Investors who love getting fat dividends often flock to the telecommunications sector. Indeed, there are several high-yielding telecoms that are attractive to income investors. If you scour the telecom landscape in search of big dividends, you're likely to come across Frontier Communications Corp. (NASDAQ:FTR) and its 6% yield.
Indeed, Frontier's dividend yield is higher than most others in the sector. But investors need to take caution. Frontier's business is highly dependent on low-growth services such as wireline. And, the company's reported free cash flow isn't as good as it seems, because it's mostly made up of depreciation. Other metrics like revenue are more appropriately reflecting its struggles.
Let's take a look at why Frontier's dividend doesn't compensate investors enough for its bleak growth prospects, and why AT&T (NYSE:T) is a better choice for dividend enthusiasts.
AT&T's significant advantage
It's a mistake to think all telecoms are created equal. The biggest and most profitable ones, which certainly include AT&T, have mastered the art of the bundle. Bundled packages, which provide customers with two or more services, are a gold mine because they allow for much higher revenue per user. This was most likely the true motivation for AT&T's pending massive $67 billion buyout of DirecTV. AT&T intends to offer DirecTV's satellite TV service in areas in which its U-Verse TV is not available. This will result in more customers signing up for bundles. Bundling is largely why AT&T's U-Verse produced revenue per user in excess of $170 per month last quarter.
It's the strength of AT&T's bundled offerings and its wireless segment that will lead the company forward. AT&T produced 1% revenue growth last quarter, with its wireless unit's 3% revenue growth pulling most of the weight.
Frontier is falling behind
By comparison, Frontier lost nearly 32,000 residential customers just last quarter. Total revenue declined approximately 1%. And to really show the disparity between the two companies, average monthly residential revenue per customer for Frontier was just $59.64 in the second quarter of 2014.
That's because Frontier has to be content with its regional services, which involve older offerings such as traditional wireline services. Recall that Frontier bought $2 billion worth of wireline assets from AT&T at the end of last year. There's a reason AT&T was content to unload these assets: because wireline is a relic of the past.
Frontier can produce cash flow from these assets for now, but that won't always be the case. Without the ability to package multiple services into high-margin bundles, Frontier faces a difficult future. Management takes pride in its free cash flow metrics, which look impressive on the surface. Indeed, Frontier generated $216 million in free cash flow last quarter and lists its dividend payout ratio at 46%, as a percentage of free cash flow.
But that doesn't tell the whole story. Telecoms carry huge fixed assets, which result in high depreciation expenses that get credited back to net income in the free cash flow calculation. On this basis alone, all telecoms look good, and you'd have a hard time finding a telecom that doesn't produce a lot of free cash flow. But if the vast majority of a company's free cash flow consists of depreciation and not profits, dividends aren't sustainable.
This is why, despite seemingly comfortable free cash flow payout ratios, Frontier has cut its dividend twice since 2010. Meanwhile, AT&T has increased its dividend for 30 years in a row.
Better dividend stock: AT&T wins
Both AT&T and Frontier are high-yielding telecom stocks that generate a lot of cash flow. But investors need to dig deeper than just free cash flow to understand what's really going on. AT&T is growing, thanks to its competitive position and ability to offer highly lucrative bundled services. On the other hand, Frontier is in a much more difficult position. Its regional offerings of older services, such as wireline, don't have nearly the same growth potential.
Even though Frontier's dividend yield is slightly higher than AT&T's 5.25% dividend yield, AT&T's payout is much more sustainable. For that reason, AT&T's dividend wins this showdown.
Bob Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. 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.