Dividend Investing: Should You Buy Frontier Communications and Windstream?

Frontier Communications (FTR) and Windstream Holdings (WINMQ) are telecom service providers. Both companies provide regional telco services such as data, broadband, voice, and video services to rural markets that are often neglected by large industry players such as AT&T (T 1.88%).

Frontier Communications and Windstream stand out as some of the highest dividend payers among mid-caps stocks. Now, the mid-cap sector as a whole paid out 50% more dividends than large caps over the last five years, which implies that high dividends in this sector are nothing unusual.

Both companies' stocks, however, sport unusually high dividend yields when measured by any yardstick. Frontier Communications shares sport a dividend yield of 7.2%, while Windstream's dividend yield is close to 12%, higher than that of many real estate investment trusts, which are typically considered the highest dividend-paying stocks.

High dividends can be a powerful attraction for income investors. However, long-term investors need to question the reason(s) behind the unusually high yields. Are the companies trying to reward investors with high dividends to compensate for some deep flaws? More importantly, how sustainable are the dividends, and can investors realistically expect the companies to at least maintain them at their current levels?

The truth about Frontier Communications and Windstream Holdings
Many traditional telcos are facing market headwinds, with several witnessing substantial declines in business revenue. We have yet to receive the results for the just-ended quarter, so let's consider the results for the fourth quarter of fiscal 2013.

Frontier Communications reported a 4% revenue decline in the fourth quarter of fiscal 2013, while AT&T saw a 3% decline, and Windstream's revenue declined 2%.

One positive for Windstream, though, was that its high-speed and Internet revenue grew by 3%. But, this positive was watered down by the fact that the company witnessed a worrying 7% decline in business customers. While its enterprise customers have been growing at an average of 3% per year, its small-business customers have been decreasing by 8%-9% every year. Both AT&T and Frontier Communications saw their high-speed Internet and video subscriber base increase substantially.

It therefore appears as if Windstream managed to grow its revenue by charging its smaller customer base more, which is generally not a good thing.

Let's now revisit the dividend issue. The problem with the two companies' dividend yields is not the amount of dividend paid out per se, but rather the dividend payout ratio. The dividend payout ratio is the percentage of earnings that a company pays out as dividends. The higher it is, the harder it becomes for the company to increase it.

Windstream sports an unusually high cash dividend payout ratio. It's not surprising that it has simply maintained its current dividend and not increased it even once in the last five years -- it's simply run out of gas. Frontier Communications' cash dividend payout ratio topped 100% by the end of 2012, and has since fallen sharply.

Another worrying metric about Windstream shares is their near-flat price over the last five years. Share prices have increased a mere 2% during that period. As a result, total shareholder returns over the period are less than half that of the S&P 500.

Not surprisingly, short interest in Windstream shares remains high at around 20% of total outstanding shares.

Better mid-cap alternatives
For investors looking for healthier midcaps that are trading at reasonable values, Expeditors International of Washington and CH Robinson Worldwide seem like good investments. The two companies are dominant transport and shipping logistics companies.

Shares of both companies have fallen about 10% year-to-date, and Morningstar estimates that they are now trading at approximately 20% discount to their fair values (the broader market is mostly trading at fair value). Their dividend yields are still below 2%. Expeditor's cash dividend payout ratio of 35%, however, is half that of CH Robinson's, which gives it more room for growth.

Foolish bottom line
The temptation to buy Windstream shares for their 12% dividend yield can be very strong. But, it's critical for investors to keep in mind the risks involved with the gamble. For the bold, or nutty, riding the short interest in Windshield might be a viable option. Maybe Frontier Communications shares would be a better bet for an investor not willing to stomach excessive risk.