Konstantin Tourevski, CFA, Head of Fixed Income Mar 12, 2020 7:00:00 AM 5 min read Stock Insights

Frontier Communications (FTR): Has Their Cord Been Cut?

Technological innovation is creating both opportunities and hazards across nearly all businesses. For every new advancement that makes life better, there are bound to be casualties among incumbents. For investors, the dilemma becomes uncertainty about whether such incumbents will be able to reinvent themselves or if such disruption will result in complete obsolescence.

Tangled Wires

As Frontier Communications Corporation (FTR) heads into bankruptcy and its senior unsecured notes trade below 50 cents on the dollar, we look at the history of its H-Factor and periods of inclusion and exclusion of its notes in our New Age Alpha USD Corporate High Yield Bond Index. The H-Factor is a risk that comes from humans interpreting vague or ambiguous information in a systematically incorrect way that causes securities to be over or under priced. When the market gets too optimistic without any support from fundamentals, H-Factor scores increase. When it gets too pessimistic, the H-Factor scores decline.

Frontier Communications has been an important company in the High Yield market for a long time. As of March 10th, 2020, it is the ninth largest issuer in the Bloomberg Barclays HY index by face value with total debt exceeding $17.5 billion. The company provides wireline telecommunications services to U.S. consumers and businesses across 30 states.

Market participants understand that the company operates in a secularly declining industry and most have recognized the challenges facing it for at least a decade. However, prior to 2016, the conventional wisdom was that the company had a substantial cash flow and equity cushion and should be able to stay ahead of the declines by continuously right sizing its balance sheet, tightly controlling costs and targeting consistent free cash flow. Acquisitions were also used to offset core revenue declines with the biggest coming in 2016, when it acquired millions of rural lines from Verizon Communications. As we know today, expectations that the company could continue to mitigate revenue declines proved to be wishful thinking. H-Factor on the other hand was well ahead of the market in sounding the alarm. As shown in the chart below, the H-Factor of Frontier rose to near 90% in mid- 2016, suggesting a very high likelihood of missing market expectations. At the same time its communication services industry peers had an average H-Factor of 43%, similar to overall market.

NAA_NAA_Frontier_1-01

Price Data: Provided by Refinitiv as of January 2, 2020
H-Factor Data: Provided by New Age Alpha as of January 2, 2020

The historical H-Factor Information cited above is being provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security.

 

NAA_Frontier_2-01

Price Data: Provided by Bloomberg as of January 2, 2020
H-Factor Data: Provided by New Age Alpha as of January 2, 2020

The historical H-Factor Information cited above is being provided for illustrative purposes only and should not be construed as providing investment advice or as a recommendation to buy or sell any particular security.

H-Factor Analysis

The high H-Factor of 89% caused our NAA USD High Yield Corporate Bond Index to exit its FTR position in July 2016, well before its various notes dropped anywhere from 20% to 30%, depending on maturity and structural position. The drop happened between September 2016 and May 2017 as the market learned the company would not deliver, and Frontier lowered guidance and cut its dividend. The stock declined over 70% during the same period. Subsequently, we can see H-Factor declining as expectations moderated, but FTR was not included in the index again. New Age Alpha includes market cap and dollar price limitations to avoid distressed securities in the index based on our belief that the H-Factor performance may be less consistent when equity becomes a very small part of the issuer’s enterprise value. In this case, the H-Factor signal was correct again in June 2019, rising to 83% from 23%, after Frontier securities rallied as the company posted in-line revenues and an EBITDA beat. Subsequently, the company’s board questioned overly optimistic earnings guidance amidst continued execution challenges and subscriber attrition. This led them to consider exchange offers or even potential restructuring, resulting in an incremental 30 - 35% fall in bond prices to the sub-50 levels we see today.

Cable Outage

Looking historically at the New Age Alpha back-tested High Yield index model, we see holdings of Frontier debt in 2014, 2015 and until July 2016. At that point they were removed while still trading well above par, entirely avoiding the subsequent ~ 60% decline. As one of the largest issuers in the broad High Yield index, Frontier’s decline was meaningful in both the magnitude of the price drop and the amount of debt they had outstanding. With the H-Factor methodology, we believe we can identify names like Frontier at the time when they have the highest risk of missing expectations and actively avoid such securities. Successful bond investing is predominantly about avoiding losers and we believe that our actuarial, rules-based approach lends itself well to fulfilling that task and generating above market returns.

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The above statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. You cannot invest directly into an index. The views stated herein are only current through the date stated and are subject to change at any time based on market or other conditions and New Age Alpha disclaims any responsibility to update such views. New Age Alpha does not currently own FTR and did not own it at the times set forth in this article. There is no intention for New Age Alpha to include this security in its portfolio unless it becomes part of the established universe of eligible securities that are part of each specific investment strategy (e.g. the S&P 500®). It is important to note that there can be no guarantee that the application of the H-Factor to investment portfolios or certain stock or securities can produce profitable results. For full disclosure, click here.

March 12, 2020

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