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4 Reasons Investors Overreacted to Frontier’s Earnings Beat

By Chad Henage – Mar 1, 2014 at 9:00AM

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The stock jumped more than 10% for what exactly?

Did Frontier Communications (FTR) investors overreact to the company's recent earnings? If the company outperformed its peers or reported stronger than expected cash flow it might make sense for the stock to rise. However, there are at least four reasons to believe that Frontier's recent jump in price won't be sustained.

Two problems for the price of one
Investors looking for a stock with a sustainable dividend should at least hope for sustained revenue and earnings. While it isn't hard to understand that a local telecom like Frontier is having trouble maintaining its revenue, its peers are doing better. In addition, analysts expect the company's peers to continue outperforming Frontier on an EPS basis going forward.

The first reason investors may have overreacted: Frontier reported total revenue dropped more than 4% in the current quarter, which underperformed its peers. By comparison, CenturyLink (LUMN 1.97%) reported revenue declined by less than 1%, and Verizon Communications' (VZ 0.03%) huge wireless division helped the company grow revenue by more than 3%.

As if Frontier's revenue challenges today aren't enough, the second reason investors may have overreacted is analysts expect the company to report a decline of 4% in EPS over the next several years, which is also worse than its peers. With CenturyLink expected to see just a 1% decline and Verizon expected to grow by 10%, Frontier is running from behind by both measures.

Falling faster than others
Everyone knows that voice lines are being cancelled in favor of voice over IP and cell phones. With virtually every wireless carrier offering some type of unlimited calling, landlines are increasingly redundant.

While voice lines aren't as important to Frontier as they have been in the past, the company is spending $2 billion to buy more wireline assets from AT&T. With 60% of the customers gained in this deal consisting of voiceline users, CenturyLink is buying more of what it keeps losing.

The third issue facing Frontier is in the last quarter, the company reported that switched access minutes declined by more than 11%. By comparison, CenturyLink saw a decline of just over 5%, and Verizon reported a 6% decline.

If Frontier hopes to deliver good returns to shareholders, the company needs to make sure that it is not about to spend $2 billion on assets that it may lose at a faster rate than its peers.

Let's get to the core of the issue
The fourth issue facing Frontier is the company's core free cash flow numbers aren't as promising as the reported numbers might suggest. Using Frontier's version of free cash flow, the company reported a payout ratio of just 40% covering its nearly 8% yield. On the surface this looks great, in particular for a company that was forced to cut its dividend just two years ago.

However, if we dig a little further into the numbers, Frontier's free cash flow payout ratio looks worrisome. The company generated about $650 million in core free cash flow (net income + depreciation – capital expenditures) in the last 12 months. Given the company's dividend costs nearly $400 million, this generates a core free cash flow payout ratio of more than 61%.

In addition, Frontier's projections for free cash flow in 2014 suggest that including acquisition costs the company could at best experience a 3% increase, and at worst cash flow could decline more than 1%. These aren't exactly numbers for investors to get excited about.

CenturyLink also cut its dividend last year, but as part of a capital reallocation plan that led to the repurchase of about 6% of diluted shares. With its current payout, CenturyLink's core free cash flow payout stands at 52%. Verizon offers even more safety with more than $23 billion in core free cash flow in the last year giving investors a payout ratio of just 25%.

A 10% jump for what?
Following Frontier's earnings, the stock reacted by jumping more than 10% in a day. The question facing investors is, what do they do now? The company's revenue decline continues to lag their peers. Frontier is also spending $2 billion on more wireline assets that are running off.

To be blunt, Frontier is doing worse than several of their peers on multiple measures. Long-term investors would be advised to stay away until Frontier can find a way to return to growth. It hasn't happened yet, and the company's current results don't suggest that changing anytime soon.

Chad Henage owns shares of CenturyLink and Verizon Communications. The Motley Fool has no position in any of the stocks mentioned. 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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