Why I Bought Shares in Frontier Communications

Where the financials statement reveals little economic reality

Published on:
March 23, 2018
Written on:

About The Author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Noam worked as a Vice President in Capital Markets at Silvergate (publicly traded on NYSE under SI since Nov-2019.) At SI, which he joined in 2010, Noam was responsible for advisory services to family offices,  private companies, and financial advisors.

**This week I became a lawful permanent resident. And so, I am celebrating with a hot dog, Budweiser, and apple pie.**

It is a misconception to think that each stock purchase involves an elaborate, detailed analysis. If you would have asked me how to analyze a company immediately after my business school days, my answer would be: "First, you HAVE to understand the balance sheet and income statement. Then you NEED to make sure that the cash flow statements reconcile to the balance sheet. After that, you MUST prepare a SWOT analysis, KNOW the competition, LISTEN to analyst calls with management and then READ everything Wall Street has to say." 

But my answer, filled with action verbs, would be utterly wrong because all you really need is one, good investment idea. The great investors of our times realized this principle a long time ago. When Mohnish Pabrai purchased the stock of BYD, a Chinese manufacturer of automobiles, I doubt how much he understood the underlying economics of the company. Yet, I am confident that he was following what Charlie Munger said about the company’s founder, Wang Chuyan-Fu.

In Charlie’s words: 

“Wang is a combination of Thomas Edison and Jack Welch - something like Edison in solving technical problems, and something like Welch in getting done what he needs to do. I have never seen anything like it.”

So Pabrai’s idea was to follow the footsteps of Munger. And it worked.  

Frontier Communications

Last week I placed a position in Frontier Communications (FTR) that now represents about 7% of my stock portfolio. The investment idea is a mispricing, due to the 2017 goodwill expense and a change in the dividend policy.

Adjusted for a 15-to-1 stock split in 2017, over the past decade, FTR traded as low as $46 and as high as $241, with a 10-year average stock price of $90. Compare that to 2017, when the stock traded for as low as $6 and as high as $57. At the time of this writing, FTR trades at about $7. 

I attribute the steep decline in stock price to two reasons. First, management reported a loss of about $2 billion in 2017. This was the steepest reported loss over the past decade. Details on the reported loss can be found on page 70 of the 10-k report, where you will read that management took about $2.75 billion in a goodwill impairment. And if you would like to see how it affected the balance sheet, just flip to page 69 and you will see that the account titled "Goodwill, net" declined to $7 billion from $9.7 billion the year prior.

The second reason for the steep decline in stock price is that management decided to no longer distribute dividends to common shareholders. On page 48 of the 2017 annual report, they wrote:

"The Board of Directors has suspended the quarterly cash dividend on the Company’s common stock beginning with the first quarter of 2018. The declaration and payment of future dividends on our common stock is at the discretion of our Board of Directors, and will depend upon many factors, including our financial condition, results of operations, growth prospects, funding requirements, payment of cumulative dividends on Series A Preferred Stock, applicable law, restrictions in agreements governing our indebtedness and other factors our Board of Directors deem relevant."

Goodwill expense

Management explained that the goodwill expense was taken because the reported balance sheet value of the company was higher than the price shareholders would receive if the company was sold in real life. To arrive at a fair value for FTR, management reduced their EBITDA multiple from 5.8 times the EBITDA to 5.5 times.

Do you see the disproportion? Management lowered the EBITDA multiple by 5%, and the stock price declined by 90% from its average price over the past three years. What is even more peculiar is that in 2014, management reported an EBITDA of $2.1 billion (the stock traded for as low as $63 and as high as $127 during that year) and the EBITDA for 2016 was $3.3 billion.

Let me remind the reader that a goodwill expense is, by definition, a non-cash expense. It is no different than if the real estate market told you that the home you purchased for $100,000 a year ago is now worth $50,000. Yet, while your bank account would be unaffected by the change in your home’s market value, in the case of GAAP accounting for public companies, you would realize a loss. 

Dividend Policy  

To explain how little I care about FTR's elimination of dividends to common shareholders I will use a thought experiment. Let’s imagine that instead of buying shares in FTR, I lent out the money to my friend, John. In the loan agreement, John promised to return 1/5 of the loan at the end of each year. But in year 4, John explained to me that instead of returning the 1/5 of the loan amount owed to me, he wanted to invest the money by opening, say, a food truck, in which he would give me an interest percentage.

Just as it would be unreasonable for me to conclude that John was a deadbeat for not returning the 1/5 of the original loan amount, I don’t see any issues with FTR retaining profits for future endeavors.

What is considered a praiseworthy practice by Wall Street is often not in the best interest of the shareholders. When FTR acquired the wireline operations of Verizon Communications, it used debt in the form of preferred stock to finance the acquisition.  This was not a cheap source of financing. To date, the total interest expense paid to the preferred common shareholder is $550 million. And had management refrained from paying dividends on the common stock between 2017 and 2015 (it paid $1.2 billion in dividends during that time), the entire acquisition of Verizon could have been with cash.

A note on valuation

The careful reader will note that I did not write about FTR’s true, intrinsic value. This was not an omission of thought, but due to the simple reality: I have no idea at this point. I know little about the wireless industry and even less about Frontier Communication’s market share. Yet, as I alluded to in the second paragraph, sometimes all that we need as investors is just one good idea.  

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