Verizon's purchase of Frontier could prove costly for a group of shareholders

The news that Verizon Communications (NYSE: VZ) will acquire Frontier Communications-Parent Company (NASDAQ: FYBR) seems to make strategic sense. Despite all the focus on 5G, fiber optic remains a crucial part of the broadband communications infrastructure, serving both consumers and businesses.

Unfortunately for Verizon shareholders, the company decided to buy Frontier at a time when the company is experiencing significant financial problems, so even if the acquisition goes through, it will likely be to the detriment of a certain group of shareholders. Here's why.

Who suffers from the acquisition of Frontier?

The most likely victims of the purchase are Verizon's income investors – in other words, those who own the stock only for the dividend.

Under the given conditions, Verizon is one of the highest dividend payers in the S&P500. With an annual payout of $2.71 per share, new investors receive a dividend yield of 6.5%. That's five times the S&P 500's average yield of 1.3%. It also exceeds the yield you can get from a certificate of deposit, which rarely exceeds 5% even in today's market.

In addition, the payout has increased for 18 consecutive years, with the company announcing the last increase right after Labor Day. This is also notable because dividends can be adjusted at any time. Since the end of such a winning streak could mean reputational damage for a stock, companies tend to maintain such winning streaks whenever possible.

The dividend costs over $11 billion annually. That's well below the $19 billion in free cash flow that Verizon generated over the past twelve months. Under such conditions, the payout appears sustainable – until you take a closer look.

Why the dividend is probably not sustainable

Unfortunately for Verizon shareholders, the company must generate over $8 billion in annual free cash flow that is not tied to the dividend.

This is not because the purchase price for Frontier is an all-cash purchase of $20 billion. Verizon can refinance Frontier's $11 billion in debt, which is included in the purchase price. Combined with Verizon's current liquidity of $3.9 billion, Verizon can likely accumulate enough cash to complete the acquisition.

What should worry dividend investors, however, is the total debt, which was over $149 billion before Verizon announced its impending purchase of Frontier. The company had only reduced this by $1.4 billion in the first six months of the year, suggesting it is making slow progress on this challenge. In addition, as mentioned, Verizon will assume $11 billion of Frontier's long-term debt, bringing the total debt to $160 billion.

The story continues

In addition, there could be pressure from competitors to cut the dividend or stop it altogether. T-Mobile did not pay dividends before it introduced a payout late last year. However, with a dividend yield of 1.3%, this is a relatively modest expense for the company.

More problematic for Verizon shareholders is likely AT&TExample: After 35 years of continuous increases, AT&T cut its dividend by 45% in 2022 while its own debt load was crushingly high. The stock suffered for about 18 months after the dividend cut, but has risen about 45% over the past year. This move could give Verizon management the cover it needs for a dividend cut that looks increasingly inevitable.

Dealing with Verizon's dividend situation

Given the news of the Frontier acquisition, Verizon dividend investors should consider selling the stock. In fact, income investors may not want to give up such a high yield, and with free cash flows exceeding dividend costs, some shareholders may see no reason to sell.

Unfortunately, the Frontier purchase will add to an already crushing debt burden, so Verizon's wisest move will likely be to drastically cut or eliminate its dividend payments.

Even if the dividend cut boosts Verizon stock in the long run, it will do little to benefit investors who have stuck with Verizon until the payout, so dividend investors should probably dump this stock before a dividend cut triggers further selling.

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Will Healy does not own any 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 a group of shareholders was originally published by The Motley Fool