It has been a busy month for Frontier Communications (NYSE:FTR), and in this case busy isn't better for investors that have chosen to be long the stock. The share price stood at $6.26 at the end of October and is off nearly 14% as we head into the last week of November. And this is despite a $0.75 annual dividend that yields just under 14%. With a yield at this level, the market has clearly priced in a dividend cut. Is the market correct?
On November 2nd, the day before the company released its third quarter earnings, the board declared a regular quarterly dividend of $0.1875 to shareholders of record December 9th, payable on December 30th. So, for those looking for some income before the end of the year, there's still time. Is there a risk? Absolutely. Stocks do not carry dividend yields more than 10 percentage points above the rate of inflation unless there is fear that the dividend won't be maintained. Is the fear justified? Can an investor mitigate the impact of a potential dividend cut?
When an investor buys shares in a company they are depending on several factors for the investment to be a success. Some of these are the company's cost structure, competitive position in its markets and industry, how it will be affected by macro-economic factors and the capabilities of the company's management. Like many other investors, once I have become comfortable with the risk levels associated with the company, I am dependent on the company's management team to perform and deliver acceptable results.
Over a year ago, Frontier acquired significant assets from Verizon Communications (NYSE:VZ) in an exchange of stock that actually gave Verizon shareholders more than 60% of Frontier. At the same time, Frontier cut the annual dividend from $1 to $0.75, a reduction that was announced more than a year earlier - May 13, 2009 - at the same time it announced that it was making the acquisition. At the time of the cut the board stated:
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.
They laid out an ambitious program to improve service, expand broadband access and generate substantial savings by converting the newly acquired customers over to the company's legacy systems and backbone. During various investor conferences and on earnings calls the management continues to spend considerable time focusing on leverage and the dividend payout ratio. Recently, during its November 3rd, 2011 third quarter conference call, Maggie Wilderotter, Frontier CEO, stated:
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.
And, Frontier CFO Donald Shassian spent considerable time talking about the leverage, free cash flow and the payout ratio:
Our dividend payout ratio, excluding one-time integration CapEx and operating expenses is 71% in Q3 and at 75%, year-to-date. With no changes in Washington as yet, corporations will still receive 50% bonus depreciation in 2012, followed by 0 bonus depreciation in 2013. We will provide full 2012 guidance on our next earnings call, but our preliminary view is that, assuming only 50% of bonus depreciation in 2012, our cash taxes in 2012 should be approximately $150 million.
... 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.
More recently, on November 15th, David Whitehouse, Frontier SVP & Treasurer spoke at the Citi Global Markets Credit Conference. He spoke at length about ultimately lowering the leverage ratio to 2.5x. When questioned as to whether the leverage goal or maintaining the dividend took precedence, he noted that they were not mutually exclusive, and since the merger, the payout ratio was not out of line with expectations. The company knew they would be investing heavily in broadband while at the same time spending money to migrate the acquired properties to the company's legacy systems. Also important was the discussion on the realignment of the debt in terms of the amounts and laddering of the maturity dates.
The migration and broadband expansion plans are important to the company's future success. The recent conversion of four states that was completed in October bodes well for the company's future plans to migrate the remaining nine states during the first half of 2012. Completion of the migration will see management deliver (and, in my opinion, exceed) on its promise of $600 million (currently at $496 million) in synergy related annual savings since it will relieve the company of its annual software licensing payment on the acquired properties.
The ongoing broadband rollout helps in several ways. First, selling the product increases the average revenue per customer. Second, it improves customer churn. Third, it puts the company in a better competitive position by allowing it to offer bundled services similar to the cable companies. Fourth, broadband is appealing to a younger demographic and allows the company to pair it with reselling of AT&T (NYSE:T) wireless services (discussed on the conference call and announced in a press release on November 15th).
Total access line losses are troubling, although broadband provided one of the bright spots in the third quarter, showing significant customer growth. This growth, along with the debt realignment and management's continued delivery on their cost savings, are the reasons I remain long in the stock and confident in the maintenance of the dividend.
Earlier I asked the question, "Can an investor mitigate the impact of a potential dividend cut?" Using options or LEAPs, and taking the risk of losing out on capital appreciation, an investor can reduce their exposure. Currently, Frontier is trading at $5.39. January 2013 LEAPs with a strike price of $5 are trading at $0.75 bid. Buynig the stock and selling the LEAP will cost a net of $4.64 (excluding commissions).
What are the possible outcomes on this strategy? Well, the worst case scenario is that the company goes bankrupt before the end of the year, never pays a dividend and the investor loses everything and has a loss of $4.64. The idea of bankruptcy is extremely remote, and even a problem making the dividend payments over the next year seems unlikely.
A more likely scenario is that at some point before January 2013 one can reasonably expect the shares to be called away for $5, representing a capital loss of $.39 on the stock and a capital gain of $.75 on the LEAP for a net profit of $0.36, the equivalent of nearly two full dividend payments. If no dividend payments are received, it means that the shares are called away within the next two weeks and the investor has a return of more than 7%. (The shares would be sold for $5, about 7.7% above the net cost of $4.64.) Each dividend payment received enhances the total return, although the annualized return declines with each ensuing payment. If all four dividends are paid and the shares are called in January of 2013, the total return is more than 16% over a bit less than 14 months on the net investment of $4.64. ($0.75 in dividends divided by the $4.64 net cash outlay is 16.2%).
If the market is correct, and the dividend is cut at some point over the next year, the calculations become much more variable and two questions need to be asked. How large is the cut likely to be and what would be the impact on the share price? Assume the dividend is cut by one third - a fairly substantial amount - to a $0.50 annual rate. Is it reasonable to assume that the new dividend would then be sustainable? If you think the answer is yes, than a $0.50 dividend on a share price of $5 would represent a 10% yield, fairly substantial in today's low interest rate environment. If the hypothetical $5 stock price remains in effect, the shares would not be called and the current yield would be 10%. However, because the net cost on this transaction is only $4.64, the yield on cost would be 10.8%.
One can speculate on a variety of different dividend rate cuts (or none at all), the market's reaction and the resulting share prices. And, what may seem reasonable to me could be viewed as wildly optimistic by you. But with management committed to high dividends and a low interest rate environment, it is hard for me to see where a covered call strategy would not result in an above average return.
Additional disclosure: I may add to my positions in Frontier and/or initiate a covered call strategy at any time.