Telecom stocks have been favorites of dividend investors for years, because their yields tend to be among the highest in the market. Frontier Communications (NASDAQ:FTR) in particular sports a highly attractive dividend yield of 8.7% right now, and income investors have celebrated the fact that the growing telecom company raised its quarterly dividend by 5% earlier this year. Yet one thing that's confusing about Frontier is that its earnings are consistently less than what it pays out in dividends each year, raising concerns about whether the payout is sustainable. With analysts now expecting Frontier's latest acquisition of assets from Verizon (NYSE:VZ) to allow for dividend increases in the future, understanding why earnings don't seem to matter to Frontier's dividend policy is more important than ever. Let's take a closer look at Frontier and why it can pay dividends that exceed its earnings.
The battle between telecoms and GAAP earnings
Generally accepted accounting principles serve the purpose of trying to put companies on an even playing field. Yet at least in the telecom industry, GAAP earnings routinely mislead casual investors who don't look beyond the headline numbers.
For instance, take a look at Frontier's first-quarter results from this year. On a GAAP basis, Frontier lost $51 million during the quarter, working out to a loss of $0.05 per share. Even after you make some revisions to reflect one-time acquisition costs, adjusted earnings for the quarter were just $0.02 per share, far less than the $0.105 quarterly dividend it paid out.
However, included in those GAAP results is a huge amount of depreciation and amortization of Frontier's extensive asset base. For the first quarter, those amounts totaled $341 million. With Frontier already having made the investment of capital in order to build those assets, the telecom company prefers to look at free cash flow as its basis for judging the health of its dividend.
When you look at Frontier's free cash flow calculations, the dividend looks much more sustainable. Even after including capital expenditures and interest expense, Frontier posted free cash flow of $197 million in the first quarter, which works out to almost $0.20 per share. By Frontier's calculations, the stock's dividend payout ratio based on cash flow is just 54%, and while that's up from last year's 43%, Frontier has spent more on capital expenditures recently to build up its future business prospects.
How the Verizon deal will help Frontier's dividend
Frontier's acquisition strategy centers on the fact that it can often produce boosts in cash flow from acquiring assets from other companies. The Verizon deal that Frontier announced earlier this year will definitely be a game changer for Frontier and its capacity for dividends, with new assets in the key markets of Florida, Texas, and California offering new opportunities for future organic growth as well as the immediate bump to Frontier's already-impressive customer network.
New CEO Dan McCarthy recently discussed Frontier's dividend opportunity from the Verizon acquisition. McCarthy stressed that Frontier will see immediate positive impact to its free cash flow in the first full year following the deal's closure, with estimates of about 35% accretion. In addition, Frontier anticipates a decline in its dividend payout ratio of 13 percentage points, based on the way the company calculates its payout ratio.
Moreover, Frontier expects substantial cost savings from the acquisition as well. By taking advantage of Frontier's lower cost structure, the company expects to cut expenses by $525 million in the first year following the transaction, with an eventual goal of around $700 million in cost savings by the third year.
What's ahead for Frontier?
Eventually, these positive impacts on free cash flow could give Frontier a chance to raise its dividend again. For long-term shareholders who remember when Frontier's payout was more than double its current dividend, hopes that the dividend will eventually return to its former level are probably too optimistic for the near future. Still, if Frontier's growth strategy works out, consistent boosts in cash flow should lead the telecom to keep rewarding shareholders in the years to come.
Frontier Communications has an attractive dividend yield, but the disparity between GAAP earnings and the amount it pays in dividends has worried many investors for a long time. By understanding the reason for the differences, though, you can make a better assessment of whether the risks involved with Frontier are worth taking on in exchange for the healthy income the stock generates.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Verizon Communications. 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.