Frontier Communications (FTR) and Verizon by D. Klein 7/9/2009

Frontier announced a deal with Verizon Communications (in May) under which Frontier will acquire approximately 4.8 million access lines from Verizon. The Verizon properties will be packaged into an entity called SpinCo and merged with FTR. The all stock transaction is valued at approximately $8.6 billion. The transaction will create the nation’s fifth largest incumbent local exchange carrier (ILEC) with more than 7 million access lines, 8.6 million voice and broadband connections and 16,000 employees in 27 states.  Frontier announced the dividend will be cut from $1.00 to $0.75 once the deal is complete.

So is the stock a buy?  FTR will need to integrate a company about three times larger than FTR.  They have successfully integrated Rochester Telephone, Commonwealth Telephone, and Global Valley Networks, realizing greater than anticipated synergies, and have consolidated 5 billing systems in the past 5 years.  Another plus is 13 states will operate on existing systems as a stand-alone entity at closing and only 1 state will need to convert to the Frontier platform at closing. They have experience, a plus, but this is much bigger than any past deals and they could encounter unexpected road blocks.

Some negatives are:

  • Both companies continue to lose access lines, FTR at 7% and SpinCo at 10% in 2008.
  • Debt will top eight billion.
  • Dilution to the FTR shareholders will be around 70% however this will be offset by the increased cash flow.
  • Dividend cut by 25%
  • Possible culture clashes
  • SpinCo is 3X the size of FTR making integration more difficult.

On the plus side assuming integration goes close to as planned:

  • FTR expect synergies of 500 million by year two (310 million after taxes)
  • Substantial increase in free cash flow (FCF)
  • Combined companies yield a stronger balance sheet.
  • Growth opportunities in areas of high speed internet access, SpinCo is at 20.9% vs a FTR penetration of 25.7%, Long Distance 46.3% vs 69% and Satellite TV 5.2% vs 8.9%.  Broadband is only available to about 60% of households in the SpinCo market.
  • Economies of scale.
  • Current dividend yield over 10% based on a close under (6.61 today).

So what does it all mean?  The combined entity will have a substantial reduction in Debt to FCF and Debt to EBIDTA, a major improvement and a major reduction to the payout ratio, increasing the safety of the new dividend.  Once combined this is not a growth play IMO but a dividend play, considering the high yield.  So what about the dilution?  Looking at past numbers FTR’s PE ranged from 10 to 16.  Given the economy and the length of time it will take to determine if they did not bite of more than they can chew, so to speak, I don’t see a high PE number anytime soon.  Shares outstanding will top a billion so if I use a PE of say 11 and apply it to earnings before synergies, and after synergies, I get stock prices of approximately $5.63 and $8.68 which would have corresponding yields of 13.3% and 8.6%.  (Note: 52 week low was 5.32).   I own the stock and like the yield so I think I’ll keep a close eye out for any integration problems but so far the numbers for the deal look attractive.  Time will tell.

All this based on the following guesstimates, most from FTR, some I extrapolated.

(in thousands)   Annual Income Statement
  Pro-forma 31-Dec-08 31-Dec-08 31-Dec-07 31-Dec-06
Net Income with synergies $855,265 $182,660 $214,654 $344,555
Net Income w/o synergies (used 300,000) $555,265      
Preferred Stock And Other Adjustments  
EBIDTA $3,132,000 $1,204,257 $1,251,272 $1,116,813
Debt/Free Cash Flow 5.6 10.5 9.4 7.8
Shares OS 1,083,000 318,000 330,000 326,000
Year end stock price   $ 8.14 $ 10.78 $ 11.34
PE   14.2 16.6 10.7
Net Income Applicable To Common Shares $855,265 $182,660 $214,654 $344,555
Total Cash Flow From Operating Activities $2,124,000 $739,266 $821,683 $847,016
Capital Expenditures -$701,000 -$288,264 -$315,793 -$268,806
Free Cash Flow with out synergies $1,423,000 $451,002 $505,890 $578,210

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