Frontier Communications: Sky-High Dividend Yield Looks Priced to Fall

Jul.31.11 | About: Frontier Communications (FTR)

Frontier Communications Corporation's (NYSE: FTR) appeal seems to be driven by its sky high dividend yield, which, after recent price declines, is now about 10%. While it is a really impressive yield, there is a fundamental question of whether or not this stock is fairly valued. I'll use the Dividend Discount Model (DDM) to value FTR. As I noted before in my article on Communications Services stocks, one should not expect any capital appreciation with FTR. In fact, an investor should expect annual price losses of about 2%, as noted in the article.

The DDM is a simple way to compute a fair value price. It is most appropriate for stocks that provide investors value from dividend payments. Hence this is an appropriate approach for valuing FTR. If most of FTR's expected return had been from capital appreciation and not dividends, the DDM would provide a potentially conservative estimate; however, as noted earlier, essentially all of FTR's value is from dividends. In fact, it is possible that DDM will result in an aggressive valuation for FTR. The Dividend Discount Model (DDM) uses the following formula:

Price = Forward Dividend / (Hurdle Rate - Long Term Growth)

Investors use the hurdle rate to discount future dividends back to the present time. Long term growth is the expected steady state growth of anticipated future dividends. Applying the capital asset pricing model to FTR to get the hurdle rate would yield a rate of about 7.5% (based on a 10 year Treasury bond of 2.8%, a beta of .78 from Yahoo!Finance, and a equity risk premium of 6%). Being conservative, one might bump this rate up to 8% or even 9%.

The next key assumption in a dividend discount model is the forward dividend. FTR's most recent quarterly dividend was $0.1875, which is substantially down from earlier quarterly dividends of $0.25. While management might be seeking to redirect operating cash flow to internal business investments, this is still a worrisome sign. Furthermore, this drop was four quarters ago and management has not raised the dividend since. Prior to that point, the quarterly dividend was fixed at $0.25 for several years. Looking forward, I think $0.75 is the high end for a forward annual dividend. Being conservative, one might consider a lower figure, perhaps $0.70.

The third variable in the dividend discount model is long term growth. Historical performance suggests that there is no growth or perhaps even negative growth. In 2010, FTR paid out about 350% of its net income in dividends. It was able to do this due to improved operating cash flow in 2010, but overall 2010 cash flow was still negative. While, its more recent quarterly performances appear to be slightly better on a cash flow basis, FTR has a limited cushion, if any. I would estimate 0% to be the high end for dividend growth and use a -5% as the low end. I'll also check -3%. This is probably quite reasonable and perhaps a little favorable to FTR since their past three year annual dividend growth rate has been -9.1%

DDM Results for FTR


Forward Dividend ($) Discount Rate Long Term Growth Implied Price ($) FV Premium/(Discount) to current price
0.75 8% 0% 9.38 25%
0.70 8% 0% 8.75 17%
0.75 8% -3% 6.82 -9%
0.75 8% -5% 5.77 -23%
0.65 8% 0% 8.13 8%
0.65 8% -3% 5.91 -21%
0.75 9% 0% 8.33 11%
0.75 9% -3% 6.25 -17%
Click to enlarge
Source: Author estimates and calculations

While in the high cases, FTR might appear to be slightly undervalued, I see the more realistic case, the third case, as showing a fair value discount to the most recent closing price of $7.49. With a payout rate over 300%, significant capital requirements, and significant competition, it seems that FTR might have trouble paying its dividends going forward. In my view, this stock is not a good long. While I might not want to short it, I still think it has negative outlook.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.