Cautious on Frontier???s Transition

Zacks

We continue to maintain our cautious approach on Frontier Communications Corp. (FTR) as it is going through a transitional phase by absorbing the acquired properties and deleveraging its balance sheet.

Despite weak subscriber growth and declining revenues, the company generated the strongest quarterly revenue in the fourth quarter of 2011 since the acquisition of Verizon Communications’ (VZ) phone lines in 14 states. Adjusted earnings were above the Zacks Consensus Estimate and the year-ago level.

The rural telecommunications service provider continued to lower its rate of revenue decline following the reduction of access line losses, offering high-speed and triple pay services, broadband expansion, and new product deployment. Frontier’s main goal is to convert its acquired rural fixed-line from Verizon into its own systems.

The company successfully transformed its five operations and the integration of operations in the remaining nine states is still underway, with the next quarter-end being the completion target. As a result, the first half of this year would have an adverse impact from these conversions while the second half would generate additional revenue and cash flow to the company. Overall, the full conversion is anticipated to boost earnings and provide cost synergies of approximately $650 million by the end of this year, up from the previous expectation of $600 million. Out of these, $552 million of the synergies have been realized by the end of the last year.

Nevertheless, we remain concerned about Frontier’s highly leveraged balance sheet, which might continue to stretch borrowing initiatives and the balance sheet. The company continues to operate with a high debt level of approximately $8.21 billion at the end of 2011, up from $7.98 billion at the end of 2010. But Frontier is strengthening its balance sheet and is trying to improve its leverage to 2.5 times through a combination of EBITDA improvements, debt reductions and dividend cuts.

The company reduced its annual dividend by 47% to 40 cents per share for this year, which would bring down the payout ratio from 68% last year to 42%. We believe the cut will provide greater operational and financial flexibility as well as improve the cash position of the company. The new dividend will generate annual savings of $348 million in cash, bringing it to $1.4 billion over the next four years. The excess cash would also act as a catalyst for any headwind arising in future from higher pension contribution, increased cash taxes and potential setback in revenue growth. Further, Frontier would be able to accelerate its investments for network upgrades, IT automation and new products.

Despite these efforts and initiatives, we believe competitive threats, regulatory pressure as well as unsuccessful integration of the remaining Verizon properties might limit further earnings upside in the upcoming quarters.

While waiting for the impact of these changes on the company’s financials, we are maintaining our long-term Neutral recommendation on Frontier. For the short term (1-3 months), the stock retains the Zacks # 3 (Hold) Rank.

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