As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
We can't know for sure whether Buffett is about to buy Frontier Communications (Nasdaq: FTR ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us. In this series, we do just that.
Writing in a recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Does Frontier meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Frontier's earnings and free cash flow history:
Source: S&P Capital IQ.
Because of large depreciation charges for legacy assets, it's fairly common for telcos to generate significantly higher free cash flow than net income. Frontier is obviously no exception. Over the past five years, Frontier's earnings have held steady, while its free cash flow has soared, in large part due to its purchase of 4.8 million Verizon landlines.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
While historically Frontier has generated a moderately high return on equity, that figure has shrunk significantly over the past couple of years after its equity grew dramatically. I'm not especially concerned, however, as Frontier managed to generate a reasonable 13% free cash flow return on equity over the past year. Its debt-to-equity ratio of 186% may seem large, but it's well within the normal bounds of the telco industry.
CEO Mary Wilderotter has been at the job since 2004. Before starting at Frontier, she worked at Microsoft, AT&T, and McCaw Cellular.
Integrated telecommunication isn't particularly susceptible to rapid wholesale technological disruption, though over the medium to long term, wireline and long-distance communication is becoming increasingly supplanted by mobile phones.
The Foolish conclusion
So is Frontier a Buffett stock? It's a mixed picture. The company has consistent earnings and free cash flow and tenured management. On the other hand, it doesn't generate particularly high returns on equity with limited debt, and its industry is in a state of long-term decline -- something that would likely worry Buffett, whose favorite holding period is "forever." If you're looking for some solid dividend stocks, I also suggest you check out "Secure Your Future With 9 Rock-Solid Dividend Stocks," a special report from the Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these nine generous dividend payers -- simply click here.