Frontier Communications Drops The Bomb

Summary

• Frontier Communications reported its fourth quarter results yesterday.
• While the results were largely in-line with the street's estimates, it's the forward looking guidance and dividend elimination that hurt the investors' sentiment.
• Moody's could downgrade the stock this year as Frontier's EBITDA hasn't stabilised yet.

Frontier (FTR) just posted its fourth quarter results. While its revenue and adjusted EBITDA figures were largely in-line with the street’s estimates, its dismal net subscriber additions during Q4 and disappointing FY19 guidance left a bad taste in many FTR investors’ mouths. If that wasn’t enough, the company dropped a bomb on the investment community by completely slashing its dividends. Rather than beating around the bush any further, let’s delve deeper into its Q4 results to have a better understanding of its current state of affairs.

Letting it churn

Let me start by saying that Frontier recorded revenues of $2.21 billion for the fourth quarter, which was largely in-line with the street’s estimates. Its adjusted EBITDA for the period came in at $919 million which is almost the same as its mid-point guided figure of $920 million. Also, I had forecasted in my last article that its overall churn would improve to 1.95% during Q4. Well, the actual churn figure came in really close at 1.98% so I won’t call it a miss.

Its management highlighted in the conference call that their CTF FiOS operations, which was notoriously responsible for the bulk of the company’s subscriber losses over the past year, finally showed signs of stabilization. While I agree that everything discussed so far painted an optimistic picture about the company, there are also a few issues in its Q4 earnings report that raise a few red flags.

As the chart attached above would indicate, Frontier’s churn rate did improve. It’s a fact and not conjecture. However, an improvement in churn rate can’t singlehandedly turn around the fortunes of a troubled services business. Ideally, one would want the number of customers leaving a service to be less than the number of subscribers enrolling for the service, so that the overall subscriber base expands anyway.

But that's not happening at Frontier-land just yet. The company managed to improve its churn rate this quarter but its gross subscriber adds fell short on a sequential basis. The net result was that Frontier’s broadband and business verticals kept losing subscribers at the same rate on a net basis, even though the telecom stalwart’s overall churn rate improved overall. I’ve attached a chart below for your reference. So, while the company may have the good intentions of pushing its net adds into the positive territory, it’s not there yet.

The art of guidance

Secondly, my readers would know that I’ve been critical of Frontier management’s guidance discipline. I’ve discussed this aspect of their business many times in the past and also brought this issue up in my earnings preview article on the name. Unfortunately, this issue is prominent yet again, perhaps more than it ever was.

Frontier lowered its annual guidance yet again. Its management is now aiming to generate $3.6 billion in adjusted EBITDA over the course of the next fiscal year. In fact, for anyone who’s new to analyzing Frontier Communications, this happens to be the fourth downward revision to its guidance over the past 5-6 quarters.

Annual Guidance	Quarterly Guidance	Announced for Period	Result	Announced during…
$4 billion for FY17	$1 billion*	FY17	Missed	Q3 FY16 conference call
$3.8 billion for FY17	$950 million*	FY17	Missed	Q1 FY17 conference call
$3.8 billion run-rate	$950 million	Q3 & Q4 of FY17	Missed	Q2 FY17 conference call
N/A	$920 million	Q4 of FY17	Met	Q3 FY17 conference call
$3.6 billion for FY18	$900 million*	FY18	TBD	Q4 FY17 conference call

Click to enlarge

The table attached above should provide some perspective. Frontier’s management has been consistently lowering their guidance in the past, and then missing it. It’s almost like someone is moving the goalpost closer in their favor, but still failing to score the goal. I leave it to readers to decide why this keeps happening.

But overall, it’s quite surprising to see that Frontier won’t reach the coveted goal of $4 billion in adjusted EBITDA even during FY18. For the record, it has been five quarters since its management originally issued the ambitious guidance after all. Not to mention, the company has been recognizing cost synergies/savings along the way that has been bolstering its adjusted EBITDA figures over the past several quarters now.

The difference between Frontier’s original FY17 and FY18 guidance amounts to a healthy $400 million. While the amount may seem paltry for mega corps like Apple or Amazon, it’s a handsome amount nonetheless for a company like Frontier that’s reeling under an overall debt burden of $17.9 billion. To put things in perspective, that’s about 5x of Frontier’s guided FY18 adjusted EBITDA.

And how does Frontier plan to recoup a part of its lost $400 million opportunity? By eliminating dividends.

Dividend Fiasco

After paying dividends on common stock for many years straight, Frontier finally eliminated its payouts to ensure that it’s left with enough financial flexibility to pare down its mountain of debt. Management noted that the move will free up $250 million in cash during FY18, post the conversion of preferred shares in June.

This action will make available $250 million of additional cash annually following the conversion of the mandatory convertible preferred stock in June of this year... We will use this cash to reduce debt at a faster rate supporting our ability to address the larger debt towers in coming years and giving us ample runway to execute our strategy. —Daniel J. McCarthy, Q4 conference call.

I’ve been a vocal proponent of slashing dividends to repurchase debt in many of my previous articles, and it seems like that’s what the management is planning to do. Fact of the matter is that there’s a good portion of Frontier’s bonds that are trading at steep discounts. While some are still trading at par, some notes are discounted by as much as 27-30%. So, it’s possible that in extreme cases, Frontier can retire as much as $1.42 debt for every $1 spent on repurchasing debt maturities. Not to mention, the telecom stalwart won’t have to pay any interest payments (7-8%) on debt that’s already retired.

While this may sound like a good business move, the problem here is that it alienates Frontier’s broad swath of income-seeking investors. The screenshot attached below would indicate that institutional ownership in Frontier Communications stood at over 75%. If these entities start unloading their massive positions, because the telecom stalwart doesn’t belong in their income portfolios anymore, then the stock is bound to collapse.

(Source: Nasdaq)

Frontier really needed to wait for its operations to show signs of growth, or meet its previous guidance, so that value and growth investors would come in to support its stock price when income investors start abandoning the name in large numbers. But after a series of disappointing guidance revisions and dismal financial performance in the past several quarters, it’s hard to see that scenario playing out anytime soon. Not to mention that shorts can now have a free run at Frontier Communications as they won’t have to worry about bearing dividend expenses -- as a cost of maintaining their short positions -- anymore.

Investors takeaway

Just to rehash a bit here, I noted in my last article that Moody’s could downgrade Frontier if its EBITDA didn’t stabilize anytime soon. With the lowered annual guidance, it’s possible that Frontier gets downgraded again.

Moody's could downgrade Frontier's ratings further if the company is unable to transition to approximately stable EBITDA over the next 12 to 18 months, its liquidity deteriorates or its subscriber trends worsen. Moody's could stabilize the outlook if Frontier was on track to achieve stable EBITDA, while maintaining leverage below 6x and good liquidity. Given the company's weak fundamentals ratings upgrade is unlikely at this point. —Moody's, January 2018

With that said, I’d recommend readers to not try to catch falling knives with Frontier Communications. Maybe wait for the company to at least start showing some signs of growth. Institutions collectively hold 75% of the company’s overall shares outstanding, and if they start selling in large quantities, the stock can collapse further.

Author's note: I'll be covering Frontier's debt profile in my next report. Make sure to click that "Follow" button at the top of this page to get an alert as soon as the report goes live. Thanks!

Analyst’s 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.