The news that Verizon Communications (NYSE: VZ) will acquire Frontier Communications Parent (NASDAQ: FYBR) appears to make strategic sense. For all of its focus on 5G, fiber remains a critical part of the broadband communications infrastructure, serving both consumers and businesses.
Unfortunately for Verizon's shareholders, it has decided to buy Frontier at a time when the company faces significant financial struggles. Hence, even if the acquisition goes through, it is likely to happen to the detriment of a specific group of shareholders. Here's why.
Who suffers in the Frontier acquisition?
The most likely victims of the purchase are Verizon's income investors -- in other words, those who own the stock purely for the dividend.
As conditions stand now, Verizon is one of the highest dividend payers in the S&P 500. At a payout of $2.71 per share annually, new investors earn a dividend yield of 6.5%. This is five times as high as the S&P 500's 1.3% average return. Also, it exceeds the returns one can earn from a certificate of deposit, which, even in today's market, rarely exceed 5%.
Additionally, the payout has risen for 18 consecutive years, with the company announcing the latest increase right after the Labor Day holiday. It is also notable because dividends can be adjusted at any time. Since ending such a streak could mean reputational damage to a stock, companies tend to maintain such streaks if possible.
The dividend comes with an annual cost of more than $11 billion. That is significantly below the $19 billion in free cash flow Verizon generated over the last 12 months. Such conditions make the payout appear sustainable -- until you look deeper.
Why the dividend is probably not sustainable
Unfortunately for Verizon's shareholders, the company needs to generate more than $8 billion in annual free cash flow not tied to the dividend.
This is not because the purchase price for Frontier is an all-cash deal of $20 billion. Verizon can refinance Frontier's $11 billion in debt, which is included in the purchase price. After adding Verizon's current liquidity of $3.9 billion, Verizon can probably accumulate enough cash to complete the acquisition.
Instead, the difficulty that should worry dividend investors is its total debt, which was more than $149 billion before Verizon announced the coming Frontier purchase. The company had only reduced that by $1.4 billion in the first six months of the year, indicating slow progress with this challenge. Moreover, as previously mentioned, Verizon will assume Frontier's $11 billion in long-term debt, taking the total debt to $160 billion.
Additionally, pressure to reduce or suspend its dividend may come from its competition. T-Mobile did not pay dividends before introducing a payout late last year. Still, at a 1.3% dividend yield, it is a comparatively modest expense for the company.
What may be more problematic for Verizon shareholders is AT&T's example. After 35 straight years of increases, AT&T slashed its dividend by 45% in 2022 amid its own crushing debt burden. Its stock suffered for about 18 months after the dividend cut but has increased by about 45% over the last year. That move may give Verizon's management the cover needed for a dividend cut that looks increasingly inevitable.
Addressing Verizon's dividend situation
Amid news of the Frontier acquisition, Verizon dividend investors should consider selling the stock. Indeed, income investors may not want to let go of such a high yield, and with free cash flows exceeding dividend costs, some shareholders may not see a reason to sell.
Unfortunately, the Frontier purchase will significantly add to an already crushing debt burden. That will likely make Verizon's wisest course of action to drastically reduce or suspend dividend payments.
Even if reducing the dividend boosts Verizon's stock longer term, it will be of little use to investors who stuck with Verizon for its payout. Hence, dividend investors should probably unload this stock before a dividend cut brings further selling.
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Will Healy has no position in any of the stocks mentioned. The Motley Fool recommends T-Mobile US and Verizon Communications. The Motley Fool has a disclosure policy.
Prediction: Verizon's Purchase of Frontier Could Prove Costly for 1 Group of Shareholders was originally published by The Motley Fool