Fitch Ratings has affirmed the 'BB-(EXP)' Long-Term Issuer Default Rating (IDR) of Frontier Communications Corp. (Frontier, OTC: FTRCQ) and its subsidiaries with a Stable Outlook.
Fitch has also affirmed Frontier's $625 million first lien secured exit revolver due 2024 at 'BB+ (EXP)'/'RR1', the $1.7 billion pre-petition first lien secured term loan due 2024 at 'BB+(EXP)'/'RR1', the $1.15 billion first lien exit notes due 2027 at 'BB+(EXP)'/'RR1' and the $1.6 billion pre-petition second lien secured notes due 2026 at 'BB+(EXP)'/'RR1'.
In addition, Fitch has affirmed the first lien secured term loan exit facility due 2027 at 'BB+(EXP)'/'RR1'; Frontier plans to increase the size of this exit facility from its existing $500 million to $1 billion, with proceeds expected to be used to repay a portion of the $1.7 billion prepetition first lien term loan due 2024. In addition, Fitch expects the remainder of the $1.7 billion first lien term loan and the entire $1.6 billion pre-petition second lien notes to be refinanced with other secured debt.
Frontier's and Frontier Southwest Inc.'s senior secured debt is affirmed at 'BB+(EXP)'/'RR1'. The senior unsecured debt of Frontier North Inc., Frontier California Inc. and Frontier West Virginia Inc. is affirmed at 'BB(EXP)'/'RR2'. The senior unsecured debt of Frontier Florida LLC is affirmed at 'B+(EXP)'/'RR5'.
Fitch expects to assign the ratings following Frontier's emergence in early 2021. The expected ratings will be reviewed for material changes prior to Fitch assigning final ratings. Material changes may include changes in the company's capital structure at emergence, any material deviations from current assumptions, and Fitch's issuance of updated criteria or criteria exposure drafts. Expected ratings, similar to any other rating, can be raised, lowered, placed on Rating Watch or withdrawn.
KEY RATING DRIVERS
Low Leverage Upon Emergence: Frontier's 'BB-(EXP)' and Stable Outlook is supported by relatively low leverage for the rating and relatively low leverage compared with other telecom operators in Fitch's U.S. telecom universe. We expect gross leverage of 2.8x at YE 2021 and net leverage of 2.4x. Absent additional rural broadband support, leverage, both gross and net, could rise to 0.4x to 0.5x.
A much improved FCF position will result from a reduction in interest expense of more than $1 billion annually. Fitch believes the company will have the opportunity to increase investments in key strategic areas including fiber to the home and greater fiber investment to support enterprise and wholesale services, including fiber to the tower. The rating is constrained by the near-term expected decline in legacy revenues and the need to continue to take costs out of the business.
Managing Coronavirus Effects: Fitch believes the risk of the coronavirus pandemic on the operational performance of the telecom sector is low relative to other sectors. Enterprise revenues have some pressure with businesses temporarily closed with the effect on small businesses more pronounced.
This was mitigated by increased use in communication services to conduct business as travel is down materially and remote working continues. Stability in consumer revenues is supported by demand for broadband, not only for work-at-home, but remote learning and increased consumption of entertainment services, such as video and gaming.
Capital Allocation: Frontier is expected to emerge from bankruptcy in early 2021. The current holders of the senior unsecured debt will become the new owners of the company as a result of the restructuring support agreement (RSA). The capital allocation policy remains uncertain, while the company is in bankruptcy with respect to more aggressive investment plans and an articulated capital structure. Fitch believes the company and parties to the RSA are targeting a net leverage ratio of less than 3.0x based upon the anticipated level of debt at emergence.
Challenging Operating Environment: The rating incorporates a challenging operating environment for wireline operators. We expect Frontier's revenue trends to continue to be negative in the next couple of years on an organic basis. The expiration of CAF II funding in 2022 will affect the company.
Fitch expects this latter effect to be mitigated by the next generation of broadband support through the Rural Digital Opportunity Fund, although our assumptions exclude potential funding from this program. The de-emphasis of products, such as video, will affect revenues but will have a far lower effect on EBITDA margins, given programming cost offsets.
FCF and Debt: Fitch is estimating FCF will be around $500 million in 2021, when the company is expected to emerge from bankruptcy. FCF could decline to around $250 million to $300 million in 2022 upon the expiration of CAF II funding. The effect on FCF due to the expiration of CAF II funding could be mitigated by additional broadband funding support. Following the emergence from bankruptcy, Frontier will have a much more tenable capital structure.
Asset Sales: Frontier sold operations in Washington, Oregon, Idaho and Montana, the Northwest operations, to WaveDivision Capital, LLC for $1.35 billion in cash, subject to closing adjustments. This cash, combined with existing cash, will be used to settle claims in bankruptcy. Fitch estimated the transaction multiple was approximately 5.3x based on 2019 estimated EBITDA. Fitch-calculated EBITDA is before restructuring, other charges and a goodwill impairment for operations.
Secured Debt Notching: Frontier parent secured debt is notched up two levels from the IDR. The secured debt benefits from certain guarantees and equity pledges. The first mortgage bonds of Frontier Southwest are also notched up two levels from the IDR, given the security provided by a first lien on substantially all of its assets. For rated entities with IDRs of 'BB-' or above, Fitch does not perform a bespoke analysis of recovery upon default for each issuance. Instead, we use notching guidance whereby an issuer's secured debt can be notched upward zero to two rating levels.
Unsecured Debt Notching: For corporate entities rated 'BB-' and above, the rating assigned to an issuer's senior unsecured debt instrument assumes an average recovery available to these creditors in the event of bankruptcy. When average recovery prospects are present, IDRs and unsecured debt instrument ratings are equal, with no notching.
For subsidiary unsecured debt, Fitch notes the structural seniority to Frontier parent debt and the rating is notched up one level to 'BB(EXP)'/'RR2'. At any rating level where the bespoke approach is not used, analysts can denote contractual or structural subordination that is detrimental to the unsecured debt by rating it lower than the IDR. A bespoke style analysis determining below average recoveries could lead to a rating lower than the IDR. The 'B+(EXP)'/'RR5' assigned to Frontier Florida's unsecured debt reflects Frontier Florida as a guarantor of Frontier's secured credit facility.
Parent-Subsidiary Relationship: Fitch linked the IDRs of Frontier and its operating subsidiaries based on strong operational ties.
Frontier has higher exposure to the more volatile residential market compared with CenturyLink, Inc. (BB/Stable), a wireline peer, and to some extent, Windstream Services, LLC. Incumbent wireline operators within the residential market face wireless substitution and competition from cable operators, such as Comcast Corp. (A-/Stable) and Charter Communications Inc. Fitch rates Charter's indirect subsidiary, CCO Holdings, LLC (BB+/Stable).
Cheaper alternative offerings, such as voice over internet protocol and over-the-top video services provide additional challenges. Incumbent wireline operators had modest success with bundling broadband and satellite video service offerings in response to these threats. Fitch expects Frontier to emerge from bankruptcy with lower leverage than higher-rated peers CenturyLink and Charter.
Frontier needs to improve its competitive position in the enterprise market. In this market, Frontier is smaller than AT&T Inc. (A-/Stable), Verizon Communications Inc. (A-/Stable) and CenturyLink.
All three companies have an advantage with national or multinational companies, given extensive footprints in the U.S. and abroad. Frontier has a slightly smaller enterprise business than wireline peer Windstream. Compared with Frontier, AT&T and Verizon, have wireless offerings providing more service diversification. Frontier's gross leverage is expected to be slightly higher than AT&T and Verizon following emergence from bankruptcy.
Revenues decline just above 10% in 2020, largely reflecting the sale of the Pacific Northwest properties on May 1, 2020.
Revenue declines at a slightly lower rate in 2021 and 2022, due to the partial year of the Northwest assets in 2020, and the loss of CAF II revenues, respectively.
EBITDA margin is expected to decline to the high 30% range in 2020 and 2021 from the low 40% range in 2019. The loss of CAF II funding further lowers EBTIDA margins in 2022. Pressure in 2022 could be partly offset by future rural broadband subsidies.
Capital spending reflects company plans of approximately $1.3 billion in 2020. Thereafter, capital intensity ranges from 16% to 18%.
Cash taxes are nominal in 2020-2023.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
Gross leverage, defined as total debt with equity credit/operating EBITDA, expected to be sustained at or below 3.0x, with FFO leverage of 3.0x, while consistently generating positive FCF margins in the mid-single-digits.
Greater certainty around capital allocation, given the new shareholder base upon emergence.
Successful execution on cost reduction plans.
Consistent gains in revenues from anticipated investments in fiber/broadband product areas.
Demonstrating stable EBITDA and FCF growth
Factors that could, individually or collectively, lead to negative rating action/downgrade:
A weakening of operating results, including deteriorating EBITDA margins and an inability to stabilize revenue erosion in key product areas or offset EBITDA pressure through cost reductions.
Discretionary management decisions, including but not limited to, execution of M&A activity that increases gross leverage beyond 4.5x, with FFO leverage of 4.5x, in the absence of a credible deleveraging plan.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Frontier has a substantial amount of liquidity at this current point-in-time with more than $1.7 billion of unrestricted cash. At emergence, the company expects to have $150 million of unrestricted cash and an undrawn $625 million credit facility. First-lien debt is expected to be $3.96 billion, second-lien debt is expected to total $1 billion, and subsidiary debt is expected to total $856 million. Parent takeback debt is expected to be $750 million, and whether or not it is secured or unsecured will be determined at emergence. Fitch expects to provide a final rating on the takeback debt at that time.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Frontier has an ESG Relevance Score of 4 for Management Strategy due operational challenges following the close of the Verizon transaction that resulted in elevated subscriber churn and weaker than expected revenue, which had a negative impact on the credit profile, and is relevant to the rating in conjunction with other factors.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.
ENTITY/DEBT RATING RECOVERY PRIOR
Frontier North Inc. LT IDR BB-(EXP) Affirmed BB-(EXP)
LT BB(EXP) Affirmed RR2 BB(EXP)
Frontier Florida LLC LT IDR BB-(EXP) Affirmed BB-(EXP)
LT B+(EXP) Affirmed RR5 B+(EXP)
Frontier California, Inc. LT IDR BB-(EXP) Affirmed BB-(EXP)
LT BB(EXP) Affirmed RR2 BB(EXP)
Frontier Communications Corporation LT IDR BB-(EXP) Affirmed BB-(EXP)
LT BB+(EXP) Affirmed RR1 BB+(EXP)
Frontier Southwest Inc. LT IDR BB-(EXP) Affirmed BB-(EXP)
LT BB+(EXP) Affirmed RR1 BB+(EXP)
Frontier West Virginia Inc. LT IDR BB-(EXP) Affirmed BB-(EXP)
LT BB(EXP) Affirmed RR2 BB(EXP)
VIEW ADDITIONAL RATING DETAILS
Additional information is available on www.fitchratings.com