The Dividend Cut No One Sees Coming

One of the worst scenarios for an investor is when a stock in his portfolio has a dividend cut that no one expected. Typically, the stock price then falls because the dividend is cut and the yield is less attractive. To find balance, the stock must fall enough to make the yield attractive again. Existing investors not only have less potential dividend income, but a loss of capital as well. Frontier Communications (FTR) stockholders have experienced this scenario and may think they don't have to worry, but there are signs the company's lower dividend may not be safe.

This is growing, and that's not a good sign
Growth is one of the key measures for investors in a company like Frontier. The company, along with rivals Windstream Holdings (WINMQ) and CenturyLink (LUMN -5.15%), is trying to find a way to stem the flow of voice line losses.

To build their other businesses, each of these companies has issued debt to raise money for expenses. On the surface, it looks like Frontier lands between its two peers with respect to relative debt. Frontier sports a debt-to-equity ratio of about 2, whereas CenturyLink is at 1.2 and Windstream is at a staggering 10.

However, the story isn't quite that simple. In the last three years, Frontier's debt-to-equity ratio has risen from approximately 1.5 to 2, and the company's long-term debt has risen about 2% in just the last four quarters. If Frontier continues down this path, the company's interest charges could become a problem.

Actually, now that you mention it
Frontier's rising debt load is already becoming a problem. One of the best ways to determine if a company is spending too much on debt is by comparing its interest expense to its operating income. After all, if the company spends a lot on interest expense, there won't be money left over for capital expenditures or dividends.

As a percentage of Frontier's operating income, the company is spending 66.5% even if we adjust for a current quarter pension expense. By comparison, Windstream is spending 62.6% of its operating income on interest expenses and CenturyLink is only spending 49%. Unless Frontier finds a way to grow its operating earnings, the company's growing debt will only make this situation worse.

One of these things is not like the others
One central issue that should worry Frontier investors is, the company is performing poorly relative to its peers when it comes to both residential and business revenue growth. In the current quarter, Frontier reported residential revenue was down about 5% and business revenue suffered an identical decline of 5%.

By comparison, Windstream and CenturyLink reported residential revenue declines of 3% and 1% respectively. An even bigger difference between the three came in the business revenue side of things, where Windstream and CenturyLink both reported a 1% increase in revenue.

Frontier simply can't afford to see a 5% annual decline in revenue from both residential and business customers and hope to turn this ship around.

A slow creep toward the inevitable
To be clear, Frontier's dividend isn't in trouble today, but if the company continues on its current path, the final result is clear. Look at how the company's core free cash flow (net income + depreciation-capex) payout ratio changes in the next year if the company doesn't make some major changes.

(*10% annual net income decline-2% quarterly depreciation decline - stable capex of last 4 quarters-stable dividends)

Analysts expect a roughly 10% decline in EPS over the next few years. In addition, Frontier is seeing a 2% quarterly decline in its depreciation allowance. Even if we assume the company maintains its capital expenditures average over the last four quarters, the payout ratio rises every quarter.

Again, the dividend isn't in trouble today, but the above table suggests Frontier's dividend will get relatively less safe each quarter. If you want to monitor how the company is doing, consider adding FTR to your personalized Watchlist. You don't want to be caught unaware by a dividend cut that no one sees coming.