the Verizon property acquisition completed a little over a year ago," said Maggie Wilderotter, Chairman and Chief Executive Officer.
On the Q3 conference call on November 3, 2011, call both Wilderotter and Shassian spoke about Frontier's dividend and borrowing capability. First Wilderotter said:
As we wind down our broadband expansion in 2013, we expect improvements in our dividend payout ratio, which was still a respectable 71% in Q3. Frontier's Board of Directors declared a fourth quarter dividend equal to $0.75 per annum at our November 2 board meeting.
Our dividend payout ratio, excluding one-time integration CapEx and operating expenses is 71% in Q3 and at 75%, year-to-date. ...
Slide 14 shows a strong $1.1 billion of cash and borrowing capacity as of Q3, which is incremental to our annual generation of positive visible free cash flow. Leverage at September 30 was 3.17x. Subsequent to the end of the quarter, we raised $575 million of senior unsecured bank debt, and used the proceeds to repay 3 loans, totaling $473 million. We now have no significant maturities scheduled until 2013.
At subsequent investor conferences in mid-November and early December, management continued discussing the dividend coverage. On November 15th, David Whitehouse, Frontier SVP & Treasurer spoke at the Citi Global Markets Credit Conference. He stated that the payout ratio was not out of line with the expectations at the time of the merger. In December similar statements were made by Wilderotter and Shassian.
Why was the Dividend Cut?
There were a host of reasons given in the press release and during the conference call for the cut in the dividend. The press release listed debt reduction, improved leverage, increased cash to invest in the network and other strategic initiatives, and to provide a more sustainable shareholder return through a lower dividend payout ratio. These are all valid reasons. On the conference call, Wikderotter noted three important considerations:
- To get to the 2.5 times net debt-to-EBITDA leverage goal and to improve access to capital.
- To enable increased investment in strategic initiatives - mostly in the area of increased bandwidth and high speed Internet connections to residential and business customers. This includes investing in high bandwidth data connections to cell towers.
- To provide a more sustainable return. The payout ratio was reduced to 42%.
These are important, but again, there was absolutely nothing new in these objectives. The leverage was expected to be reduced as a result of cost savings, increasing revenues from broadband sales and reductions in capital expenditures that would increase free cash flow. Investors had been told that cost savings from merger related synergies were ahead of schedule and guidance had been increase twice since the merger. Investors were told that after 2012, cap-ex would decline to more traditional levels as the broadband infrastructure buildout neared completion in 2012. Investors had repeatedly been told that the dividend WAS sustainable.
Listening to the conference call one would get the impression that Frontier was firing on all cylinders as Wilderotter said:
- This was the best quarter since closing the acquisition in July 2010.
- We continue to cut operating costs. Our 48% EBITDA margin was the strongest since the acquisition.
- Our new synergies of $14 million resulted in an annual run rate of $552 million. We are very much on track to achieve our new $650 million goal in 2012. [an increase of $50 million over previous guidance]
- We expanded broadband to 415,000 new household and businesses in 2011, within our guidance range and fully aligned with State and FCC mandates.
- Based on our conversion track record, we are targeting March of 2012 to begin the conversion of our final nine states. This new target is nine months ahead of our original conversion plans that we announced back in 2009.
It would appear that the dividend cut, and especially the magnitude of the cut, was extreme. Batya Levi of UBS appeared just as puzzled as I am when she posed these questions during the Q&A:
So what I'm hearing -- everything I'm hearing from your comments is incrementally more positive than the last time you addressed The Street, I think it was back in December, revenue decline is improving, churn is improving, synergies are ahead, integration is going well. And you're actually accelerating the conversion of the remaining states. So I want to ask, based on this momentum, why was the magnitude of the dividend cut so large? And you mentioned you want some financial flexibility, but it looks like the CapEx that you want to spend in 2012 is pretty much in line with the prior targets that you've talked about.
The answer was not particularly enlightening, with the only additional bit of information being some vague references to increasing pension costs and cash taxes.
The Issue for Investors
If Q4 was such a great quarter, what has changed that required ANY dividend cut? Did the S&P threat of a downgrade scare management? Did the economic environment where Frontier operates suddenly drop off a cliff? Did management and the board deliberately lie to shareholders about the dividend coverage and sustainability or are they merely incompetent in understanding their customers and the credit markets?
We really don't know what has changed, and it presents a very real problem for investors and analysts. This isn't an issue where management was silent on the future of the dividend. On numerous occasions during the fourth quarter, the board and management told investors that the dividend policy was unchanged and coverage was where management expected it to be. Did revenues show so much weakness since early December that the board was forced to take drastic action resulting in the 47% cut? It certainly was not apparent from the Q4 performance.
For me, the issue is less about a cut in the dividend than it is about trust in management. In a previous article I wrote:
Investors should expect and value management honesty. It's one of the reasons we entrust our money to their care. Until they violate that trust, I will remain an investor in Frontier and continue to expect that $0.1875 quarterly dividend.
Management and my board has violated that trust. The inconsistency of their statements and actions leads me to question the reliability of ANY guidance that they give. Is the new dividend sustainable? Management says the new dividend will "provide a more sustainable shareholder return through a lower dividend payout ratio." The only thing is, management statements aren't worth very much any more.
I will be reassessing my holdings in Frontier and depending a lot less on management statements.
Additional disclosure: I am long Frontier and Verizon. I day trade Frontier, especially with the increase in volatility. I also have several covered call positions positions in Frontier and may close or initiate a covered call strategy at any time.