Well, once again, my hat is off to my colleague, Louis Basenese. Back in December 2011, he warned readers against falling victim to the yield trap. Here's a quick recap in case you missed it: A yield trap is similar to the more common "value trap" - when investors buy up the dying stock of a company just because share prices look cheap.
High-yielding stocks have a similar problem. Like a cheap stock that keeps getting cheaper, a too-good-to-be-true yield often results in a dividend cut. Hence, chasing high yields can be a risky business. And it turns out that Louis was dead-on in his lineup of suspiciously high yielders. Because one of them, Frontier Communications (NASDAQ:FTR), is in danger of cutting its dividend - and not for the first time.
Where There's Smoke, There's Fire
Frontier Communications is a telecommunications firm. Its primary business has been residential and business phone services. Back in December 2011, its stock looked appealing, with a double-digit dividend yield. But Louis was right when he warned readers about Frontier Communications in his article - they cut the dividend, just as he suspected.
You see, Frontier had an enormous and unsustainable dividend payout ratio [DPR] of 500%. Because of it, the company cut the dividend big time - from a $0.19 quarterly payout to $0.10 per share. Even today, despite having reduced the dividend by nearly 50%, Frontier still has a very high DPR of 305%. So while its current 9% dividend yield seems appealing, unfortunately, the dividend is no more sustainable now than it was before.
Although the cut may benefit the company in the long term, it is awful for shareholders. Before we can assume that the dividend is safe from future slashes, we need to know that Frontier is out of the woods. As it stands, the company is in the process of restructuring its business. Frontier continues to lose traditional phone customers, so it's moving in new directions. Its recent decision to sell its standalone internet service will add to the bottom line, but so far, the results haven't met expectations.
The ongoing re-allocation of capital threatens the dividend. The company needs to spend more money on investments in order to keep pace with competitors, but it also needs to reduce its debt levels. That's a tough balance to strike. When push comes to shove, the money for those investments could very well come from a further reduction of its dividend expense. To make a long story short, Frontier could be on the right track long term, but in the short term, there's a hard road ahead.
Adding to the risk is Frontier's volatile share price. The stock was in free fall for years, before peaking at about $16 in 2007. Trading at $5.00 per share in December 2011, shares fell another 40%, then bottomed at about $3.00 in May 2012. Since then, the share price has recovered a bit, and trades at about $4.50 today.
Bottom line: We need to keep in mind that FTR is a work in progress. If Frontier does all the right things and if it can evolve its business, then maybe the share price will rise and the dividend will be safe. But that's a whole lot of "ifs."
I'd stay away from Frontier for the foreseeable future, as 9% yields can become 4% overnight. The stock is also susceptible to violent price swings. I see Frontier Communications as a speculative and risky proposition.