Recent stock strength drives yield below 6%.
AT&T and Verizon provide alternatives with lower yields but with dividend growth.
Consider covered call strategy.
I have been long Frontier Communications (NASDAQ:FTR) for almost five years because of the attractive dividend yield. The first purchase occurred after management had announced that it would be acquiring assets from Verizon Communications (NYSE:VZ) in mid 2010. It was also announced that the acquisition would result in a dividend cut from $1 to $0.75.
I had initially placed too much trust in management's statements and ability to maintain that $0.75 dividend. Despite repeated assurances by management that the dividend was secure, it was subsequently cut again to $0.40 in early 2012 as the company had difficulty stemming customer losses while it was upgrading its network and integrating the acquired Verizon assets. Not too long after a belated Valentine's gift of that dividend cut, the company released an April Fool's Day announcement that the last of the acquired property billing systems had been converted to Frontier's legacy system.
And while the billing systems had been converted, it would be months before Frontier could take full advantage with a unified call center and go-to-market strategy to leverage the network upgrades and broadband speed improvements. By the end of 2012 the pieces were in place and the company ran an Apple gift card promotion that resulted in 28,200 broadband net adds in the first quarter of 2013. Not only was it the highest quarterly total since the acquisition from Verizon, but it was also more than all of 2012.
The strength of broadband net adds continued even after the company discontinued the Apple promotion.
Q2 was even more impressive as the total reached 29,500, followed by 26,800 in Q3 and 27,800 in Q4. The company credited much of the success to a simplified pricing plan of $19.95/month if part of a bundled offering, or $29.95/month as a standalone product of the 4Mbps speed. It was an all inclusive plan with no long-term contract or separate charges for a modem.
A second major event was announced in December of 2013 - Frontier would be acquiring AT&T's (NYSE:T) Connecticut wireline assets. The acquisition is currently scheduled to close on October 24th. This acquisition should be particularly important to Frontier investors concerned about the dividend, especially after the Verizon experience. Fortunately, this acquisition should not result in an immediate dilution to current shareholders (no new shares are being issued as was the case with the Verizon acquisition) and it is not scheduled to bring on an immediate dividend cut (as occurred with Verizon). And, instead of a cut, management claims that the dividend coverage has improved by 5 percentage points, which should make the dividend more secure.
Not surprisingly, the stock reacted favorably to the AT&T news, as the Frontier shares gained 8.6% (to $4.78) the day of the announcement, probably focusing on statements about the improved dividend coverage, $200 million of savings and a statement that the transaction would be accretive to cash flow in the first full year (2015). While I have no doubt that the assets will be more easily integrated into Frontier - it's only a single state, the network appears to require less upgrades, and the financial systems are already being set up for the conversion - there is the trust issue and the believability factor of management. There is also the issue about the rate of customer losses in the acquired property.
But the AT&T transaction wasn't the only signature event for the sector. At the end of July, Windstream Communications (NASDAQ:WIN) announced that it had received a letter ruling from the IRS that would permit it to place most of its capital assets into a separately traded Real Estate Investment Trust, or REIT. The transaction would generate approximately $115 million per year in tax savings for the company, and the market sent the five largest wireline telephone company shares higher. One interesting aspect of the transaction is that Windstream, instead of using the savings to preserve its $1 dividend, used the opportunity to announce that the combined dividends of the two companies would be cut by 30%.
Ignoring the future dividend cut by Windstream, the market immediately sent the shares of those five large companies - AT&T, Verizon, CenturyLink (NYSE:CTL), Frontier and Windstream - higher. The increases were relatively small amounts at Verizon (0.8%) and AT&T (2.6%), and double digit gains at Frontier (13.3%) and Windstream (12.3%). This created an interesting decision point.
As the share prices rose, the yields fell. And, the Frontier dividend yield has suffered quite a bit from the combined good news of that IRS ruling, reasonable performance, and the anticipated AT&T acquisition. As of Friday's closing share price of $6.79, the yield had declined to just under 5.9%. That compares to a yield of 9.9% just prior to the AT&T announcement. This is no longer particularly attractive for me compared to a 5.26% yield at AT&T, especially since AT&T has increased its dividend each year for three decades.
I should point out that a large portion of Frontier's dividend over the past several years has been classified as a return of capital. While this reduces the current taxable portion, it also reduces the cost basis and increases the capital gains when the shares are eventually sold. This is also not a particular concern of mine as most of my shares are held in tax deferred IRA accounts or tax free Roth IRA accounts where the dividends and capital gains are treated the same. In the former case, when a distribution from the IRA occurs it is taxed as ordinary income, and in the latter case, it would be tax free.
Will I switch the funds to AT&T to take advantage of the narrowed yield differential? Not yet. I am now even more comfortable with the safety of Frontier's dividend, and will defer that decision for another six months. Instead, I have chosen to use covered calls to boost the return on Frontier.
To put things in perspective, my Frontier investment has always focused on the current yield and/or reinvesting the dividends to grow future income. With that in mind, I have been willing to sell a variety of - at, in, and out of - the money covered calls. This served two purposes:
- It reduced my net cash outlay (and risk exposure) on new purchases. For example, buying the shares today at $6.79 and selling a February 2015 call option with a strike price of $7 for $0.25 reduces the net outlay to ~$6.55.
- If the share price reaches or exceeds $7 and the shares are assigned, it means that the dividend yield had fallen even farther - to 5.71% - making the decision to go with AT&T and its increasing dividend an even more attractive alternative in the future.
Note that the $0.40 dividend opened on a new position with a net cost of $6.55 produces an annualized yield of 6.1% on the net cost of $6.55. If the shares are trading above $7 by expiration in February, and the shares are assigned, the total return is a minimum of 6.87% ($7/$6.55=6.87%). Any quarterly dividends earned and paid during the period will increase that total return. Next, consider that this transaction expires in February and another call can be sold, again increasing the return. Finally, consider that if the shares are assigned (either from the initial call or a subsequent call) any time prior to the end of a 12 month period, the annual percentage yield on the investment is substantially higher.
The benefits for my current positions are similar. The additional $0.25 from the calls greatly increases the total return - and yield - on those positions. Instead of anticipating $0.40 of dividend income over the next year, I am looking at $0.65 in income - the $0.25 from the call and the $0.40 from the dividend. The $0.65 drives the yield on the current price of $6.79 above 9.5%, and if the shares are not assigned, a new call can be sold in February. If the shares are assigned at any time prior to expiration, the total return is similar (the additional $0.21 of capital gains offsets the potential loss of two dividends over the next six months), but the annual percentage yield is higher because of the shorter time to achieve the return.
There are several risks with using options. Perhaps the largest is the opportunity for capital appreciation above $7. I view this particular one as unimportant (to me) because the purpose of my Frontier investment was based on income from an attractive dividend yield. As shown above, the relative attractiveness of the dividend has been greatly reduced as the share price has risen, and above $7 it becomes even less attractive.
I could be wrong about the dividend. It may not be as safe as I seem to think and a future cut occurs. Or, Frontier could go the REIT route similar to Windstream and take the opportunity to cut the dividend as Windstream anticipates. Or, Frontier actually reverses customer losses and resumes a growth path and increases the dividend.
The covered call places a cap on the potential gains, or as some of my critics will point out, leaves money on the table.
I have been long Frontier for quite some time and have used it as a key holding in my dividend income portfolio. The high yield was the main attraction, and now that the yield spread over alternative high dividend and dividend growth opportunities has diminished, I have been forced to rethink my holdings.
I have decided that the use of covered calls is the right alternative for me at the current time. My only regret is that the options, which previously had extended for up to two years, are now only available for much shorter durations. So, unless the options are exercised sooner, I will be facing a similar decision in February of 2015.