Telecom & Wireless

Why the Super-High Dividend Yield From Frontier Is Safe

Frontier Communications Corp. (NASDAQ: FTR) is often considered a controversial stock in the world of telecom. It is involved in an acquisition and has a dividend yield of almost 8%. This yield is so high that many investors might just assume the dividend is unsustainable. What investors have to consider is not just where the company is today, but how intertwined its future earnings and free cash flow picture is with a deal involving Verizon Communications Inc. (NYSE: VZ).

While a big boost came from the brokerage and research firm D.A. Davidson raising the rating to Buy from Neutral with a $6.50 price target on Wednesday, a Wells Fargo note may show an even better reason, with formal research outlining why the high-yield dividend is safe here.

Wells Fargo’s Jennifer Fritzsche has only a Market Weight rating on the rural local exchange carrier segment, but she has an Outperform rating on Frontier Communications shares. What really stood out in a note this week was that her last full research report from earlier in May had a valuation range of $8.50 to $9.00 attached to it.

The Wells Fargo note from this week also highlighted just how intertwined the company’s future growth and dividend situation is now with Verizon. Frontier announced that it was raising $2.5 billion in equity and $8.35 billion in debt to fund its $10.5 billion acquisition of Verizon’s wireline assets in California, Texas and Florida.

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Of the $2.5 billion in new equity, the breakdown was $750 million in common stock and some $1.75 billion in a convertible preferred issue. This equity component is slightly downsized from the originally telegraphed $3.0 billion combined. The timing of this financing also looks to be in the second or third quarter of this year, and the total transaction is expected to be 30% accretive to leveraged free cash flow, as well as improving its payout ratio by 8%.

Fritzsche said:

The company reiterated its synergy target of $700 million by year 3 post close and $525 million net cost savings on day 1 via flash cut to Frontier systems. Frontier reiterated its first half of 2016 close and does not expect any issues with its approval process.

As a reminder, Frontier already received an early termination of the Hart-Scott-Rodino Antitrust Act review from the Federal Trade Commission in May. State approvals are said to also be well under way.

The big concern is about the new stock and the convertible issue. Wells Fargo called the issuance somewhat painful at these levels — after all, the stock was down over 20% since the start of May. The firm also expects that getting this issuance out of the way should remove a huge overhang on the shares. Another unknown is the future interest rate moves with the slow summer ahead.

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In Fritzsche’s view, Frontier shares remain very compelling, with a dividend yield of 8.1% and a payout ratio of only 54%, which is lower than its peers.

Wells Fargo has not yet published a pro forma Frontier-Verizon model, but the firm expects this deal to be accretive on free cash flow and with a lower payout ratio, which should only further support Frontier’s future dividend stream.

24/7 Wall St. always tries to show both sides of the coin. If we have or see a very bullish view, we try to temper it with other available reports or data. This shows other calls and data in an effort to not just represent a much higher target price.

As a reminder, Morgan Stanley just raised Frontier’s rating last week to Overweight from Underweight. Morgan Stanley also called Frontier oversold, with its more than 20% sell-off in 2015 being due to the financing overhang here. The firm felt that its integrations in Florida, Connecticut and the western states are starting to stabilize. Still, the firm ticked its price target down to $6.00 from $7.00 in that call.

In early May, S&P Capital IQ kept its Hold rating but cut the target price down by $1.00 to $7.50. This was based on a lower revised enterprise value-to-EBITDA of 7.4 times the firm’s 2016 estimate. The firm also cut the operating earnings per share estimate to $0.16 from $0.23 in 2015, and the estimate was cut to $0.17 from $0.26 for 2016. Still, S&P Capital IQ said:

Sales rose 19%, near expectations, aided by acquired Connecticut assets. We are encouraged by broadband net subscriber additions and believe Frontier’s planned purchase of Verizon wireline assets provides significant scale. We view FTR’s 6% plus dividend as safe (54% dividend payout ratio).

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Frontier has a mixed dividend history, but the mid-2012 dividend of $0.10 paid each quarter through late 2014 went up to $0.105 per share. With a $5.40 share price, that leaves a dividend yield for new buyers of 7.7%. That yield had been higher in recent days and weeks, due to Frontier shares being down around $5.00.

When Frontier announced the $750 million offering of stock and $1.75 billion mandatory convertible preferred stock, the company said:

Frontier intends to use the proceeds from the offerings to finance a portion of the cash consideration payable in connection with Frontier’s previously announced acquisition of the wireline properties of Verizon Communications Inc. in California, Florida and Texas and to pay related fees and expenses. The acquisition is expected to close in the first half of 2016. The closings of these offerings are not conditioned on each other or on the closing of the acquisition.

Short sellers have a huge role here as well. The May 15 settlement date had a short interest that ticked up slightly to 111.9 million, with 6.7 days to cover. The previous settlement date’s short interest was 111.0 million, with 17.7 days to cover. The highest short interest reading of the past year was nearly a year ago at 176.4 million in late July of 2014.

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Investors might want to expect that many brokerage firms will issue research reports now that the offering commenced. It is hard to predict how they will cover the stock, but skeptics (or financial conspiracy theorists) sometimes say that around initial public offerings and secondaries the firms covering them are generally more positive. Frontier’s joint book-running managers were JPMorgan, Bank of America Merrill Lynch and Citigroup. Also, co-managers were listed as Barclays, Credit Suisse, Morgan Stanley, Mizuho, Deutsche Bank, Goldman Sachs and UBS.

Frontier’s $5.40 recent share price compares to a consensus analyst price target of $7.23, and the stock’s 52-week range is $4.90 to $8.46.

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