Is Frontier Worth Its Salt?

Return on invested capital is one of my very favorite metrics. In this article, I'll show how you can use it to find stocks to buy, stocks to watch, and stocks to avoid, starting with Frontier Communications (Nasdaq: FTR  ) .

Beware ROE
You've probably heard of return on equity, a favorite of Warren Buffett. It measures net income (the "return") relative to the equity capital a business has raised and built. A higher ROE signals a more efficient business.

But ROE can be gamed. Because debt is cheaper than equity financing, a management team whose bonuses depend on ROE targets may be tempted to lever up, increasing risk, just to juice net income and ROE.

Return on invested capital -- which is like a return on debt and equity -- catches this. ("RODE" would have been a catchy acronym, no?) To find ROIC, simply divide a company's after-tax operating profit by the sum of its debt and equity. Because it includes debt, ROIC is harder to fudge than ROE. Studies also indicate that watching ROIC can improve your returns.

Why ROIC reigns supreme
Michael Mauboussin -- the chief smart dude at Legg Mason Capital Management -- divided stocks into quintiles by ROIC in 1997, then tracked them through 2006. The lowest 1997 quintile ended up performing worst, unsurprisingly. But the stocks with the highest starting ROIC didn't perform the best, with annual returns of less than 6%, mainly because they fell out of the top quintile along the way.

Two investing secrets emerge from the nuances of Mauboussin's findings:

1. If you find a rising ROIC, you could have a winner
Companies that started 1997 in the lowest or second-lowest ROIC buckets, but finished 2006 in the highest or second-highest, delivered returns of 14% annually.

2. While a high ROIC alone doesn't help, consistently high ROIC is a marker of outperformance
Companies that started in the No. 1 or No. 2 quintile in 1997, and remained there through 2006, delivered a whopping 11% annually.

Will our next contestant come on down?
Let's see how Frontier, a rural telecom that just bought a slew of lines from Verizon (NYSE: VZ  ) , which it will now attempt to integrate, stacks up by this measurement. We'll be using numbers from Capital IQ (a division of Standard & Poor's). For most moderate-risk companies, I consider anything greater than 9% to be a decent ROIC; more than 12% is even better. The higher the risk, the higher the ROIC you'll need to be content.

ROIC for Frontier Communications

2005

2006

2007

2008

2009

TTM

6.8%

7.5%

7.9%

7.4%

7.7%

8.3%

What can we conclude? While Frontier's ROIC isn't huge, it's steady, with a standard deviation of just 0.5%. I actually like Frontier's ROIC history and its nearly 10% yield. But I unloaded this one-time recommendation from my Income Investor newsletter because the lines it's buying from Verizon are both much larger in size and much worse than Frontier's existing -- and pretty decent -- business. In other words, Frontier's ROIC could be poised to fall, which, according to Mauboussin's findings, would be a reason to get out now.

James Early owns no stocks mentioned in this article. You can investigate his Motley Fool Income Investor newsletter free for 30 days. The Motley Fool has a disclosure policy.


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  • Report this Comment On August 23, 2010, at 7:12 PM, awallejr wrote:

    Just see what happened to FRP before considering FTR. I own V and promptly sold the FTR shares I got.

  • Report this Comment On August 24, 2010, at 2:41 PM, tk77mann wrote:

    FRP took on a ton of debt, and many of the lines they bought were in states they had not previously done business in, so they had to do tons of custom software development to support the purchased lines. FTR is also bigger, and hopefully more mature and capable, than FRP was when it did its Verizon wireline buy. Most of the lines it bought are in their existing coverage states, so hopefully they will not have the software development required that FRP did.

    But you are potentially right, awellejr, there is a large potential downside if FTR screws up the integration of the new lines they bought.

    Signed,

    A former FRP shareholder and holding-my-breath FTR shareholder

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