Dividend Increase May Come To Haunt Frontier

| About: Frontier Communications (FTR)
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Summary

Company should not have increased dividends as it already offers attractive yield and cash flows could be invested in future growth projects.

FTR is overvalued according to my price target.

Strong broadband subscriber addition to continue in future as well due to attractive speeds capabilities.

Frontier Communication (NYSE:FTR) is a rural local exchange carrier in the U.S. It provides voice data and video services to business, residential and wholesale subscribers. I am reiterating my neutral stance on the company. FTR will continue its growth in the broadband segment; it also recorded the highest broadband additions in the third quarter among its peers. The company currently operates at a decent payout ratio, but the increase in dividends and the potential rejection of bonus depreciation by the Senate could elevate the payout ratio. Lastly, I also believe the company is overvalued based on the discounted free cash flow analysis and EV-to-EBITDA multiple.

Broadband Momentum to continue in 2015
I believe FTR can continue to provide solid broadband subscriber growth in the next year as well. Firstly, the company offers attractive speeds, as 55% of households are capable of being offered speeds of 20Mbps or higher and 75% of households are capable of being provided speeds of 12Mbps or higher. In addition to this, the management is also launching 1Gbps and 500Mbps broadband capabilities, which will attract subscribers who need fast internet speeds. The high speeds are becoming attractive, as 34% of broadband sales and upgrades were above the basic speed tier in the last quarter. Furthermore, I believe high speed capabilities will be attractive for small-and-medium-sized business enterprises, who could utilize these speeds to 'cloud-enable' their businesses. This move would help businesses achieve cost efficiencies. One of its peer companies, CenturyLink (NYSE:CTL), has successfully done this recently and has attracted small-and-medium-sized enterprises.

I also believe CAF funds provide a great opportunity to increase the company's broadband operations. The company has $60 million of CAF-1 funds available, as it has only utilized $73 million in the last six months. From these funds, FTR has completed 33K CAF households in the last quarter, which includes both upgrades and new households. I believe the remaining $60 million of CAF-1 funds and CAF-2 will create a tremendous opportunity for the company to not only upgrade its existing capabilities, but also penetrate new un-served locations as well. Lastly, the company has completed its acquisition of the Connecticut wireline business from AT&T (NYSE:T). This will continue to drive significant growth next year as well in the form of TV and broadband additions.

The company has added almost 22K broadband subscribers in the third quarter, which is significantly higher than its peer companies; CTL and Windstream (NASDAQ:WIN) added 8.4K and -11.8K broadband subscribers, respectively.

Dividend Increase could Hurt in Future
Recently, the company has announced a dividend increase of 5% and raised its quarterly dividends to $0.105 per share. I believe this was not a sound decision by the management and they have overestimated the benefits of the Connecticut transaction. The company has a decent payout ratio as shown in the table below. The company pays an annual dividend of $0.40 per share and the 5% increase in dividends is $0.02 per share. FTR has 1 billion outstanding shares, which translates into an annual dividend increase of $20 million. This will increase the payout ratio to almost 54%. Furthermore, if the Senate decides to not extend the bonus depreciation bill, cash taxes will increase and payout ratio will further deteriorate. So, very little free cash flows would be left to invest in the growth of the business, as the company operates in a capital-intensive industry.

Companies

Dividends Paid (YTD at Sep 30, 2014)

Free Cash Flows (YTD at Sep 30, 2014)

Payout Ratio (Div Paid/ Free Cash Flows)

Dividend Yield

CTL

$924 million

$2,317 million

40%

5.60%

Frontier

$300.6 million

$600.1 million

50%

6.20%

Windstream

$451.6 million

$693 million

65%

10.90%

Source: Company's Earnings Report

Moreover, the company has a total debt-to-equity ratio of 242.73x, which is significantly higher than its peer CTL, which has a total debt-to-equity ratio of 128.62x. In addition to this, FTR has around $2.5 billion maturing in debt in the next 5 years. So, the company needs hefty free cash flows to repay debt. The management has also increased its free cash flows guidance for the current year, but the increase was driven by a decrease in capital expenditures. Capital expenditure is very important to extend the company's broadband coverage and offer competitive speeds.

The increase in dividend is effective from the first quarter of the next year. The table above shows that the company is already offering an attractive dividend yield. One of its competitors, WIN, offers the highest dividend yield and has also decided to reduce aggregate dividends by $0.30 per share after the spinoff, which will translate into a yield of 8%. So, the company's yield was competitive and I believe it should have used its free cash flows to invest in future growth or pay off debt, rather than going for an increase in dividends.

Valuation
In order to determine a price target for the company, I have used two methods. Firstly, I have discounted free cash flows using a WACC of 6.2%. Secondly, I have used a ratio of EV/EBITDA to calculate the price. My price target comes out to be $6.44 per share, which is the average of the two methods mentioned above. Currently, the company is trading at $6.74, which shows that the company is overvalued and I am expecting a pull back.

Discounted Free Cash Flow Analysis
I am raising my estimates for free cash flows after the completion of the Connecticut transaction. The management itself has updated its guidance for free cash flows to $755-780 million for the current year. Furthermore, I have discounted free cash flows using a WACC of 6.2%. The terminal growth rate to calculate the terminal value is 0.25%, due to secular decline of traditional legacy revenues. Furthermore, the figures for total debt and number for shares outstanding has been taken from Yahoo Finance. In my estimates of future free cash flows, I have used another assumption, which is that the Senate will extend the bonus depreciation bill, which will eventually result in lower cash taxes.

 

2015

2016

2017

Terminal Value

Estimated Free cash Flows

$896

$926

$948

$15,973

Discount Factor

0.9416

0.8866

0.8349

0.8349

Present Value

$844

$821

$791

13,336

Total Value to firm = $844+$821+$791+$13,336=$15,792 million

Total Debt= $9,450 million

Total Value to firm - Total Debt = Total Equity value

$15,792 - $9,450= $6,342 million

Share Outstanding = 1000 million

Target Price = Total Equity Value/Share Outstanding

$6.34 = $6,342/1000

Enterprise to EBITDA Multiple
The company itself is trading at a premium Enterprise-to-EBITDA multiple of 7.26x, which I believe is not justified. To calculate the justified Enterprise-to-EBITDA multiple, I have used the average, as shown in the table below. The EBITDA estimate is $2,450 million for next year. With an average multiple of 6.54x, the firm value comes out to be $16,023 million and the equity value comes out to be $6,573 million after adjusting for total debt of $9,450 million. Divided by the 1,000 million outstanding shares, the price target comes out to be $6.57 per share.

Companies

Enterprise to EBITDA Ratio

FTR

7.26x

CenturyLink

6.00x

Windstream

6.36x

Average

6.54x

Source: Yahoo Finance

Final Words
I believe the company should not have increased its dividends, as it already offers an attractive yield and cash flows could be invested in the company's future growth. According to my price target of $6.44 per share, the company is overvalued. However, I expect the strong subscriber additions to continue in the future as well due to attractive speeds capabilities. CAF funding will also assist in up gradation and expansion of its broadband footprint.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.