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**** comment from Merrill Lynch ****
* Focus is on Frontier's ability to pay maturities, de-lever
In response to questions we have received since our Frontier bond update of 3/8/17 ("A lot of yield in Frontier as bonds have lagged the market on disappointing results"), we address several additional topics in this report. Can Frontier de-lever? How can it meet its upcoming maturities of $4.35Bn through 2020 and $6.90Bn through 2021? With Frontier's current unsecured cost of debt high (if not prohibitive), how much secured debt can it issue? What would be the impact of secured debt issuance for refinancing?
* We see the dividend as cushion to credit risk concerns
As reviewed in our prior report, Frontier's performance after acquiring Verizon's CA-TX-FL properties is disappointing and we view its resulting leverage of 4.7x, 4.6x net as high for an ILEC. But it seems to us that Frontier bond yields, which reach into the 10%-11% area and are notably wide of the 6.0% YTW for the HY Telecom Index and 5.8% for all of HY, reflect some concern of default risk, while we believe Frontier should be able to meet its debt maturities via a combination of repayment with existing cash sources, incl. potential redeployment of its common stock dividend (now ~$500MM annually and growing to ~$660MM after the preferred stock conversion next year), and refinancing. As we previously stated, we believe Frontier's current stock price, which equates to a 20% dividend yield, implies that investors do not see its current dividend as sustainable and expect it to be cut. BofAML Equity Research analyst, David Barden, has said he believes the market is pricing in a cut of potentially 50% - which we believe can become self-fulfilling as the company could reason that, if it is not getting credit for the dividend, it may as well cut it to repay debt. We would further argue that a company's duty to shareholders incl. maintaining access to capital markets to avoid default risk.
*We project that maturities through 2020 can be met
While we believe Frontier needs to improve investors' perception of its credit quality so it can refinance bond maturities on an unsecured basis, in the near term we also believe investors are looking for a back-up plan, esp. as they eye the 2020 maturity tower. As we illustrate, in a scenario of a 50% dividend cut combined with bond buybacks funded with $2Bn of secured debt proceeds, we est. the company would be able to meet its maturities through 2020. However, this is not a permanent fix as it will have tapped out much of its secured capacity as it faces another $1.3Bn of bond maturities in 2021 and $2.7Bn in 2022. In all, we believe if its operations and EBITDA performance are such that leverage is not stable to improving over time after an initial 50% dividend cut, it will be compelled to consider further cuts to redeploy cash to improve its credit profile.
*Yields are high - and we view as adequate for credit risk
While we like the yields on Frontier bonds and believe the pace of customer declines should improve this year, we rate the bonds Marketweight (vs. Overweight) to convey that there is still some risk of protracted operational. issues. That said, we believe the yields are very adequate relative to the credit risk across the maturity curve esp. when taking into account the dividend cushion. Given our view that Frontier has the means to address its 2020 maturity tower, we view the 8.5% notes due 4/15/20 and 8.875% notes due 9/15/20, with yields in the 6%-area, as a more defensive investment, but note that if it should begin to proactively address the 2020s, longer-dated bonds should benefit and we would expect initial upside in the 9.125% notes due 7/1/21, which yield ~200bp wider than 8.875% notes due 9/15/20 for less than a yr of maturity extension. .
Best regards,
Frontier Communications
FRT 10.5% Sept 2022 US35906AAW80 (B1/B+/BB-)
Frontier Communications Corporation is a leader in providing communications services to urban, suburban and rural communities in 29 states across US. Frontier offers a variety of services to residential customers over its fiber-optic and copper networks, including video and TV service (in cooperation with DISH Network) high-speed internet, advanced voice and Frontier Secure digital protection solutions. They have approximately 5.4 million customers, 4.3m million broadband subscribers and 28,300 employees.
Frontier reported 1Q17 results which were in line with consensus and estimates. Revenue came in at $2.356 billion vs. consensus of $2.347 billion (0.4% ahead), while adjusted EBITDA was $923 million vs. consensus of $928 billion. Both revenue and EBITDA beat estimates.
Management is targeting a leverage ratio of 4.0x by the end of 2019 and 3.5x by year-end 2021, from a current leverage around 4.5x.
The company generated about $370m in free cash flow and kept the EBITDA margin around 40%.
Market is encouraged by improvements in gross customer adds.
In May 2017 the company cut the dividend by 60%. This is obviously credit positive.
The move will generate $1.9 billion of additional cash through 2021 which will primarily be used to accelerate debt pay-down.
On the downside Frontier had some issues in integrating assets purchased in 2017 from Verizon in California Florida and Texas (in 2016).
Company intends to issue secured debt in 2Q17 the proceeds of which will be used to take a “liability management” approach addressing near and/or mid-term debt but most likely in the form of new loans as it is cheaper for the company compared to issuing secured bonds. The maturity is expected to be in line with the $2.2 billion 10.5% senior note issue due 2022 and the proceeds to be applied to address debt maturing inside 2022 with potential bonds buyback.
Telecom industry in US is living times of convergence, M&As and cable companies are looking to enter in the wireless markets and vice versa where wireless ones need cables to stream more contents. Cable companies are the most favorite because they have higher quality assets.
Even if we recognize the challenges ahead for this name, we believe FTR bonds offer compelling yields at current levels and adequately compensate investors for what we believe will likely be another soft quarter in 2Q17 before stabilizing in 2H17.
We hold a preference for the FTR 10.5% Senior Notes 2022 (10.75% YTM) but investors should also consider the 11% Senior Notes 2025 (12.15% YTM).