New Way to Fail in Capital Allocation: Frontier’s $10B Fiasco

In 2016, Frontier Communications, a broadband internet and landline phone company, made a bold move. They acquired Verizon’s assets in California, Texas, and Florida (CTF) for a whopping $10 billion. This massive investment instantly doubled Frontier’s sales, but at what cost?

They were buying:

  1. Landline phone services
  2. Broadband internet
  3. Cable TV

Each of these segments generated about $400 million in sales per quarter. Impressive numbers, right? But Frontier didn’t have $10 billion lying around. They had to borrow heavily, taking on enormous debt.

The Deal on Paper

Let’s break down Frontier’s acquisition:

  • Annual Revenue: $5 billion
  • Annual Costs: $5 billion (including $700 million in depreciation)
  • Yearly Capital Expenditure: $500 million

Capital expenditure is the money a company spends on assets like equipment or property. It’s essential for maintaining and growing the business.

Sales and cost amounts were exactly the same, so buying a zero-profit company for $10 billion seems crazy. You must wonder why they did this.

Anyway, to calculate the true cash flow:

  1. Start with revenue: $5 billion
  2. Subtract costs: $5 billion
  3. Add back depreciation: $700 million (since it’s not a cash expense)
  4. Subtract capital expenditure: $500 million

The result: $5B – $5B + $700M – $500M = $200 million in annual cash flow

This $200 million barely covered the $800 million in yearly interest on their loans.

The Synergy Dream

Frontier’s executives weren’t worried. They had a plan – synergy. By cutting overlapping departments and streamlining operations, they aimed to slash costs by up to $1 billion annually. This would boost their cash flow to a healthy $400 million per year after interest payments.

At this rate, they could pay off the acquisition in 25 years. Plus, they’d be multiplying their previous annual net income of $100 million several times over.

The Fatal Flaw

So, where did it all go wrong? They assumed the future would mirror the present. They bet on steady revenue for the next 25 years in a rapidly evolving tech landscape.

Reality hit hard and fast. Within nine months of the purchase, sales had already plummeted from $1.25 billion to $1.13 billion per quarter. And the sales decline didn’t stop there. As revenue shrank, operating profits thinned. With crushing interest costs unchanged, these ate up the dwindling profits, pushing the company into deep losses.

Frontier’s dream of doubling in size turned into a nightmare of spiraling debt and shrinking revenue. Their billion-dollar bet was starting to look like a billion-dollar blunder.

The situation deteriorated so rapidly that by 2020, Frontier was forced to file for bankruptcy, unable to manage the massive debt from its ill-fated acquisition.

The Autopsy of a Billion-Dollar Mistake

So, where did Frontier go wrong? Let’s break down the fatal flaws in their decision-making:

  1. Ignoring Industry Trends: Frontier invested heavily in landlines and cable TV – two industries clearly in decline. Even a child could see that these technologies were being rapidly outpaced by mobile phones and streaming services. Major telecom companies had already reported shrinking landline revenues, and cable TV growth had flatlined. With Netflix hot on cable TV titan Comcast’s heels, the writing was on the wall.
  2. Betting on Synergy: Frontier’s plan hinged on cost-cutting “synergies” to make the deal profitable. While these savings did materialize, basing a multibillion-dollar acquisition on hoped-for efficiencies is incredibly risky. You’ll only know if the synergy works after the merger is complete and the operations are integrated. A more prudent approach? Evaluate deals based on their standalone merit, treating synergies as a bonus rather than a necessity.
  3. The 25-Year Gamble: Frontier expected to recoup their investment over 25 years – an eternity in the fast-paced tech world. For context, 25 years ago, Netflix didn’t exist, and smartphones were science fiction. When buying a business, aim for a much shorter payback period. For small businesses, 5 times cash flow is a good rule of thumb. If the seller wants more, walk away.

The Psychology Behind the Blunder

So why did Frontier’s leadership make such a colossal misstep? Several factors were at play:

  • Scarcity Mindset: 2016 was the CEO/chairperson’s final year at the helm. The Verizon deal represented a last chance to leave a mark, even if it wasn’t a good move for the company’s future. This created a “now or never” mentality, pushing them to make a big move before time ran out.
  • Consistency Principle: The CEO/chairperson’ had a track record of growth through acquisitions, nearly doubling the company’s size previously. This created a psychological drive to repeat the pattern, regardless of changing market conditions.
  • Status Quo Bias: The board assumed business would continue as usual, failing to anticipate the rapid shifts in technology and consumer behavior.

Lessons for Smart Cash Allocation

When allocating significant capital, remember:

  1. Always assume change is coming. The status quo is temporary.
  2. Be patient. Wait for truly compelling opportunities rather than forcing a deal.
  3. Don’t rely on synergies to make a bad deal good.
  4. Consider shorter payback periods, especially in fast-moving industries.
  5. Beware of psychological biases driving decision-making.