Is This High-Yield Dividend Payer Worth It?

After a smooth first half of 2011, the second half has been anything but. With the increased volatility in the market, it seems like the market swings wildly from euphoria to pessimism and back again at a moment's notice. This is a tough environment for any investor, and it's tough to stomach the volatility.

There are two components to returns from the stock market: capital gains and dividends. Dividends result in cold hard cash in investors' hands, so it's no reason they're sought out. Two common places to look for dividends are utilities and telecommunications stocks. With stable cash flows, regional territorial advantages, and often big cash payouts, these sectors have long been favorites of those seeking steady dividend yields from boring, predictable businesses.

Of the two sectors, telecommunications companies tend to pay out more dividends. Many of these companies face slowly declining landline usage, especially by consumers who opt for cellphones in favor of landlines. The shift to mobile hasn't been kind to telecoms that rely heavily on landlines for their revenue.

Despite the tough operating environment these companies face, the dividend yields are so juicy that it's hard not to take a long look just in case we're not missing anything. One of the high-yield companies leading the pack here in the U.S. is Frontier Communications (NYSE: FTR  ) , which is sure to lure many investors with its eye-popping yield of 13.7%. With such a large payout, how could I not at least take a peek?

To start, let's compare it with the usual suspects, the other major telecom players in the U.S.:

Company

1-Year Change in Market Capitalization

Dividend Yield

Free Cash Flow Payout Ratio (unlevered)

Free Cash Flow Payout Ratio (levered)

AT&T (NYSE: T  ) 2% 5.9% 102% 130%
Verizon Communications (NYSE: VZ  ) 14% 5.4% 35% 39%
Windstream (NYSE: WIN  ) (3%) 8.5% 66% 121%
CenturyLink (NYSE: CTL  ) 82% 7.7% 24% 28%
Frontier Communications (40%) 13.7% 74% 125%

Source: S&P Capital IQ.

Why both levered and unlevered free cash flow payout ratios?
Unlevered free cash flow is the free cash flow available to all security-holders: debt and equity holders. However, we're interested in the stock, or common equity. Thus, I prefer to look at levered free cash flow, which is the same as unlevered free cash flow except that it removes interest payments and mandatory principal payments on debt. True to its name, levered free cash flow takes into account the effects of leverage.

It makes a lot more sense to look at levered free cash flow here, since telecom stocks tend to carry at least a fair degree of debt. If a chunk of cash flow is earmarked for interest and principal repayment on debt, why would we want to count that as money for potential dividends? In the table, I left both levered and unlevered free cash flow numbers to show the true health of their dividend payouts and the effect leverage has had.

Why have CenturyLink and Frontier moved so much?
Telecoms have stable cash flows and great dividend yields, so this is a great question worth exploring. The table above uses market cap as a proxy for price. Earlier this year, CenturyLink merged with Qwest Communications and created the third largest telecommunications company in the U.S.

Since we went by total market capitalization, the total aggregate equity value is up 82% over the past year, but there are now twice as many shares outstanding. That means even though the company is now much larger, the size of each individual's slice of the business didn't change much since there are now more shareholders.

Meanwhile, Frontier has been busy integrating the wireline businesses in 14 states that it acquired from Verizon in July 2010. The company reduced its dividend last year following the acquisition, and its prospects going forward are somewhat questionable. While investors aren't worried about imminent dividend cuts, many are worried about whether Frontier can maintain the dividend long term. Despite the stock's big decline over the past year, it will fall even more if the dividend is reduced further.

In order to get a more current snapshot of the companies, let's look at the levered and unlevered free cash flow payout ratios for the most recent quarter:

Company

Dividend Yield

Most Recent Quarter's Free Cash Flow Payout (unlevered)

Most Recent Quarter's Free Cash Flow Payout (levered)

AT&T 5.9% 77% 92%
Verizon Communications 5.4% 20% 21%
Windstream Corporation 8.5% 118% 534%
CenturyLink 7.7% 49% 63%
Frontier Communications 13.7% 60% 90%

Source: S&P Capital IQ.

Verizon manages to pay a healthy 5.4% dividend while paying out just a fifth of its free cash flow. The next name that jumps out at me is CenturyLink. Despite paying almost 8%, its levered free cash flow payout yield is still only 63%. Even if its business declines a bit, the dividend looks sustainable going forward unless its customers leave en masse.

I started this article because I was most interested in Frontier, but its 90% levered free cash flow payout ratio from the most recent quarter is a bit high for my taste. I'm glad to see it below 100%, but there's little room for error with this stock. With few opportunities for the company to grow organically, it cannot afford to slip up, or it may have to consider reducing its dividend in the future.

Foolish bottom line
I started this article because I was interested in Frontier, but I became more interested in Verizon and CenturyLink, which have more manageable payout ratios and still-healthy dividend yields. Nonetheless, I will keep a watchful eye on Frontier to see how it performs over the next few quarters. After all, stocks that pay more than 13% are few and far between.

If you want to find out about more, great dividend stocks, The Fool recently compiled the research report "Secure Your Future With 11 Rock-Solid Dividend Stocks." And better yet, it's absolutely free for our readers. I invite you to access your free copy today by clicking here.

Paul owns no shares of any of the companies mentioned. 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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