3 Signs There Is Trouble on the Frontier

This company can't seem to make up its mind. Frontier Communications (FTR) can't seem to decide if it is turning the corner into a well-run local telecommunications company, or if it's destined to follow other companies down the path to lower earnings and a possible dividend cut.

This was supposed to be simple
Local telecommunications companies are supposed to have essentially one problem and multiple growth opportunities. These companies are supposed to struggle to keep their traditional voice line customers. As customers and businesses move toward cell phones and away from landline phones, these losses are supposed to be offset by growth in other areas.

Competitors from CenturyLink (LUMN -5.15%) to Verizon (VZ -0.53%) are dealing with these landline losses as well. The biggest difference between Frontier and CenturyLink compared to Verizon is that Verizon has a huge wireless business, whereas the other two do not.

The first sign of trouble for Frontier is the fact that the company lagged its peers with an 8.7% decline in voice access minutes on a year-over-year basis. By comparison, CenturyLink reported a decline of 5.7% in access lines, and Verizon saw voice connections drop by 6.1%. The landline business is clearly under pressure, so what can each company do to offset these losses?

Frontier's 5.1% growth in high-speed Internet, and a 15% increase in video customers looks like great progress. When you compare this to CenturyLink's decline in broadband subscribers and Verizon's roughly 5% growth in high-speed Internet customers, it looks like Frontier shareholders have a lot to be happy about.

However, if you look at Frontier's overall results relative to its peers, the numbers are less than encouraging.

Source: SEC Filings.

As you can see, Frontier had the weakest performance in residential and business revenue of the three.

Shouldn't this number be lower?
The second problem facing Frontier is the fact that the company's interest expense as a percentage of operating income is high relative to its peers. In the same way that too much interest can harm an individual's ability to pay down his debt, too much interest on business debt can hurt the company.

If a company plans to increase earnings and reward shareholders, it has to manage its debt and interest payments appropriately. On a positive note, Frontier cut its overall long-term debt by nearly 9% versus last year. Unfortunately, Frontier still used more than 66% of its operating income on interest in the current quarter.

Frontier's interest percentage is particularly disconcerting compared to a few of its peers. CenturyLink is only using 49% of its operating income on interest, while Verizon uses just 7.8% of its operating income on interest payments. Frontier is clearly in a weaker position, and this doesn't argue well for shareholders' returns.

The core concern
The third concern for Frontier shareholders is the fact that the company's core operating cash flow (net income + depreciation) is headed in the wrong direction. In May, I wrote about Frontier and the company's core operating cash flow declined by 8.6% on a year-over-year basis at that time.

In the last nine months, the company's operating cash flow declined by 14.2%. By comparison, CenturyLink reported a decline of 3% using this same measure, while Verizon increased its cash flow by 13%. It's really no surprise that Frontier's cash flow is declining considering that the company's revenue is down.

Connected to this cash flow decline, Frontier's core free cash flow payout is troublesome. The company's dividend is using more than 66% of this cash flow. Not surprisingly, Frontier lags its peers by this measure as well. CenturyLink uses 51% of its free cash flow on dividends, while Verizon uses just 27%. Since Frontier pays a yield of more than 8%, investors should keep a close eye on these numbers to determine if this dividend is safe.

The core problem for investors is that Frontier appears to be in a weaker position than its peers. With revenue and cash flow down, the company must turn these numbers around. Given that the company's cash flow payout ratio is already higher than their peers, investors shouldn't count on this high yield. CenturyLink and Verizon may have lower yields, but their payouts seem better protected.

Frontier has already been forced to cut its dividend in the past, and if the company continues down this path then the dividend could be in trouble again. A lower yield would spell major trouble on the Frontier.