Frontier Communications' Dividends May Not Last Forever

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Companies with quarterly or annual payouts provide you with a steady stream of income, with the additional potential for capital appreciation. Simply put, dividend stocks can you give your portfolio what almost no other investment can: both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, non-dividend-paying stocks in the S&P 500 earned an average annual return of 4.1%. Dividend-paying stocks averaged a whopping 10.1% per year. You'd be crazy not to take advantage of that incredible difference.

But investing in dividends can be dangerous. Companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warning signs that may alert you. These red flags could be the crucial factor in determining whether or not a company is likely to continue paying its dividend. Today, let's drill deeper into Frontier Communications (NYSE: FTR).

What's on the surface?
Frontier Communications, which operates in the integrated telecommunication services industry, currently pays a dividend of 9.87%. That's certainly nothing to sneeze at, since the average dividend payer in the S&P 500, in 2009, sported a yield of 2%.

But more important than the dividend itself is Frontier Communications' ability to keep that that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the last five years:

Wow -- something just isn't right, here. Clearly, Frontier Communications has been maintaining its dividend at a rate that far exceeds its reported earnings. Investors should proceed with caution.

It's possible that there may be a reason for Frontier's propped-up payout. Let's look further to see how much trouble we're actually in.

The more secure, the better
The payout ratio is one of the most common metrics investors use to judge a dividend's safety. This number tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything greater than 50% is cause to look a bit further. According to the most recent data, Frontier Communications' payout ratio is 233.07%. Frontier Communications is obviously paying out a substantial portion of their net income in the form of a dividend.

This isn't necessarily a bad thing. Companies can increase their payout ratios over time, possibly because they are becoming more mature, or possibly because that's the best way to increase shareholder value. But investors need to know whether there's enough cash on hand to support that high payout ratio.

To find out, let's look at the free cash flow. Firms use free cash flow -- all the cash left over after subtracting out capital expenditures -- to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio: cash per share divided by dividends per share.

Normally, anything greater than 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Frontier Communications' coverage ratio is 0.43, -- which isn't high enough to make me feel comfortable as an investor. There could be a number of reasons the number is so low; maybe it's typical for the industry, maybe there's a significant amount of debt coming due, or maybe Frontier Communications is simply less than stellar at managing its assets.

Either way, it's always beneficial to compare an investment with its most immediate competitors. In the chart below, I've compared the above metrics with those of Frontier Communications' closest competitors.

In addition, I've included the five-year dividend growth rate, another very important indicator. If Frontier Communications can illustrate that it's grown dividends over the past five years, then there's a good chance that it will continue to put shareholders first in the future. Check out how Frontier Communications stacks up below:

The Foolish bottom line
Only you can decide what numbers you're comfortable with in the end; sometimes, a higher yield and a greater reward mean additional risk. However, when we compare Frontier Communications' payout ratio with that of its peers, we see that it’s significantly higher than most of their metrics, suggesting there may be a more prudent way to obtain dividends. Windstream, for instance, may look like the safest bet overall, with a solid coverage ratio and a stellar dividend.

With any element of your investments -- a dividend, a share repurchase, or an ordinary earnings report -- it's important to do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.