How'd Frontier Communications Get so Profitable?

Investors often use return on equity as a quick way to judge the overall quality of a company. After all, the more profit a company churns out on a given amount of equity, the more of the green stuff it can pile up for its investors.

Over the past three years, Frontier Communications (NYSE: FTR) has seen its ROE steadily climb from just under 21% to nearly 50%. But before you get too excited, it's important to remember that not all ROE gains are made equal, so it pays to figure out exactly where those gains are coming from.

DuPont analysis breaks down ROE into three parts: profit margin, asset turnover, and leverage. This allows investors to pinpoint exactly how a company is generating its returns.

Let's take a look at how Frontier has been drumming up its extra returns.

Source: Capital IQ, a Standard & Poor's company, and author's calculations.

This is the outcome we'd least like to see. While overall ROE has increased, margins have fallen, and asset efficiency has stayed flat while the company has become much more levered. And as far as leverage goes, it's not going away any time soon. The company is assuming $3.5 billion in debt thanks to its deal with Verizon (NYSE: VZ), although executives have said the deal should actually reduce total leverage.

Of course we don't want to just look at Frontier in a vacuum. Here's a look at how the company stacks up against some comparable companies.

Source: Capital IQ, a Standard & Poor's company, and author's calculations.
Data is for last 12-month period.
ROE is return on ending equity.

Though CenturyLink has opted to not jack its leverage sky high, it appears that using liberal leverage is far from unheard of among regional telecom companies. In fact, Qwest Communications (NYSE: Q) and Cincinnati Bell (NYSE: CBB) couldn't even be used in the table above because both companies have turned their equity account into a deficit.

It's obvious that these companies are trying to make the best of a bad situation -- regional wireline telecom services are under heavy attack, but this group is hoping to use the reliability of the remaining business to squeeze out more for equity holders through higher leverage.

Dividend investors have been drawn to this sector like bees to honey thanks to generous dividend payouts, but excited yield-snatchers would be well advised to keep an eye on the risk these companies are taking on.

When it comes to dividends, I prefer this rock-solid play.