Frontier Communications' 17.5% Yield: Too Good To Be True?

| About: Frontier Communications (FTR)

A stock screen for high yield stocks will show Frontier Communications (NYSE:FTR) at the top of the list. At the current time, this stock sports a 17.5% annual yield. This reported yield is not due to a one-time or variable payout. The Frontier Communications management has committed to paying the 75 cents annual payout. Outside of the mortgage REIT sector, there are very few stocks sporting a double-digit yield. A year ago, shares of FTR were worth twice as much, making the dividend yield half as high. What should income investors read into the falling share price?

A little history

Frontier provides telecommunications services such as telephone, high speed Internet and digital/satellite TV services in about half the states, primarily to small communities and rural areas. In May 2009, Frontier Communications reached an agreement to purchase the rural communications services and assets belonging to Verizon Communications (NYSE:VZ) in 14 states. The deal was valued at $8.6 billion and carried out in 2010. The press release noted the combined assets would have produced pro forma revenue of $6.5 billion and EBITDA of $3.1 billion, based on 2008 closing numbers. The deal was financed primarily by stock issuance and the number of FTR shares outstanding is currently double the number reported in 2009. The synergistic savings of merging the two asset bases was projected to be $600 million. The structure of the deal meant that Verizon shareholders were to end up with two-thirds of the new, much larger Frontier Communications. As part of the announcement, Frontier committed to pay an annual dividend of 75 cents - 18.75 cents quarterly - calling the payout rate, "an attractive and sustainable payout ratio."

The revenue from the acquisition was fully reflected by the 2010 third quarter results. All of the former Verizon customers were switched over to the Frontier operating system by the end of the 2011 third quarter. One probable factor in the recent share price decline is a steady drop in revenue from a peak of $1.4 billion in the 2010 third quarter. At the end of the third Over the next four quarters, revenue and EBITDA declined steadily. It appears the former Verizon customers dropped services faster than the company could add new customers in the acquired service areas. The 2011 third quarter revenue was $1.29 billion and the fourth quarter results are forecast to be slightly lower again.

It is important to note, Frontier communications expected the integration of the new customers and service areas would take up to two years, putting the completion date into mid-2012. The company is on track to reach full integration and the expected expense savings goals in 2012. The company has lowered the quarterly operating expenses by 7 percent, from $736 million for the 2010 fourth quarter to $682 million in the 2011 third quarter.

So what about the dividend?

The good news is Frontier Communications has sufficient free cash flow to cover the current dividend rate. The payout ratio of free cash flow was 71 percent for the 2011 third quarter and 75 percent for the first three quarters of the year. The less good news is the payout ratio was a more comfortable 60 percent at the end of 2010. The pattern of declining revenue has put a squeeze on the amount of money the company has available to continue paying the dividend. This fact is probably the biggest reason for the share price decline. The market is indicating it expects the dividend to be significantly reduced in the near future.

To save the current dividend rate a couple of things must happen, probably over the first half of 2012:

  • The quarterly revenue results must turn upward. Frontier Communications has been spending significant amounts of money to upgrade networks able to deliver high quality and higher value communications services in the company's service areas. That cap-ex spending must soon start paying "dividends" so to speak.
  • The ending of acquisitions expenses. Acquisition and integration costs were $67 million in the 2011 third quarter. Those costs should soon go away.

Investors willing to take a gamble on FTR at the current share price and stratospheric yield should be watching the revenue numbers to see if the decline in free cash flow can turn upwards. Investors can also wait for the market to indicate Frontier Communications is out of the woods by a sustained upturn in the share value. Someone who waits for confirmation may end up with an investment yielding 10 to 12 percent. An investor who buys now may get a deal, earning 18 percent on the amount invested. Or the dividend may be reduced, the share price will fall and the aggressive investor will be earning a lower yield on an investment which has lost a large chunk of value.

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