There's a Preferred Approach on Frontier

 | Mar 16, 2017 | 5:00 PM EDT
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Frontier Communications' (FTR) share price decline has been striking, especially since it has occurred against the backdrop of an exuberant market. Frontier shares have lost more than half their value in the past 12 months, and even after a bounce today, FTR shares are yielding an eye-popping 16.5%. 

That's fool's gold, isn't it? Buying a common stock for that type of yield can only lead to heartbreak when the company's board cuts the payout. I'm actually hoping FTR's board does come to their senses and slash the payout or, optimally, omit it entirely. Why? Because I'm invested in a different part of Frontier's capital structure. 

I have been buying (FTRPR) this week for my clients. FTRPR's full name is Frontier Communications, 11.125% Mandatory Convertible Preferred Stock, Series A. That's a mouthful, but the full name actually explains why I bought it. As preferred shares, FTRPR has a higher call on cash than the common dividend, although obviously FTRPR is junior to Frontier's debt. Goodness knows Frontier has a mountain of debt -- $17.4 billion at year-end 2016 -- but the relatively benign near-term maturity schedule ($363 million in 2017, $733 million in 2018) gives Frontier the financial flexibility to service that debt and still invest in the business. 

Debt service has to be Frontier's No. 1 priority. FTR management did not state that in their most recent earnings call, but unless they are completely delusional, they must see the ticking time bomb on their balance sheet. So, with that realization, there simply is no justification for Frontier paying a common stock dividend. 

Frontier paid $493 million in common stock dividends in 2016, and has held the current payout of $0.105 per quarter (next payment is March 31) for the last two years. Why? Please don't ask me, I have no idea. If FTR's board thought that increasing the dividend by 2 cents on an annual basis in March 2015 would support the stock, they miscalculated wildly. Frontier shares were trading at $7 in March 2015 and are trading today at $2.55. The market's not buying FTR as a yield stock, the chart shows that clearly.

 So, if Frontier stops paying a common dividend, that's more left over to pay preferred dividends. Technically, Frontier could stop paying the preferred dividends -- my Real Money Best Idea, Navios Maritime Holdings Series G Preferred (NM-G) , have been in non-payment status for more than a year -- but that would be a flashing red light for the capital markets. 

I believe FTR will continue to pay preferred dividends, and as FTRPR is trading at just over 50 cents on the dollar (current yield is 22.2%) that income is attractive, but not long-lived. As noted above, FTRPR is mandatorily convertible into FTR common shares. That conversion will happen on June 29, 2018, at a ratio of 20 shares of FTR for each share of FTRPR, assuming FTR shares are trading below $5 on the conversion date. Thus the current conversion factor for FTRPR is $2.65 per FTR share, a level just slightly above the common's current price. 

So, I'm betting that FTR management focuses on cash preservation between now and next June and that the balance sheet discipline will increase the equity value of Frontier. FTR management has budgeted capital expenditures of $1 billion to $1.25 billion for 2017 and that figure clearly needs to be no higher than $1 billion. FTR management has projected free cash flow of $800 million to $1 billion and, again, that figure needs to be toward the "good" end of the range. 

I can't think of a management team with a worse reputation with the Street than Frontier's, but therein lies the opportunity. If they can manage the decline in their legacy business and pull something out of the California, Texas and Florida assets they bought from Verizon (VZ) , the stock would be worth, by my figuring, at least double what it trades for today.

There are a lot of "ifs" on the FTRPR trade, but I believe the rewards outweigh the risk. So, I'm again applying the clothespin to my nose and buying what the market thinks is a stinker. I'll follow up on his trade in a couple of months in a future RM column.

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