If you run a screen for high-yielding stocks, telecom company Frontier Communications (FTR) will probably come up. While you might be tempted by its high dividend yield, there's a key difference between Frontier and industry peers Verizon Communications (VZ 0.65%) and AT&T (T 1.13%).
The big boys in the telecom sector are wisely focusing on wireless communications and positioning themselves for future growth, but Frontier seems stuck in reverse. That's because it's still heavily oriented toward traditional wireline telephone service, a technology that looks increasingly like a relic of the past with each passing year.
This is a troubling sign for Frontier, and the results are evident in its underlying financial performance.
Here are some key metrics that you should know about to evaluate the strength and safety of Frontier's dividend.
Warning signs aplenty
|
Dividend Yield |
Cash Flow Payout Ratio |
5-Year Dividend CAGR | |
|---|---|---|---|
|
Frontier |
6.8% |
46% |
(16%) |
|
Verizon |
4.2% |
39% |
4% |
|
AT&T |
5.1% |
71% |
2% |
Verizon's free cash-flow payout ratio, which measures how much of its free cash is distributed to investors via the dividend, stands at just 39%. That makes Verizon the best of the group on that metric.
On this measure, you might be thinking that Frontier's cash flow looks good. After all, it's distributing less than half of its free cash flow to investors. Yet, Frontier has cut its dividend twice in the past five years.
One of the reasons is that Frontier is bloated with debt. The company has $7.7 billion in debt and just $3.9 billion in shareholder equity.
Free cash flow isn't created equal
Another reason to be skeptical about Frontier's dividend is that a disproportionate amount of the company's free cash flow comes from depreciation. This is a key difference between Frontier and a very high-quality peer like Verizon, and it's another reason to dig deeper into commonly used valuation metrics for a better understanding of a business.
For example, Frontier generated $860 million in free cash flow last year. But, it needs to be stated that the company generated just $115 million in net income. The reason its free cash flow looks so good is that it took $1.1 billion in depreciation, which is added back to net income in the free cash-flow calculation.
By comparison, Verizon posted $22 billion in free cash flow last year. Of this, $16 billion came from depreciation, a much more comfortable level than Frontier. Verizon's net income clocked in at $32 billion last year.
Put simply, there's a difference between a company whose free cash flow is backed largely by net income, versus one in which free cash flow is made up mostly of adding back non-cash items like depreciation.
When yield can be deceiving
On the surface, you might be tempted to buy Frontier for its hefty dividend yield. Indeed, its 6.8% dividend yield is surely enticing to those who love to receive income from their investments. Plus, Frontier's high dividend yield places it near the top of its peer group. As you can see, larger, more established competitors like Verizon and AT&T offer yields that are several hundred basis points lower.
But, there's good reason for this discrepancy. Frontier's higher dividend represents its higher level of risk. The fact that its yield is several percentage points higher than Verizon's and AT&T's is for all the wrong reasons. Instead of a higher yield based on stronger dividend growth backed by supporting cash flow, Frontier's above-average yield has everything to do with the fact that its share price has fallen considerably over the past several years.
Frontier's share price has tracked its fundamentals, which have deteriorated. The company's revenue fell in 2012, then again last year. In fact, its diluted earnings per share have declined every year since 2009.
Not surprisingly, Frontier cut its dividend twice over the past five years to try to save as much cash as possible. Its annualized dividend has dropped from $1 per share to its current level of $0.40 per share since July 2009.
Frontier's cash flow is now sufficient enough to cover its dividend, so investors don't have much to worry about when it comes to the sustainability of its payout. At the same time, however, there isn't much reason to expect dividend growth in the near future.
