Frontier Communications (NASDAQ:FTR) just completed the biggest acquisition in company history. Subsequently four hedge funds run by billionaires shed all or part of their holdings in the cable, phone, and broadband company.
Of course, billionaires aren't infallible, but the actions of Tudor Investment Corp. Baupost Group, Highbridge Capital Management, and Millennium Management, led by billionaires Paul Tudor Jones, Seth Klarman, Glenn Russell Dubin, and Israel Englander, respectively, show how risky a proposition Frontier has become. Combined, the four companies dumped nearly 23.8 million shares of Frontier.
It was a telling move, as Baupost and Highbridge got out entirely while the other two funds vastly reduced their positions. So is Frontier a sell? I think so, as the company has taken on a lot of debt to get bigger, only to still be a small player in cable and broadband.
Why is Frontier a risk?
The company just spent $10.54 billion to buy Verizon's (NYSE:VZ) wireline operations in California, Texas, and Florida. It's a move that brings Frontier approximately 3.3 million voice connections, 2.1 million broadband connections, and 1.2 million FiOS video subscribers. The deal doubles Frontier's size, but it still leaves it a small-time player in cable and broadband.
Frontier had to make the move. Before the transaction, the company had just 2.48 million broadband customers and 543,000 video subscribers, along with its legacy phone business. It's hard to see home phone lines as a growth area, and the company's broadband/cable base wasn't big enough to fund the needed research and development expenses required to keep pace in the field.
But just because the company has bought its way to more revenue, doesn't mean the strategy will work. The company has borrowed billions to fund its purchases and much-needed network improvements. That debt is manageable, but it's an albatross hanging around the company's neck if it can't grow, or at least hold on to its subscribers.
There are reasons to think the company will shrink
It goes without saying that the company's phone business will get smaller as the amount of people who want a landline shrinks. It's hard to think of any way to offset that decline, as even if the company can add some business customers, the numbers won't be big enough to offset the residential loss.
In broadband and video, the prospects are less certain. Frontier gained 24,600 broadband customers in Q1, in line with industry trends. During the quarter it lost 10,300 video customers -- not a huge drop, but notable when overall the industry posted a slight gain.
Frontier also faces notable challenges in both of these segments. In cable it remains vulnerable to cord-cutting. Even though that phenomenon hasn't been as big as many have predicted, people dropping cable for streaming services remains a threat to the entire industry. In broadband, Frontier faces intense competition as it operates entirely in competitive markets. It also carries the risk of competition from an alternative provider such as Google Fiber or other potential entries in the space.
Getting out makes sense
Had Frontier stayed small, it probably would have slowly bled to death. Management was right to buy the Verizon properties, but that deal still leaves the company as a small-time player. To ultimately succeed, or even to be an acquisition target, Frontier needs to get bigger. That's possible, but it's clearly not going to happen just by adding users in its current markets, including the ones it just bought.
That means that somewhere down the road, Frontier needs to buy more systems or merge with another small-time player. It's a very long road to success and one that carries a strong risk of failure. It's reasonable to think that not all investors would be up for the lengthy ride with a limited chance of a major payoff at the end.
Daniel Kline has no position in any stocks mentioned. He is watching Dan Rather interview "Weird" Al as he writes this. The Motley Fool owns shares of and recommends Verizon Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.