Some companies make a habit of growing by acquisition, and growing telecom player Frontier Communications (NASDAQ:FTR) has used mergers and acquisitions to foster extremely fast growth rates over the years. In its biggest deal yet, Frontier recently got key approvals to acquire about $10.5 billion in assets from Verizon Communications (NYSE:VZ), with the potential benefits of adding millions of customers in key states like Texas, California, and Florida to its nationwide reach. Frontier is optimistic about the positive financial benefits of the deal over the long run, but before you celebrating the deal too much, it's important to understand the financial costs involved and the impact they could have on Frontier.
Dealing with debt
Last week, Frontier said that it would raise $6.6 billion in a private offering of senior notes, with the proceeds going toward covering part of the up-front cash that it will pay Verizon in its latest deal. Although the deal hasn't yet gotten final approval, Frontier said that it would deposit the proceeds of the bond sales in an escrow account pending the expected closing on the transaction, which it expects will occur by the end of the first quarter of 2016. In the event that the deal doesn't go through, Frontier would use the escrowed funds to redeem the offered securities.
A few days after the announcement, Frontier announced the pricing on the bonds it offered. For the $1 billion in five-year notes it offered, Frontier will pay interest of 8.875% per year. It also offered $2 billion in seven-year notes, with an even higher 10.5% interest rate, and the bulk of the offering will come in the form of $3.6 billion in 10-year notes bearing a rate of 11%.
Doing the math, you can see just how big an impact the Verizon acquisition will have on the amount of interest expense Frontier will have to cover in order to maintain its debt. When you consider $88.75 million in interest on the five-year notes, $210 million on the seven-year paper, and $396 million for its 10-year debt, Frontier will add almost $700 million to the expense side of its income statement every year. That will essentially double what the telecom company paid in interest expense during 2014, showing just how much is at stake in the Verizon deal.
Trying to keep a clean balance sheet
As high as those interest rates are, they didn't come as a big shock to those who follow Frontier closely. Although the company has done its best to maintain as high a bond rating as possible, it is still squarely within the high-yield junk bond range of the credit markets, with bond ratings of BB- from Standard & Poor's and Ba3 from Moody's. Even with prevailing rates at low levels, a bond rating that's a few notches into junk status makes it difficult to raise capital without paying a big premium.
Still, things could have been worse for Frontier. In an effort to appease bond-rating agencies, it raised $2.5 billion in June by issuing new common stock as well as a convertible preferred stock issue. Some criticized the move at the time, given its dilutive impact on existing shareholders. Yet by ensuring that a substantial portion of the Verizon deal was financed through equity rather than debt, Frontier demonstrated its commitment to keep its bond ratings relatively strong. So far, that strategy has succeeded in dissuading any further deterioration in Frontier's credit quality.
Will the Verizon deal pay off for Frontier?
Even with that high price tag, Frontier is still confident that the added interest expense will be well worth the cost. In announcing the deal, it pointed to more than $5.7 billion in revenue that the Verizon assets generated in 2014, and the company said it expected to reduce annual costs by $525 million in the first year and $700 million by the third year after the deal closes. That cost savings will go a long way toward covering the interest expense associated with the deal.
Indeed, Frontier thinks that the deal will pay off broadly enough to give shareholders potential dividend increases as well. Of course, it will have to balance the needs of its shareholders with maintaining its credit rating and getting debt paid down in a timely manner. Yet with plenty of experience from past deals, Frontier has navigated similar situations fairly well in the past.
Frontier Communications has high hopes for its Verizon deal, and getting bond financing is a key element of its eventually moving forward. Despite the costs involved, Frontier thinks that this deal could revolutionize its business and have positive effects that extend throughout its rapidly growing telecom network.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool 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.