Frontier: High-Yield Bonds vs Stock vs Options

To the chagrin of yield-chasers, Frontier Communications (FTR) finally cut its big dividend. Specifically, the dividend was reduced by 62% last week (it now sits at 13.2%), and the stock is now down 64% this year. For your consideration, this article reviews the potential risks and rewards of investing in Frontier's high-yield bonds (+10% YTM), big-dividend stock, and leveraged options.


Overview

Frontier provides phone, Internet and data services to urban, suburban and rural communities in 29 states. The company has been struggling with customer attrition, challenging integration issues (they recently acquired assets from Verizon in California, Texas and Florida), and a significant amount of debt. Despite the significant price decline, the recent dividend cut is a strong signal from managements that they believe a more stable Frontier is around the corner.

The High-Yield Bonds

As the following chart shows, AT&T has various magnitudes of high-yield debt outstanding (some of which offers double digit yield) that will mature in the coming years.

And as the discounts and premiums to par in the following table indicate, the market has a high degree of confidence in the company’s near-term bonds, but not so much the longer-term bonds.

For example, the outstanding 2018 – 2020 bonds all trade at a premium to par (and offer reasonable yields to maturity), indicating the bond market believes the chances of default are less likely than the longer dated bonds. On the other hand, the outstanding bonds that mature in 2021 and beyond trade at discounts to par (and offer significantly higher yields to maturity) an indication that the bond market has far less confidence in Frontier beyond 2020. Said differently, Frontier appears to have the financial wherewithal to stay afloat for a couple more years, but beyond that timeframe things are very uncertain.

Referring back to our earlier graph of debt maturities and magnitudes, Frontier should have no problem meeting its debt obligations in 2017. It has $341 million of cash and short-term investments on its balance sheet, and only $325 million of 2017 debt maturities (much of which has already been paid off).

Next, we agree with the market’s assessment that Frontier should be able to manage its 2018 – 2020 debts (remember, these trade above par, an indication of market confidence relative to the later dated bonds that trade at a discount). Specifically, despite Frontier’s struggles, it has continued to generate hundreds of millions of dollars of positive free cash flow year after year (see chart below), and this will help pay the 2018 – 2020 debt maturities. Not to mention, the recent dividend cut frees up significantly more cash (hundreds of millions per year) to help support the debt payments.

Moving out to the large amounts of debt maturing in 2021 – 2022, things get more hairy (as indicated by the higher yields to maturity and significantly discounted prices versus par). However, Frontier has a few tricks up its sleeve to help cover these large outstanding debts.

For example, the company recently announced that it is willing and able to issue new secured debt in the second quarter. This will help pay down outstanding debt and reduce interest payments thereby freeing up more cash to support the 2021 – 2022 bonds. Additionally, there is an increasing likelihood that Frontier will go to the capital markets to raise more cash via a new equity offering. Such an offering would most likely not be good for existing shareholders (it would likely be dilutive), but it would be good for bondholders (it’ll help the company pay its debts).

Further, management was optimistic on the recent earnings call that they’d be able to stop the steady outflow of customers (the Verizon integration is improving, and for some customers Frontier is simply the only option).

If we combine Frontier’s free cash flow generation, the new debt offering, the reduced interest payments, the potential new equity offering, and the possibility of less (or even eliminating) customer attrition, the company likely does have the wherewithal to support the bonds at least through 2022, in our view. 

The debt maturities in 2023 and 2024 are relatively small, however it’s the huge maturities ($4.5 billion) in 2025 that will create the most significant challenge, in our view. And as our earlier table shows, this is the debt (2025 and beyond) that trades at the most significant discount to par. However, for the most optimistic investors, there are reasons to believe that this debt (2025+) is also “money good.” For example, aside from getting earlier maturity debt under control thereby freeing up more cash to support the later maturity debt, and aside from management’s optimistic view that they will turn things around, this debt could get support from the regulators/government and/or by another company acquiring Frontier and thereby assuming responsibility for the debt.

With regards to regulator/government support, there is an interest in ensuring Frontier customers have access to data, phone and Internet. For example, the Connecting America program allows the government to turn up and down the funds provided to Frontier to support its business. In particular, from 2012-2014 Frontier received $133 million in "Connecting America" funds, they received $280 million in 2015 (2015 annual report, p. 9), and in 2016 they received $626 million in total subsidies (2016 Annual Report, p. 30). In cases where Frontier is the only option, the government wants to make sure customers have access to phone, Internet and data.

And regarding an acquisition, if Frontier's stock price gets cheap enough, someone larger will acquire them. And this will be with the blessing (and perhaps financial support) of the regulators/government because they want Frontier's customers to continue to have access to high speed connections. And if Frontier gets acquired, it'll be by someone with better financial wherewithal, at it'll cause the value of the bonds to increase significantly.

Overall, we agree with the market’s assessment that the Frontier bonds maturing before 2021 have less risk, 2021-2024 are higher risk, and 2025 and beyond are very highly uncertain. And we also agree with our own thesis about the bonds from late February: Frontier: How to Play the Dividend Cut Fear.

The Stock

Frontier’s common stock currently offers a 13.3% dividend yield and (to some extent) it trades like an option right now. Specifically, at a price of around $1.20 per share, the downside risk is limited to $1.20 (if it goes to zero). However, if Frontier gets its business and finances in order, then the shares could easily triple in price and trade back up to the $3.60 - $3.75 range that it achieved earlier this year. 

However, in our view, the stock is much riskier than the bonds. Besides being a lower priority in the capital structure, management could easily cut the dividend on the stock to zero if they need more cash to support the bonds (and this would torpedo the stock price). In fact, this type of action is often prudent given the higher priority of bonds than stock in the capital structure. In our view, the only reason management hasn’t slashed the dividend to zero is because they still want to keep the stock price as high as they can in case they need to go to the capital markets to raise more cash via an equity offering. If they had cut the dividend to zero already it might have helped free up cash for the debt, but the stock price would have fallen much further, and the company wouldn’t be able to raise as much cash in a public equity offering, if need be. 

Frontier also has preferred shares outstanding (Frontier Communications Corp., 11.125% Mandatory Convertible Preferred Stock, Series A, liquidation preference $100 per share) which offer a high dividend and trade at a discounted price, as described below:

The preferred shares are mandatorily convertible on 6/29/2018 into a variable number of Frontier Communications Corp. (NYSE: FTR) common shares based on the then current price of the common shares for 20 consecutive trading days immediately prior to the conversion date. The conversion settlement rate will be 17.0213 shares per unit if the then current market price is equal to or greater than $5.875 and 20.0000 shares per unit if the market price is equal to or less than $5.00. For market prices between those values the settlement rate will be $100 divided by the market value.

The preferred shares are above the common in the capital structure, but they’re still very risky considering the common currently trades far below the $5 lower-end conversion rate price on the preferreds, as described above.

The Options

If the optionality-like features of investing in Frontier common stock is not enough for you, then you might also consider the actual options market for Frontier stock. For example, as the following table shows, you can purchase a call option, giving you the right to buy Frontier at $1.50 per share between now and expiration on January 19, 2018, for $0.25.

This means, for example, if the shares return back to $3.75 per share (they traded at this price earlier this year) before the option expires, you will be able to generate a 700% profit on your money (i.e. you make a profit of $2.00 and you only paid $0.25). And the largest amount you can lose is simply the $0.25 you paid for the option. Even if the shares only rise to $2.25/per share (very possible given the volatility), you’d still generate a profit of 100% (you’d have doubled your initial $0.25 investment).

Conclusion

Without question, Frontier is a very risky investment. And investors should always cater their investment portfolios to meet their own personal investment needs and tolerance for risk. Regardless of whether you are interested in investing in the bonds, the stock, the options, or "none of the above," Frontier will be very interesting to watch.

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