What You Need to Know About This Telecom's High Yield

One nice thing you can say about Frontier Communications (NYSE: FTR) is that it has increased its revenues by 79% for fiscal year 2010 over 2009. But those numbers are misleading because the revenue improvement was a byproduct of Frontier taking over assets from Verizon (NYSE: VZ) last year, which tripled its customer base.

In reality, adjusting for the Verizon acquisitions, revenues fell almost 8% year over year.

The same "great, but ..." caveat can be put forth in Frontier's stead for another number that stands out: its projected dividend yield of 10.7%. Great, but how long can Frontier keep pumping out those dividends when it does so at a whopping payout ratio of 468%?

That's a good question. If Frontier is paying out over four and one-half times its earnings to its stockholders, where is it getting the money to pay those dividends? It's a wonderful thing to get a nice chunk of money back from an investment, but not at the risk of the company starving itself by doing so.

Is payout ratio the right metric to look at?
By comparison, here are some other telecoms that also pay high dividends. In this environment of low interest rates, they can be hard to resist. But if you're tempted, it's good to know how much of those companies' profits go toward maintaining those yields.

Though the usual metric for judging the sustainability of dividend payments is the dividend payout ratio, it can be a bit disingenuous. Earnings on an income statement can paint a more-or-less accurate picture of net profits depending on how the accountants use accrual accounting to either bring income forward or push expenses back.

The cash flow statement, on the other hand, deals only in what cash is actually on hand, not on paper profits. Therefore, dividing dividends by free cash flow (net cash from operations, less capital expenditures) will give a more realistic look at payout ratios than dividing dividends by net income.

Source: Morningstar; TTM = trailing 12 months.

So it turns out that the companies with the payout ratios over 100% are not cannibalizing themselves. They are paying out those dividends by tapping into their free cash flow coffers.

This table also reveals something about Verizon and AT&T. Looking at payout ratios, AT&T looks to be in better shape to dole out its nice dividend than Verizon. But looking at the column containing percentage of free cash flow, that result is reversed. Hmmmm.

The real bottom line
Frontier is using quite a large percentage of its free cash flow for dividends, which does not leave much room for error. If it suddenly needs that cash to pay down debt or to make a critical capital expenditure and can't pay its dividend, the stock price would likely take a significant hit. So keep that in mind before being seduced by a sky-high yield.

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