Misunderstood. Unloved. Undervalued. Those are three qualities I look for when selecting securities for my Portfolio Guru, LLC asset management clients. Finding securities that meet those three criteria is undoubtedly more difficult when equity markets are near all-time highs and the spreads on high-yield bonds are also approaching cycle lows.
In these markets, there are fewer individual securities that are badly underpriced, but they do exist. I have been putting my clients in one for the past two weeks. I believe these securities are so undervalued that in addition to loading my and my clients' accounts with them, I am naming them as my new Real Money Best Idea. My top pick is:
Frontier Communications 11.125% Mandatorily Convertible Preferred Stock, Series A (FTRPR) .
FTRPR is trading at 32 cents on the dollar and yielding an almost unbelievable 34.8%. Why? Because of the mandatory nature of the conversion feature. On June 29, 2018, FTRPR will convert into 20 shares of Frontier Communications (FTR) (the ratio is lower if FTR shares trade above $5 then, extremely unlikely since they are trading at $1.34 today). So the market for this liquid security ($1.925 billion in face value) is incredibly skewed owing to the stock market's abject hatred for Frontier's common shares.
FTR shares have fallen 46%, 62% and 73% in the past three-, six- and 12-month periods, respectively. The market hates Frontier because it is experiencing -- as are its incumbent local exchange carrier peers -- declining numbers of subscribers due to cutting of cable and landline cords. Also, Frontier carries the baggage of an ill-timed, overpriced and poorly managed acquisition of Verizon's (VZ) assets in California, Texas and Florida.
I'm not arguing any of those points, but the stock market is pricing in a high chance of bankruptcy for Frontier, and that is wrong. Dead wrong.
Frontier is going to survive, and the company's strong margins -- about 40% at the Ebitda level -- will produce sufficient cash flow to service its debt. As the market realizes that the value accorded to FTR's equity will grow, the underlying value of FTRPR will increase.
Obviously, though, FTRPR is not yielding 35% for no reason, and to own any Frontier Communications security, one must gain comfort with Frontier's debt.
It is indeed a mountain, but it is serviceable. After the repayment of a bond that matured in April, Frontier has $17.9 billion in debt. That is versus an equity market capitalization of $1.65 billion. Don't be fooled by the absolute number, though. The key is the servicing cost.
Frontier's interest expense ran at a $1.55 billion annualized rate in the first quarter, but its Ebitda for the trailing four quarters was $3.92 billion. If one wanted to adopt a more conservative outlook, one could annualize FTR's first-quarter 2017 Ebitda and derive a figure of $3.69 billion. FTR is covering its interest expense and capital expenditures (budgeted at $1 billion to $1.25 billion for 2017) with, by my figuring, at least $800 million left over. Subtract the common dividend payout (which FTR's board wisely reduced in May to an annualized $0.16 per share) of $189 million and the preferred dividends of $216 million and FTR still generates $400 million annually.
That is excess cash flow -- i.e., after all expenditures -- not the more commonly referenced free cash flow. Companies that generate excess cash flow are not distressed and they typically do not have securities yielding 15%, let alone 35%. That is why I am buying FTRPR with both hands.
So, cross-referencing with Frontier's listed bonds (always do this when buying a preferred), we see FTR's 11% notes due in September 2025 are trading at 91 cents on the dollar and yielding 12.7%. Elevated for sure, but nowhere near 32 cents on the dollar and a 35% yield.
If you bought FTRPR last week (when I was buying) you would receive five dividend payments until the conversion date, totaling 43.5% of your initial investment. That is an astounding amount, and means -- subtracting the cash flow you would receive from FTRPR's dividends -- you were buying FTR shares at $0.90 per share. Even if you missed the June payment (the record date was today), you can still buy FTRPR and get the common shares for an effective price of $1.04. That is nearly a 30% discount to FTR's current market price.
FTRPR is my new Real Money Best Idea, and while I'm not predicting the +330% gain that my last one -- Navios Maritime Preferred Series G (NM-G) -- has posted, I believe FTRPR shares will at least double in the next 12 months.