(Prices are closing prices on December 6th, 2016, with the price of FTR being $3.53/share and FTRPR being $75.10/share - Yahoo Finance)
I recommend purchasing Frontier Communications, 11.125% Mandatory Convertible Preferred Stock, Series A (FTRPR) as my best 2017 investing idea, targeting those who can absorb moderate risk to secure very high income and good total return potential. Buy at $79/share or less to secure a 14% dividend yield. Those buying this instrument should do so, planning to hold FTRPR through the conversion on 06/28/2018 of each FTRPR share into 17-20 shares of Frontier Communications common shares (NYSE:FTR), as described below.
Introduction and Summary:
FTRPR is a mandatory convertible preferred share issued by Frontier Communications which will be converted into the common stock of Frontier Communications. It is a preferred share, not a debt instrument, which will be converted into 17-20 shares of Frontier Common shares on June 28th, 2018. A more comprehensive description of this security is provided below.
Here are the highlights about this security:
a. FTRPR is a security issued by Frontier Communications that has a very high coupon of 11.125% yield on face value. Clearly, this security had been issued under stressed conditions.
b. Currently, since it is selling at a 25% discount to face value, it is viewed by the market as being even more stressed than at the time of issue.
c. The concerns are not about this security, per se, but about the business model of Frontier as well as the highly levered balance sheet and a concern about a dividend cut.
d. What seems to be overlooked is the very strong cash flow which would be more than sufficient to allow FTR to address the highly levered balance sheet (if leadership chooses to do so, which is also a question).
e. A dividend cut, which is used to reduce leverage would actually be a strong positive for FTR investors. Yes, no one likes their dividend cut, but reducing the dividend by half and using that to reduce debt could have a major positive impact in the intermediate term; specifically, just that step could reduce the debt burden by ca. $1B in three years. A moderate reduction in debt would allow the dividend to be restored subsequently or even raised, given a more sustainable financial position.
f. There are concerns about FTR, but even short of strong operational improvements, the company has the tools that it needs to address current investor concerns about the company and put FTR on a much stronger footing, moderating significantly the risk of investing in FTR or FTRPR.
g. Investors in FTRPR can secure a near 15% dividend yield, more than compensating for the moderate risk of the security, and look to convert into what I believe will be an improving security in FTR.
As with earlier "best idea" recommendations, the author likes to "eat his own cooking", investing a significant portion of his own money into the security that he recommends to others. As such, I have been buying FTRPR steadily over the past few months, with this security now representing about 20% of my non-retirement investment assets (my average price is significantly higher at $89.08/share FTRPR). I plan currently to hold this position through conversion into FTR in 18 months, and thereafter, plan (at least at this time) to hold the common shares to secure a strong long-term income.
Description of Frontier Communications, 11.125% Mandatory Convertible Preferred Stock, Series A (FTRPR):
Frontier Communications Mandatory Convertible Preferred Stock, Series A (FTRPR or the "Frontier Preferred") is a preferred share (equity) which has a liquidation preference of $100, pays an 11.125% dividend annually ($2.78125/share quarterly or "$2.78/share") and will be converted into Frontier Communications common shares on 06/28/2018. The actual number of shares to be received will be based upon the average market price for the FTR shares on the 20 days immediately preceding the conversion date with the actual number of shares to be delivered will vary between 17.0213 and 20 Shares. The process and proceeds from the conversion will be discussed in more detail below.
To determine the number of shares to be received, the liquidation preference of $100/share FTRPR will be divided by the calculated market price (established in the 20 trading days prior to conversion) to calculate the number of shares to be distributed (the "conversion price"). If the share price is $5/share (or less), the $100 is divided by $5 to calculate the 20 shares per FTRPR share to be distributed. On the other hand, if the FTR share price is $5.875/share (or greater), then 17.0213 shares will be distributed per FTRPR share. If the calculated market price is between $5 and $5.875 per share, then the number of FTR shares to be distributed per FTRPR share will be determined by dividing the FTRPR liquidation preference of $100 by the actual market price (again determined over the prior 20 days of trading immediately preceding the conversion, again referred to hereafter as the "conversion price"). No fewer than 17.0213 nor more than 20 shares will be distributed per share of FTRPR.
Parenthetically, the terms of this instrument allow for conversion at any time into 17.0213 shares of FTR. However, given the lost income resulting from this early conversion and the potential to receive more shares in June 2018, this option does not appear to be attractive and is not discussed here, other than to note its existence.
Illustrating the Conversion:
As issued, this security has a somewhat convoluted conversion framework, the mechanics for which are important to understand. I have assembled graphs to illustrate simply my understanding of how the conversion will occur on June 28th, 2018. In addition, following the graphs, I offer a chart with the underlying data, if that is easier for the reader to use:
Conversion Value Received per Share FTRPR as a Function of FTR "Conversion Price":
Number of Shares FTR Received per FTRPR Share as a Function of FTR "Conversion Value":
Chart of Data for Value Received and FTR Shares Received in Converting FTRPR as a Function of FTR "Conversion Price":
So it is easiest to think about the conversion using three situations, as highlighted in the graph:
a. If the price is below $5/FTR share (as determined in the 20 days prior to conversion or the "conversion price"), the investor will receive 20 shares of FTR for each FTRPR share and the conversion value. The conversion value can be calculated by taking the FTR market value at any time and simply multiplying by 20. At current prices, an FTRPR share "should" be valued at $3.53 * 20 or $70.60/FTRPR share. In fact, the "market" appears to be factoring in the higher dividend income for FTRPR (7 dividend payments for FTRPR of $0.68125 higher than for the comparable 20 shares of FTR) equaling $4.76875; adding the extra income to the $70.6/share yields $75.37, a bit above the $75.10/share on the close at 12/06/2016.
b. If the conversion price is above $5.875/share FTR, then 17.0213 shares (=$100/5.875) will be distributed for each share of FTRPR. The resulting value of the conversion will deliver significantly more value in this case than the current market price of FTRPR, but would require a substantial improvement from the current FTR price of $3.53/share.
c. If the price is between $5 and $5.875, then the number of shares distributed for each share FTRPR converted will be equal to $100 divided by the "conversion price". This will result in a number of shares being distributed that is between 17.0213 and 20. However, the value of the conversion for FTR prices ranging from $5 to $5.875/share FTR will be equal to $100. Therefore, the value received will be constant even as the number of shares distributed vary. If this scenario plays out, then it is appropriate to point out that this value received will be 33% higher than the current market price (and 14% dividend yield will have also been secured over the 18 month period of time until conversion in June 2018).
My expectation is that the FTR "conversion price" will have remained at or below $5/share and 20 shares per share FTRPR will be distributed, given that current market price is $3.53/share FTR. It is on this basis that I make the calculations below. Of course, if FTR prices are higher, then one will have secured an attractive income and will have also secured a significant capital gain on FTRPR. My premise for investment is that FTR pricing will remain relatively constant over the next 18 months, suppressed by concerns about leverage and dividend cuts but buoyed by strong cash flow.
Income Received Prior to Conversion:
Prior to conversion of the Frontier Preferred, dividend payments of $2.78/share will be made on the last calendar day of the quarter (03/31, 06/30, 09/30 and 12/31) to those owners of record on the 15th day of the month (03/15, 06/15, 09/15 and 12/15). In addition, those owning the Frontier Communications at the time of conversion will also receive the last dividend payment of $2.78/share as the record date will have been passed (06/15/2018). As such, there are seven dividend payments of $2.78/share to be paid prior to conversion, with then next record date being 12/15/2016 (trading ex-dividend on 12/13/2016). As noted above, the sum of the remaining seven dividends for each FTRPR will exceed the dividends of 20 shares of FTR by $4.76875.
Based upon the closing price of $75.10/share on 12/06/2016, FTRPR is providing a 14.8% yield. Of course, this attractive yield is only offered due to the perceived risk of FTR, focused on concerns about significant leverage and a potential dividend cut on the common shares. While this would not be of concern short term to buyers of FTRPR, it would definitely be a longer-term concern for buyers of FTRPR as one would be owning common shares in the next 18 months.
As such, the valuation of FTRPR is driven by issues related to FTR and to the financial metrics of the company. Therefore, the balance sheet of Frontier Communications and the cash flow of the company are examined in the next two sections.
FTR Balance Sheet:
Please find a simplified balance sheet for Frontier Communications provided below, focusing on key issues related to an investment in FTRPR (or FTR):
Three key issues are highlighted in the balance sheet:
a. As discussed extensively above, the leverage of this balance sheet is uncomfortably high (to the author, at least). Although the company has $29B in assets, there are also $24+B in liabilities, leaving a "sliver" of $5B in net assets. $5B in assets is a lot of money, but this still represents a small asset base given the huge liabilities. In my view, the highly leveraged nature of this balance sheet represents a drag on investor interest in FTR.
b. In discussions of market capitalization and equity in FTR, FTRPR seems to disappear in the discussion and calculations, even if it represents (at face value) $1.7B in equity. Equally substantial is that this security will convert into 350M additional shares of FTR in 18 months (assuming 20 shares per share FTRPR).
c. If you factor in the substantial number of new FTR shares to be added through mandatory conversion of FTRPR, the recalculated book value per share is $3.13/share FTR. This implies an equivalent "book value" of $62.6/share per share FTRPR (= 20 * $3.13/share FTR).
Ordinarily, this highly leveraged balance sheet would "scare me off". However, there is a compensating factor for Frontier Communications which offsets this "liability", if you will pardon the expression.
Let's consider the cash flow......
FTR Cash Flow Highlights:
OK, now the good news. The latest (3Q ending September 2016) cash flow results are provided in the chart above. In looking over recent quarters of reporting results to identify trends, there are a number of "puts and takes" in operating cash flow. This makes it difficult to identify clear trends, including the most recently acquired assets. I look to future quarterly earnings reports to begin to identify more clear-cut trends.
However, one thing clearly stood out, which is a critical element: there is a significant, quarterly depreciation charge that seemed to dominate the cash flow statement. Quarterly, FTR "spends" about $588M on depreciation of its equipment. This was consistent in both quarters since the latest acquisition (Verizon (NYSE:VZ) land lines in specific states) had closed. The implication of this sizable depreciation is that, even if such a high depreciation charge should depress earnings, this non-cash charge will result in consistently very strong cash flow, given reasonably consistent revenue generation. That is, FTR should incur about $2.3B in depreciation charges each year, which suppresses earnings but results in consistent operating cash flow going forward. Even with significant, negative Other Cash Flow items incurred in the quarter and with modestly negative Net Income of (minus $80M), the company still delivered $321M Operating Cash Flow in the quarter.
Financial Implications of FTR's Balance Sheet and Cash Flow:
As indicated above, the author would ordinarily be "scared off" by a company that is as levered as FTR, preferring strongly financed companies that are nonetheless hated by the market to create attractive, value-oriented, safe securities for purchase. However, offsetting that negative is the prospect of very strong Operating Cash Flow going forward, even as the company just barely breaks even due to high depreciation as well as high interest expense of $386M per quarter, the latter to be discussed below. As the company clears up the recent acquisitions, it is my hope and expectation that it will focus on using that strong Operating Cash Flow to strengthen its weakened balance sheet, reducing interest-bearing debt to reduce the very high interest expense. While this is not a challenge that can be solved in months, it could certainly be improved substantially in the next three years, again given the strong cash flow. My reading of its recent comments on the quarterly earnings was that it realizes that strengthening the balance sheet must be a priority.
Even without a dividend cut, significant progress could be made to begin to reduce interest-bearing liabilities. With Operating Cash Flow of $321M and dividend payments of $178M, there is still available cash to begin to redeem debt. If debt could be reduced even by $5B, there would be a readjustment of debt to assets that would look much more sustainable. While $5B looks to be a big number, let's again consider that there is a $2.3B in annual cash flow resulting from the high depreciation charge that represents half of that desired debt reduction.
This should also be a virtuous cycle of helping earnings/P&I statement as the very high liabilities come down. Consider that the quarterly interest expense is $386M per quarter; if one reduced that by 20% (consistent with taking liabilities down 20% from $25B to $20B), the interest expense would, on average, be brought down by nearly $80M per quarter. Given that the Net Income for 3Q'16 was a minus $80M, this could offset the recent modest losses that FTR reported in the most recent quarter, even with mediocre operating performance reported. A virtuous cycle of improved earnings strengthening cash flow enabling ever more debt reduction and reduced interest expense would result in a strengthened balance sheet, improved earnings, even stronger cash flow and create increased confidence in Frontier Communications.
There has also been concern expressed about a dividend cut. While no one likes their dividend reduced, reducing the dividend and redirecting those cash payments into debt reduction would result in a strengthened company sooner. Cutting the dividend in half, arguably a big cut, could result in $89M in additional, quarterly debt reduction. In three years, this would result in a debt reduction of about $1B. This would also still leave a company paying a 6% dividend, albeit on valuation reduced to $3.53/share. Once a more sustainable balance sheet will have been developed, dividends could be restored and on a much more sustainable basis; in addition, every penny not paid on a dividend and used to reduce debt would constitute a penny of additional asset value supporting the value of the shares. While some income would be lost, FTR would still be paying a 6% dividend and this increased asset base would be reflected in higher market values at some point in the future. As such, the dividend may be cut, not because it is needed, but because we want it to be better utilized.
Finally, it is worth pointing out that the conversion of FTRPR to FTR shares, even if at the 20 shares FTR per FTRPR rate, will result in a quarterly reduction of $11,900K in quarterly dividend and fully $47M annually (= $2.78 (FTRPR dividend) - $2.1 (20 shares FTR * $0.105) = $0.68 reduced dividend/FTRPR share * 17,500K shares = $11,900K). Just this conversion will free up a non-trivial amount of free cash to provide more firepower to reduce debt.
While FTR has been "on a buying spree" and has levered up substantially, these assets obtained are providing significant Operating Cash Flow that, if deployed to do so, could strengthen the balance sheet in the intermediate term. In the meantime, while there are issues that weigh on Frontier Communications, I believe that these issues are more than taken into account in the pricing of FTR and of FTRPR. Compare the Operating Cash Flow underlying the 15% dividend payment of FTRPR at today's closing price with much weaker and much less consistent Operating Cash Flow from other preferred securities paying 15% (e.g., some of the dry bulk shipping companies). As such, FTRPR looks to me to be undervalued, relative to its financial metrics and represents an attractive income vehicle providing very high risk-adjusted dividend yield. In addition, it appears to me that the company is preparing to use its Operating Cash Flow to address some of the concerns that have dragged down the valuation of both FTRPR and FTR. As such, I view FTRPR as a buy and recommend it as my 2017 strong conviction, best idea for those income investors who can tolerate moderate risk in pursuit of high income and strong total return.
I recommend purchasing Frontier Communications, 11.125% Mandatory Convertible Preferred Stock, Series A (FTRPR) as my best 2017 investing idea, targeting those who can absorb moderate risk to secure very high income and good total return potential. Buy at $79/share or less to secure a 14+% dividend yield. Those buying this instrument should do so, looking to hold into 2018 to convert each FTRPR share into 17-20 shares FTR.
Disclaimer: No guarantees or representations are made. The Owl is not a registered investment advisor and does not provide specific investment advice. The information is for informational purposes only. You should always consult an investment advisor when considering an investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: As stated in the body of the text, I am significantly long FTRPR. However, the ticker did not get picked up within the disclosure system and am disclosing it in the comments.