Frontier Communications (FTR) remains committed to an annual dividend yield of 10 percent, despite a 12-month trailing payout ratio that has exceeded earnings by almost 340 percent. Notwithstanding continued management optimism, funding the rural carrier’s aggressive infrastructure expansion plans going forward will likely lead to a material cut in these quarterly cash payments to shareholders.

In July 2010, Frontier became the largest provider of communications services to rural America after acquiring assets from Verizon Communications (VZ) – including long-distance voice, broadband and video accounts, and fiber-to-premise assets (home and business) – in a deal valued at approximately $8.6 billion. Although the transformational transaction has nearly tripled the company in size, adding more than 3.6 million local access lines in 14 states, it also increased average debt outstanding by some $3.5 billion to $8.3 billion (as of March 31).

Most of the acquired properties from Verizon were legacy assets (think less-profitable, slower copper-based technologies like DSL) in underserved rural areas. Critics have contended that servicing this debt load will slow necessary infrastructure upgrades, constrain high-speed internet build-out, and worsen service quality.

Revenue successes with rural-driven business model

To the contrary, Frontier’s management team opines the company can leverage experience in running rural networks to successfully execute on increasing market penetration and growing revenue per subscriber – aided by product deployment of upgraded, high-speed Internet (and bundled service offerings, like broadband, television and telephone) and reduced churn.

On the quarterly earnings call in May, Chairman Maggie Wilderotter pointed out that Frontier’s marketing sales and retention efforts yielded 15,000 high-speed DSL net additions in first-quarter 2011, compared to a net loss of 17,000 in the second-quarter 2010 under previous ownership. Furthermore, broadband growth faced a low hurdle rate, with “household penetration in the acquired properties, at purchase, of 20 percent, compared to 37 percent in the Frontier legacy markets,” said Wilderotter.

Reducing cash operating expenses through systems integration

The Verizon purchase also provides opportunities to improve profitability and drive sustainable cash flow growth through economies of scale – “business that is three times” its former size: Wilderotter told analysts on the earnings call that the company was on track to realize incremental cost synergies in 2011 of approximately $368 million, which was well on the way to achieving a previously targeted $550 million by end of 2012. Driving cost-saving wins are employee and external (contractors and vendors) headcount reductions and migration of (lower-margin) long-distance services to a different carrier, according to the first-quarter 2011 regulatory filing.

Is the dividend safe?

Frontier has ample liquidity, according to chief executive Don Shassian: At March 31, the company had $359 million in cash at-hand; businesses threw off approximately $253 million in free cash flow last quarter; and, the company is sitting on $750 million in revolver credit (unused and available until January 2014).

Shassian opined, too, that Frontier s balance sheet is healthier than that being painted by its detractors, with debt leverage a “moderate” 3.03 times (adjusted) operating cash flow; “minimal” amount of debt is coming due (about $1.2 billion in staggered maturities through 2013); and, the dividend payout ratio is forecasted to improve in tandem with revenue and profitability (accompanied by growth in free cash flow from expected reductions in capital expenditures).

“As imagination bodies forth the forms of things unknown,” wrote William Shakespeare, “the poet’s pen turns them to shapes and gives to airy nothing – a local habitation and a name.”

Back to the future

Looking backward helps give a glimpse into Frontier’s future. In the last four quarters, the company generated operating cash flow of $1.6 billion and paid out $638 million and roughly $717 million ($1.35 billion in total) on dividends and necessary capital expenditures (capex). Ergo, the dividend is secure – if one believes the company’s future to be as rosy and profitable as imagined by its management team. Unfortunately, fiction cannot obscure given realities:

There is good reason Verizon looked to divorce itself from these rural properties – principally because the disposed fixed-line assets weren’t as economically attractive to maintain as higher-margin, faster-growth subscriber services, such as wireless smart-phones or video/cable subscriptions in metro regions.

In my opinion, monies already spent just in West Virginia demonstrate that Frontier has under-estimated total capex spend needed to upgrade and integrate high-speed backbone of acquired Verizon legacy assets: In the last year alone, Frontier spent more than $300 million to build 305 remote broadband delivery sites, according to company vice-president Dana Waldo.

The company plans on spending in the range of $810 million to $840 million for its 2011 construction and broadband build-out program, included in this budget are projects targeting the first four (MI,IN,NC, and SC) off the other acquired 13 other (state) properties. Cost overruns resulting from this expanding IT investment program – converting erstwhile Verizon systems onto existing Frontier systems – could cripple an already constrained liquidity picture for dividend payouts going forward.

Additionally, the aforementioned $750 million credit facility is available only for general corporate purposes – and cannot be used to fund any dividend payments!

Can you hear me now?

Removing costs from the liquidity equation in coming quarters could also be hindered by competitive pressures (substitute wireless service offerings from other providers), forcing Frontier to respond with increasing dollars directed toward promotional spending (like equipment and modem giveaways). Financially-strapped municipalities at the state and federal level are also making more noise about reducing rural subsidy initiatives and third-party roaming charges(about 12 percent of aggregate sales).

In addition to slowing network integration, accelerated losses of legacy access lines could result in impairment write-downs, too. Though not a “cash drain,” goodwill/intangibles represent 48.3% of Frontier’s $17.8 billion of total assets. Consequently, write-downs could prove material to shareholder equity – and, in turn, raise future borrowing costs (currently averaging about 8 percent on long-term debt).

Until Frontier can actually demonstrate improvements in its financial flexibility and do more than just “talk” about the supposed benefits to be had from the Verizon deal, expect the company to hang-up on calls to maintain that juicy 10 percent dividend yield.

-David Phillips

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