Frontier’s financial plan for Verizon’s assets

Though Frontier Communications' (NYSE: FTR) $8.6-billion deal to acquire 4.8 million access lines from Verizon (NYSE: VZ) is stock-based (a reverse Morris trust transaction that results in Verizon shareholders owning roughly two thirds of the new triple-sized Frontier), it will require Frontier to raise about $3.2 billion sometime before the deal closes in the middle of next year. Only a few months ago, raising that much capital for this kind of Bell asset buyout – which don't have a great reputation following cautionary tales at Fairpoint Communications and Hawaiian Telcom – would have been hard to imagine. But recent softening of credit markets to telecom carriers may validate Frontier's choice of timing.

"We have no doubt that if Frontier had to go to the market today, they'd not have any issue with raising the $3.2 billion," John Killian, Verizon's executive vice president and chief financial officer, said in a conference call today. "I've had discussions with numerous banks on that particular subject, and we think they'll be in a very good position. The contract permits time periods to deal with market conditions. Clearly our treasury people will not be responsible at all for the financing, but they'll always be in communication with the Frontier team."

Though the deal requires Frontier to take on more debt, its contribution to Frontier's earnings actually reduces the carrier's overall leverage, taking its debt-to-EBITDA ratio from 4 to 2.6.
"We've reached out to three [credit rating agencies] last night and this morning," said Donald Shassian, Frontier's chief financial officer, in an earlier press conference. "They're very interested in the de-levering nature of [the deal]…We have changed our philosophy. We're pursuing becoming investment-grade. This is a change in our capital structure philosophy."

Frontier is expecting $500 million in annual synergies – or 21% of cash operating expenses, making the deal accretive to cash flow in its second year. And during a press conference today, Frontier Chief Executive Officer Maggie Wilderotter pointed to the company's 2006 acquisition of Commonwealth Telephone as evidence that Frontier knows where to find synergies. "With Commonwealth, we took out 29% of operating expenses, so 21% here is not out of the ballpark," she said.

Aiding Frontier is the fact that, according to Craig Moffet, vice president and senior analyst with Bernstein Research, "The former-GTE states to be divested are materially moreprofitable than average for Verizon's wireline business, with the former-GTE properties generally having suffered smaller-than-average line losses in the past and having benefited from significantly lower-than-average labor costs."

For example, while the average profit margins in Verizon's ILEC business were about 40% at the end of 2007, they were 55% in Ohio and Michigan, 54% in Illinois, 53% in Wisconsin and 50% in Washington, Moffet said – all areas being acquired by Frontier. And in another acquired area, West Virginia, access line loss has stayed under 5% through 2007, and margins remained flat to slightly growing since 2003.

Frontier thinks it can improve the profitability of those assets considerably, in part by deploying more broadband over them. Broadband is currently available to only about 60% of the homes in the divested areas, but it is available in 92% of Frontier's territory. Increasing broadband penetration in these rural areas – a practice in which Frontier claims particular expertise – will not only increase revenue but slow access line loss, Wilderotter said. "Broadband reach is a limitation for revenue growth. It drives access line loss when you don't have a full portfolio of products. So there's huge revenue growth upside."

In addition, there is no cable competition in 30% to 40% of the acquired markets, she said. "We'll be surgical about going for the low-hanging fruit, grabbing share in high-speed Internet where there is no competition."

Meanwhile, as part of the deal, Frontier also gains a fiber-to-the-premises network that passes some 750,000 homes in four states (South Carolina, Washington, Oregon and Indiana) but today only includes about 110,000 high-speed Internet customers (and that number is likely to be higher upon closing, as builds are continuing). Frontier will penetrate that footprint as well, selling Verizon's FiOS service using the existing brand.

"We're excited about this," Wilderotter said. "This gets us into the video business in a different way."

In an interview with Telephony, Dan McCarthy, executive vice president and chief operating officer said, "We'll take a look at whether it makes sense to expand that. But at this point, we'll confine ourselves to the market where the fiber-to-the-home equipment is."