Does Frontier Communications Pass Buffett's Test?

We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's take a look at Frontier Communications (NASDAQ: FTR  ) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Get further detail on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers, and it provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for Frontier and three industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Frontier

4.8%

4.3%

6.7%

6.7%

Windstream (NASDAQ: WIN  )

5.4%

4.9%

7.7%

12.3%

CenturyLink (NYSE: CTL  )

3.6%

3.1%

6.1%

7.3%

Verizon Communications (NYSE: VZ  )

5.6%*

6.7%

7.2%

7.7%

Source: S&P Capital IQ. TTM = trailing 12 months. *Because Verizon did not report an effective tax rate for TTM, we used a 25% rate.

None of these companies meets our 12% threshold for attractiveness. Verizon comes the closest with an ROIC at 5.6%, but its returns have declined consistently over the past five years. Windstream's ROIC is also in the 5% range, but its returns are down by almost 7 percentage points. Frontier and Century Link have also seen serious declines in their returns. However, all of these companies offer significant dividend yields: Frontier Communications at 9.1%, Windstream at 11.5%, CenturyLink at 5.8%, and Verizon at 4%. However, investors should note that Frontier has cut its dividend twice over the past several years, and CenturyLink also cut its dividend recently. Windstream, on the other hand, has managed to maintain its payout -- at least for now.

Frontier is in a tough spot due to its heavy reliance on the dying rural landline business. The company's acquisition of Verizon's landline business may have made the company's numbers look better by immediately increasing its revenues and size. However, it also forced Frontier to take on a huge load of debt and improved Verizon's position by giving it the cash to grow its wireless network more quickly.

In addition, Frontier has had limited success signing up customers for higher-margin services, such as its broadband services. In contrast, CenturyLink's involvement in cloud computing offers some promise of growth in high-margin product sales in the future, and Windstream's revenues are increasing.

The cash king margin can help you find highly profitable businesses, but it should only be the start of your search. The ratio does have its limits, especially for fast-growing small businesses. Many such companies reinvest all of their cash flow into growing the business, leaving them little or no free cash -- but that doesn't necessarily make them poor investments. Conversely, the formula works better for slower-growing blue chips. You'll need to look closer to determine exactly how a company is using its cash.

Still, if you can cut through the earnings headlines to follow the cash instead, you might be on the path toward seriously great investments.

Though Frontier Communications' juicy dividend is tempting, every investor has to understand that it's not a sure thing. A huge acquisition has transformed the company forever. Will the move bear fruit, or are investors destined for another disappointing dividend cut? In this premium research report on Frontier Communications, we walk you through all of the key opportunities and threats facing the company.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.


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Related Tickers

9/22/2014 4:00 PM
CTL $40.79 Up +0.04 +0.10%
CenturyLink, Inc. CAPS Rating: ***
FTR $6.59 Down -0.01 -0.08%
Frontier Communica… CAPS Rating: ***
VZ $50.18 Down -0.17 -0.34%
Verizon Communicat… CAPS Rating: ****
WIN $11.28 Down +0.00 +0.00%
Windstream Corp CAPS Rating: **

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