The Best Dividends in Telecom: Frontier

There's little mystery that heady dividends are driving investor interest in the telecom industry these day. With 10-year treasuries yielding about 2%, income-oriented investors have found solace in large telecoms. At the end of July, the telecommunications sector of the S&P 500 yielded 5.4%, over a percent higher than its closest peer, utilities.

Still, not all dividends are created equal, and dividend payers require close attention to the underlying fundamentals of their business. Anyone can look up a company's yield or its payout ratio, but understanding the core metrics driving a business requires digging deeper under the surface and unearthing other important measures.

Today, we'll be kicking the tires on Frontier's (NYSE: FTR  ) monstrous 10.1% yield.

The company
Frontier is part of a group of rural-focused telecom companies that includes the likes of CenturyLink (NYSE: CTL  ) and Windstream (Nasdaq: WIN  ) . The companies all share a few notable traits:

  • They derive high-margin revenues from legacy telephony businesses that fuel their dividends and investments in newer, more advanced areas of telecommunications like broadband.
  • Each company's yield is among the highest you'll find in U.S.-listed companies.
  • All three companies have been rushing to consolidate to gain more scale and achieve greater cost savings.

Speaking of the last point, Frontier pulled off one of the largest telecom deals in recent years when it acquired Verizon (NYSE: VZ  ) assets that included 4.8 million subscribers. That was a staggering acquisition when you consider Frontier's previously only had 2.6 million subscribers at the end of 2010. The charts below show the scope of how much the Verizon deal changed Frontier both in terms of revenue and geographic service area:

Source: 2010 company 10-K.

The deal had its fair share of critics as previous spin-offs from Verizon had gone sour. The most notable example was FairPoint, a company that purchased $2.3 billion worth of Verizon property and then spiraled into bankruptcy as technology transfer costs spiraled out of control.

However, while Frontier's buy of Verizon's assets is large, it's not in the same league as FairPoint, which purchased enough Verizon assets to grow six-fold in the blink of an eye. Also, while Frontier is still early into integrating all of Verizon's assets, initial results have been positive. The company now expects to achieve cost savings of up to $500 million in 2011. If Frontier hits that target, it would be $100 million more in savings than the company originally expected this year.

The company owes  a migration of traffic to its national data backbone for much of the savings. That's no doubt heartening to investors in CenturyLink and Level 3 (Nasdaq: LVLT  ) . Both CenturyLink and Level 3's mergers were heavily reliant on achieving similar savings through funneling combined traffic into a large backbone network.

The numbers
Now we get to some of the real numbers driving the massive dividends doled out by these rural-focused telecoms.

The number most investors fixate on is how dividend payouts compare to earnings and cash flow, so here's a quick comparison between Frontier and other big dividend options in the telecom industry.

Company

Common Dividends Paid

Free Cash Flow

Earnings

Frontier $745.9 $913.6 $162
CenturyLink $1,098 $1,889.9 $769.7
Alaska Communications (Nasdaq: ALSK  ) $38.6 $31.2 ($5.2)
Telefonica (NYSE: TEF  ) $9,968.8 $12,315 $13,871.5

Source: Capital IQ, a division of Standard & Poor's. All figures are in millions and cover the last 12 months.

While Alaska's 12% yield might be the most tempting, the company is also more reliant on declining telephony revenues. Let's examine some key metrics in Frontier's business versus Alaska Communications to see how the two businesses stack up against one another.

Source: Capital IQ, a division of Standard & Poor's.

While both companies have had relatively flat revenues between 2006 and 2009, a key component is looking at what kind of revenues each company is bringing in. In Frontier's case, it's balancing declining telephony against booming broadband sales which should continue to do well even in the face of technological change.

In Alaska's case, while wireless revenues jumped between 2006 and 2007, they've since stagnated while telephony continues to bleed down. Even more troubling: The company lacks the ability to bundle services, a feature that's becoming increasingly important in the telecom industry. Here's what Alaska had to say in its last annual filing [emphasis mine]:

Our principal wireline competitor, GCI, is the dominant cable television provider in Alaska. In consumer markets, GCI attempts to use its dominant cable television position by bundling its cable services with competitive telephony services, which are often based on leases of our facilities. We do not offer television service, and thus, are unable to offer competing bundles. In addition, GCI has aggressively deployed cable telephony in order to move its telephone customers off of our network and onto its own cable system.

There's a certain element of "bleeding down the cash cows" in all rural-focused telecom companies, but all competitive positions aren't created equally. Frontier looks far more "future-proofed" than a peer like Alaska Communications.

Final thoughts
I like Frontier as part of a basket of telecom stocks … if you're chasing yield. The telecom industry is seeing a period of extremely advanced technological change. How we interface with our mobile devices, televisions, and even consume data is changing at an extremely rapid pace. It's for that reason I'd suggest also incorporating a foreign telecom like Telefonica that has exposure in rapidly growing emerging markets and pays a great yield, as well as including a domestic carrier like Verizon. Such a basket would still give investors yields in excess of 8% and would spread out the risk of any particular part of the telecom industry seeing faster-than-expected obsolescence.

To keep updated on any of the companies above, add them to our free My Watchlist service. It'll give you up-to-date news and analysis on more dividend ideas as well as well as more analysis on stocks already in your portfolio.

Eric Bleeker owns shares of no companies listed above. You can follow him on Twitter to see all of his technology and market commentary. The Motley Fool owns shares of Telefonica. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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