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2 Telecom Stocks That Could Make Huge Moves Next Week

By Brian Stoffel – Feb 22, 2014 at 10:15AM

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Ignore the noise and focus on these two things when earnings come out.

Investing in telecom stocks isn't supposed to be a volatile game. Traditionally, these companies spend tons of money setting up the infrastructure necessary to connect the world, then spend years watching that money come back to them in the form of monthly utility payments. Investors get the benefit of some outsize dividends, and everyone's happy.

Things started to change, however, at the turn of the millennium, with landlines giving way to mobile devices. But despite what you might think, not everyone has given up landlines. The companies that provide that service are also wise enough to know that they need to diversify to survive.

That's right about where Frontier Communications (FTR) and Windstream (WINMQ) come in. Each still serves a customer base with landline service, but both are working hard to diversify.

Not everyone thinks they'll make it. That, in part, explains why their dividends are so high, and why so many investors are betting against -- or shorting -- their short-term success. Each company is reporting earnings next week, and the stocks could be making big moves based on what comes out.

Here's a view of what Wall Street is looking for from these telecom stocks, followed by a more detailed look at what's going on.

Company

% of Shares Short

When

Expected Revenue (millions)

Expected EPS

Frontier

20%

Tuesday

$1,200

$0.06

Windstream

16%

Thursday

$1,500

$0.09

Sources: finviz.com, E*Trade.

There will be three things on the forefront of most investors' minds when these companies report. The first will be how the company performs in terms of meeting analyst expectations. We Fools are a long-term bunch, so we won't worry too much about any one quarter.

Overall trends
The second will be an evaluation of where each business is headed. Of course, this means checking to see if the companies met expectations, but it also involves looking at the bigger picture. Both companies are trying to diversify by adding business clients, offering cloud services, and providing high-speed Internet to customers.

Frontier's revenue has fallen by about 8% over the past two years, and analysts don't expect it to start nudging back up again until some time in 2015. The transition to providing data and Internet services -- instead of landline telephony -- is crucial. At the end of last quarter, Frontier got 45% of its revenue from data and Internet services. It would be a very positive sign to see this percentage increase.

Since 2011, Windstream's revenue is actually up markedly, but much of this was via acquisition, and isn't, therefore, a very good proxy for how healthy the business is. In a fairer comparison, Windstream's revenue is only down slightly over the past year. As with Frontier, analysts don't see things starting to pick up again for a while -- 2016, in Windstream's case.

For Windstream, the key moving forward is to increase its revenue from enterprise customers -- defined as those paying more than $750 per month for services. Last quarter, 31% of revenue came from enterprise services. Long-term investors should look for this to increase, but, hopefully, not just because the other segments of the business are falling off.

Dividend health
The second thing investors will have their eyes on is the health of each company's dividends. Both Windstream and Frontier have spent tons of money either via acquisition or in building out their newer infrastructure.

Unfortunately for both companies, they are now heavily indebted and spend a significant chunk of operating cash flow paying interest on their debt. That's not a good equation for financial success, but it's even more troubling when investors are hoping that each company will continue to pay its dividends.

The metric I most like to use to measure dividend health is the amount of free cash flow each company uses to issue its payout. Anything below about 85% is relatively healthy, but the closer the metric gets to going above 100%, you have a situation where caution needs to be exercised.

Here's what each company's metrics look like over the past 12 months:

Company

Free Cash Flow

Dividends

Payout Ratio

Frontier

$811

$400

49%

Windstream

$736

$592

80%

Sources: Yahoo! Finance. Cash flow and dividends in millions.

As you can see, Frontier clearly has the upper hand, here. Right now, it has far more flexibility when it comes to its dividend payment. Though Windstream's dividend isn't in immediate danger, it's also not great to see such a high ratio for a business with falling revenues.

When each company comes out with earnings this week, it'll be important to recalibrate these ratios and see where each company stands.

Brian Stoffel has no position in any stocks mentioned, and neither does The Motley Fool. 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.

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Stocks Mentioned

Windstream Holdings, Inc. Stock Quote
Windstream Holdings, Inc.
WINMQ
Frontier Communications Stock Quote
Frontier Communications
FTR

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