Prediction: Verizon’s acquisition of Frontier could prove costly for a group of shareholders

The news that Verizon Communications (See 3.84%) you will gain Frontier Communications Parent (FYBR 0.68%) seems to make strategic sense. For all the focus on 5G, fiber remains a critical part of the broadband communications infrastructure, serving both consumers and businesses.

Unfortunately for Verizon shareholders, it decided to buy Frontier at a time when the company is facing significant financial struggles. Therefore, even if the acquisition goes through, it is likely to be at the expense of a particular group of shareholders. Here’s why.

Who Suffers in the Frontier Acquisition?

The most likely victims of the acquisition are Verizon’s income investors — in other words, those who hold the stock solely for dividends.

In today’s conditions, Verizon is one of the largest 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%. That’s five times the S&P 500’s average return of 1.3%. It also beats the returns you can earn on a certificate of deposit, which, even in today’s market, rarely exceed 5%.

Additionally, pay has increased for 18 consecutive years, with the company announcing the most recent increase just after the Labor Day holiday. It is also remarkable because dividends can be adjusted at any time. Because ending such a streak could mean reputational damage to a stock, companies tend to maintain such streaks if possible.

The dividend comes at an annual cost of over $11 billion. That’s significantly below the $19 billion in free cash flow generated by Verizon over the past 12 months. Such conditions make the payment seem sustainable – until you look deeper.

Why the dividend probably isn’t sustainable

Unfortunately for Verizon shareholders, the company needs to generate more than $8 billion in annual non-dividend free cash flow.

That’s not because the purchase price for Frontier is a $20 billion cash deal. 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 likely 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 its upcoming acquisition of Frontier. The company cut just $1.4 billion in the first six months of the year, indicating slow progress in this challenge. Additionally, as previously noted, Verizon will assume $11 billion of Frontier’s long-term debt, bringing total debt to $160 billion.

In addition, pressure to reduce or suspend the dividend may come from the competition. T-Mobile it didn’t pay a dividend before introducing a payout at the end of last year. Still, at a dividend yield of 1.3%, it’s a relatively modest expense for the company.

What may be more problematic for Verizon shareholders is AT&This example. After 35 consecutive years of increases, AT&T cut its dividend by 45% in 2022 amid its own crushing debt. Its shares suffered about 18 months after the dividend cut, but are up about 45% over the past year. The move may give Verizon management the necessary cover for a dividend cut that looks increasingly inevitable.

Addressing the Verizon Dividend Situation

Amid news of the Frontier acquisition, Verizon dividend investors should consider selling the stock. Indeed, income investors won’t want to give up such a high yield, and with free cash flows exceeding dividend costs, some shareholders may not see a reason to sell.

Unfortunately, the Frontier acquisition will add significantly to an already crushing debt burden. This will likely make Verizon’s wisest course of action to drastically reduce or suspend dividend payments.

Even if the dividend cut boosts Verizon stock over the longer term, it will do little good for investors who stuck with Verizon for its payout. Therefore, dividend investors should probably unload this stock before a dividend cut leads to further selling.