In Where the Financial Statements Reveal Little Economist Reality , I bragged that buying Frontier Communication was effortless. All one had to do, I proclaimed, was to compare the prior years price, which was in the triple digits, to the 2018 stock price of $5.
A year passed and the stock price more than halved - which issues a few lessons. In this essay I describe these lessons and explain why I am still holding the stock nonetheless.
The first lesson is that not all equity is created equal. What I failed to see last year was that the reported 2017 equity of $2,274 million consisted of $5,035 million in additional paid-in capital which was offset by $2,263 million in accumulated deficit (The remaining $497 million was related to treasury stock and OCI). What this means is that the equity balance consisted of proceeds from past stock issuances - not from profits.
The reported equity should have embarrassed management. But instead management had no problem diluting common shareholders by issuing additional shares. There were 66 million outstanding common shares five years ago. There were 78 million outstanding shares a year ago. There are now over 90 million outstanding shares. This 6% annual growth in common shares, likely to continue, is worrisome.
The value of reported goodwill and intangibles assets is always questionable. But in FTR's case, these two accounts were no assets at all. In 2016 goodwill and intangibles were $12,336 million. Management had written down these assets to $7,877 million by 2018, a whopping $4,459 million loss that was fully recognized in the income statement.
FTR's goodwill and intangibles are over a third of the value of the reported assets. And if we are to remove these accounts, as any bidder for the company surely would, we would be left with exactly nil - zero, nadir, nothing, zilch - in common equity. FTR's tangible assets, which exclude the goodwill and intangibles accounts are $15,782 million or $17 per share. FTR's liabilities are $22,059 million or $24 per share. Since the liabilities are worth more than the assets, the common equity is worthless. The omission of thought related to the intangibles is lesson number two.
The third lesson was the lack of margin of safety. Even at $5 per share, which was historically low, FTR had too many concerns. To name a few: (a) the fixed coverage ratio was deteriorating. The ratio was over three times in prior years and is now less than two times; (b) leverage, defined as total liabilities divided by total assets, was historically at 75% but is now at 93%; (c) pension liability increased from $1,055 million in 2012 to $1,750 in 2018. And there is no sign of this liability but to grow; (d) the percentage of employees under labor agreement increased from 23% to 64% and (e) the wireline telecommunication industry is doing bad.
Practically all telecommunication companies’ stock prices dropped. Anixter (AXE on Nyse) now trades at $57 compared to $99 five years ago. Centurylink (CTL on Nyse) now trades at $10 compared to $37 five years ago. See the table below for more examples.
That I bought too much stock is the fourth lesson. I started to buy FTR in March of last year, when the stock traded at $7.76 per share. Then I bought twice as much stock, at $4 per share in November. I finished 2018 with 8,000 shares at a weighted average cost of $5 per share. The FTR position represents 8% of my portfolio while no stock represents more than 2% in comparison.
Admittedly, I bought too much stock and was careless, too. Reviewing FTR's latest public filing, I was ready to sell the entire position and to recognize the loss. But I found enough reasons (or excuses) to keep it.
There is - and I project will be continued - a reasonable pre-tax cash flow. FTR gathered $3,752 million in after-tax cash flow, after capital expenditures that is, since 2011. In two years the company showed a cash flow deficit: in 2016 the deficit was $227 million, and in 2015 the deficit was $31. But in 2018 the pre-tax cash flow was $687, and the 7-year pre-tax cash flow was $525 million.
The pre-tax cash flow matters. It allows management to change the capital structure by reducing the total liabilities (indeed, management reduced total liabilities by $551 million over the year and is planning to sell asset according to Barron's.) The pre-tax cash flow will allow the company to compete better as well.
Plus the operating data improved over the past decade. FTR now has more customers in both the consumer and the business segments. For example it had no broadband or video subscribers ten years ago and now reports on 4.7 million broadband and video subscribers. In addition, the churn rate, the annual percentage rate at which customers stop subscribing to a service, is at normal levels.
So FTR still meets the cheap, distressed criteria of a stock that trades at less than 50% of the net asset value and of less than 10 times the adjusted earnings per share. The reported book value per share today is $18 and the adjusted pre-tax cash flow is $7.
My brother asked if I had a stop loss in place. Stop loss means that if a stock drops below a certain price, say a drop by 40%, then it is automatically sold to prevent the investor from future losses.
No, I said. Investors, especially investors who target distressed companies, expect - and should be ready - to see much volatility in market prices of their holdings. May the case of FTR serve as a case in point a year from today.
"Facts are stubborn things," said my favorite American founder, John Adams. "And whatever may be our wishes, our inclinations or the dictates of our passions, they cannot alter the state of facts and evidence." And so, I collected a few facts about Frontier Communication for this week's meditation.
A few facts on Frontier are needed because Frontier’s stock is trading at 71% compared to a year ago. And as most analysts are rushing investors to cut their losses and sell Frontier position, I plan to do the opposite.
After adjusting for non-cash expenses, I expect Frontier to report on a billion dollars of after-tax cash flow. The company’s average quarterly revenue was $2.1 billion in 2018, the average quarterly expense for interest was $400 million and the average capital expenditures were $320 million.
If we remove non-cash charges, such as depreciation ($480 million each quarter) and goodwill expense ($400 million in the third quarter), we get a quarterly after-tax cash flow of $250 million. Multiplied by four quarters, we get the billion-dollar estimate. It is a fact that these after-tax earnings, adjusted for non-cash items, are higher than the after-tax earnings when the stock was trading in the double digits.
Another way to look at my estimate of Frontier's 2018 after-tax cash flow of a billion dollars is to say that the company profit margin is about 12% and that while the debt service coverage ratio is thin, it is adequate. The operating income to debt service ratio is slightly above two times. It is a fact that operating income for 2018 will be higher than $3.9 billion and that the interest expense will be $1.5 billion.
As of the third quarter of 2018 public filing, Frontier reported total assets of $24 billion. If we remove goodwill of $6.6 billion, we find tangible assets of $17.4 billion. And so, with a rate of return of capital of 5.75%, I cannot understand why there is an increased demand in investors who are shorting the company.
Twelve months ago, the short interest, as reported by Nasdaq, was $2.9 million with average daily volume of $2.7 million. As of today, the short interest is $49.4 million. The stock price declined from $8 to $2, too.
While operating results slightly improved, Frontier's valuation is materially below what the stock was valued in the past. Between 2013 and 2017, revenue grew by 14% compounded annually. In 2013, revenue was $4.7 billion, and in 2017 revenue was $9.1 billion. Earnings before taxes (EBT) grew by 6% compounded annually. The 2013 EBT was $1.5 billion, and the 2017 EBT was $2.02 billion. It is true that the after-tax cash flow declined from $857 million in 2013 to $618 million in 2017, but to me, a drop of 30% in after-tax cash flow does not explain the gloomy outlook.
If we expand our time horizon and look at the past decade we see that the stock traded as high as $194 (in 2008) and as low as $2 (current valuation). The earning multiple ranged from 6 to 12 the earnings. My estimate of a billion in after tax cash flow, alongside the reported outstanding shares of $103 million, translates a market valuation of less than one times the earnings multiple.
But the stock market’s focus is in future trends (for example, that employess are unhappy) and not in the historical record. "Quarterly revenues continue to decline at Frontier Communication," writes Wayne Nef of Value Line, an investing newsletter. "Both the consumer segment and the commercial business are under pressure. Management is optimistic that the revenue trend will turn in the fourth quarter due to new marketing programs and seasonality, but we are less sanguine."
In Seeking Alpha, the crowd-sourced financial website, you will read of a bearish outlook, too. Here are a few headlines I found: "Frontier Communications: Fundamentals Are Meaningless in a Bear Market" writes one author. "After A 60% Decline, Frontier Communications Offers Little Value," argues another. And picked by Seeking Alpha's editor as a favorite article is "Frontier Communications is uinvestable."
Ashraf Essa, who writes for The Motley Fool, is bearish, too. He warns us that "Frontier's business is on the decline, and the company had about $1 billion worth of long-term debt coming due within the next year." And that Frontier Communications shaky business fundamentals, coupled with its massive debt load, make it an extremely risk stock to own."
Since I began to buy the common stock of Frontier in March of last year, I did not pay much attention to the company. In 2017 the stock price was in the two digits and it would surely climb again, I thought to myself. I did not plan to think about Frontier before it published its 2018 fiscal year-end results, which was reported on February 28, 2019 and which I have yet to read.
But Jeff, a Charles Schwab representative, called this morning and asked whether I would be interested in lending the securities I owned. There is an increasing short demand, he said. He offered an interest rate of 10%, which is the equivalent of two Starbucks per today.
The math behind the two-Starbucks-per-day: Charles Schwab is borrowing from me 8,000 stocks at a rate of 10%. The stock is today worth $18,000 (I bought the stock for little over $40,000). This translates to an annual payment of $1,800, or daily payment of $5. The terms of the agreement between us are that Schwab may pay off the loan at any time and payments are made every month.
In 1774, Adams renounced tea drinking as unpatriotic and switched to coffee drinking according to a letter he wrote to his wife, Amelia. He would have been supportive with my securities lending practice, I am quite sure.
**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.
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."
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.
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.
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.