Verizon’s Deal To Buy Frontier Will Face Regulatory Challenges

Frontier’s Financial Performance

Frontier Communications has experienced marginal sales growth in 2024, with revenue reaching $2.9 billion during the first six months of the year, a modest increase from the previous year. However, this growth was overshadowed by a rise in operating expenses, amounting to $130 million more than the previous year. Noncash depreciation expenses primarily drove this expense increase. As a result, operating income declined to $181 million. Interest expenses also rose significantly, leading to a net loss of $122 million for the first half of 2024.

Frontier’s Balance Sheet

Frontier’s balance sheet is characterized by a heavy reliance on debt and property. The company maintains a substantial cash balance of $1.1 billion, which it has sustained throughout the year. However, its long-term debt has remained at $11.2 billion, and it had to burn $1 billion in short-term investments to meet its capital commitments in 2024. Shareholder equity has declined to $5.1 billion, a drop of over $140 million.

Financing the Acquisition

The $20 billion deal announcement for Frontier, with a $7 billion market cap, is attributed to its significant debt burden of over $11 billion. This debt will likely be paid off at the closing of the acquisition. Frontier’s debt carries an average interest rate of 7%, higher than Verizon’s current rates. Verizon is expected to finance the majority of the deal through long-term debt issuance, potentially increasing its debt balance to $170 billion. However, if Verizon can secure financing at 100 basis points below Frontier’s average debt rate, it will add over $110 million to its future annual earnings.

Cash Flow Concerns

Despite its $1.1 billion cash balance, Frontier Communications has a cash burn problem. While cash flow from operations improved during the first half of the year from $665 million to $709 million, the company spent $1.3 billion on capital expenditures, resulting in a free cash flow burn of nearly $600 million. At this rate, Frontier will deplete its cash balance and require additional financing in the second half of 2025.

Verizon’s Impact on Cash Flow

Verizon’s strong free cash flow, which has grown from $15 billion to $19 billion over the past year, will help absorb Frontier’s cash burn. However, investors should monitor this combination in relation to dividend obligations. Currently, both companies have sufficient free cash flow to cover dividends, but this could change with adverse earnings or share dilution if Verizon issues shares to fund the deal.

Fiber Transformation and Integration

Frontier is transitioning its business from copper to fiber as rapidly as possible, with notable results. In the first half of 2024, fiber sales increased by 12%, while copper sales declined by 8%. Fiber now accounts for over 55% of total revenue and nearly 70% of adjusted EBITDA. This has the potential to improve profitability if Frontier were to remain a standalone business. Verizon’s existing fiber network and capital structure will further accelerate this transformation, leading to increased earnings growth.

Regulatory Challenges

The pending merger faces regulatory scrutiny. Verizon’s previous sale of its landline business to Frontier encountered significant regulatory hurdles, and the current deal will likely be met with similar challenges. State regulators in Illinois and the federal government have shown a heightened focus on merger activity involving companies of Verizon’s size. It is uncertain whether the deal will receive approval, but regulatory hurdles are expected to create volatility in the shares of both companies. Investors may consider these speed bumps as potential buying opportunities for Frontier stock.

Investment Considerations

For Frontier shareholders, selling shares at the current price near the deal value may be a wise move due to the regulatory hurdles ahead. Verizon shareholders may see value in the deal, but the 18-month timeframe and regulatory uncertainty do not provide enough certainty to justify an investment.