One of the significant differences between companies that have sustainable dividends and those that may not is how much they talk about their payout. Solid companies don't talk about payout ratios because their numbers speak louder than words.
By contrast, it seems like every earnings report from the local telecommunications sector is devoted to convincing investors that these fat yields are safe. The problem for Frontier Communications (NASDAQ:FTR) investors is, their false sense of security could catch them unaware of a looming dividend cut again.
This problem starts at the top
It's no secret that the local telecom business isn't a growth industry. With thousands of customers choosing to cancel their landlines in favor of their cell phones, this business has been difficult for several years. While the local players are fighting back by offering high-speed Internet and premium video services, it's hard to project when or if these companies will ever witness real growth.
With this in mind, when a company like Frontier reports that overall revenue declined by more than 5% year over year, it's not a surprise. However, when you realize that its competition CenturyLink (NYSE:CTL) and Windstream (NASDAQ:WIN) reported revenue declines of 1% and 3%, the obvious question is, what did Frontier do wrong?
This is the first and most obvious reason investors in Frontier could be in for a rough ride. In a struggling industry, you don't usually want to own the company that reports the greatest decline in revenue.
An often overlooked warning sign
In personal finance, it is pretty easy to understand that you don't want to pay too much interest on debt you owe. For some reason, the same investor who would never pay a high interest rate on their credit is more than willing to invest in a company that is up to its eyeballs in interest payments.
The telecom industry requires a lot of capital so it's not unusual for these companies to take on debt. However, just like when an individual takes on too much debt these payments can cause problems. One way to try and determine if a telecom is carrying too much debt is by looking at the company's interest expense compared to its operating income during the current quarter.
The second reason the ride could be rough for Frontier investors is, last quarter the company reported that more than 79% of the company's operating earnings were used on interest expenses. Even if you adjust for the company's $40 million pension expense, Frontier still used more than 66% of its operating income on interest. Looking at last year's linked quarter, Frontier used about 62% of operating income on interest.
By comparison, Windstream carries a relatively high level of debt, but the company used about 63% of its operating income on interest in the last quarter. Of the three local telecoms, CenturyLink spent the least on interest at 49% of operating income. Simple math says if Frontier continues to use a higher percentage of its operating income on interest compared to its peers, that the company won't have as much for dividends and other expenses.
This shouldn't be a surprise
What do you get when a company's revenue declines faster than its peers, and that same company spends relatively more on its debt? In short, you get Frontier reporting that its operating cash flow declined faster than its peers.
This is the third reason the ride could be rough for investors. Frontier reported in the nine months that ended in November, that core operating cash flow (net income + depreciation) declined by almost 14% on a year-over-year basis. Given that Windstream's operating cash flow was flat, and CenturyLink actually witnessed a near 5% increase, Frontier's performance is particularly troubling.
Don't be foolish
The Motley Fool encourages Foolishness, but underestimating the problems facing a company isn't the type of foolishness (note the lowercase f) we're talking about. On the surface, Frontier's over 8% yield seems appealing, the company seems to mention in each earnings report that its dividend is well covered.
However, good companies with safe dividends don't have to talk about their payouts. With mounting challenges facing Frontier, unaware investors could be in for a bumpy ride.
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Chad Henage owns shares of CenturyLink. The Motley Fool has no position in any of the stocks 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.