Stay Away From Frontier Communications

| About: Frontier Communications (FTR)

By Tim Begany

Many investors have had the agonizing experience of hanging on to a stock and refusing to let go long after it became clear the stock was no longer a keeper. If that's you, then you know what I'm talking about -- the seemingly endless watching, waiting and hoping against all hope for the stock to turn around and recapture its former glory.

I'm not saying this just to dredge up painful memories, but to remind investors of what it feels like so they (and I) will be less likely to make the same mistake again. And, as you might have guessed, I have a particular stock in mind.

The company, a major telecommunications firm, is a key player in the rural areas of 27 states. Altogether, it has about 7.3 million customers, providing phone lines for 5.6 million and high-speed Internet access for 1.7 million. The company tripled in size when, in July 2010, it acquired 4.8 million rural customers in Indiana, Illinois, Ohio, Washington and West Virginia from Verizon Communications Inc. (NYSE:VZ) for nearly $9 billion in an all-stock transaction. Shares of this company are yielding 9.2% -- enough to make any income investor salivate.

The company may sound impressive based on this short description, but I assure you it's not. The stock -- Frontier Communications Corp. (NYSE:FTR) -- has served shareholders well over the years, but in my opinion, those days are gone. All the stock has to offer now is underperformance.

The dividend, for instance, used to be a major draw. After being set at $1 a share for many years, it was cut to $0.75 a share around the time of the Verizon deal and then again to $0.40 a share last February. In both cases, the main reason for the reduction was to free up cash to service an enormous debt load of about $13 billion, which is more than twice what Frontier brings in revenue (which was $5.2 billion last year). In 2013 alone, Frontier has nearly $600 million of debt coming due, with another $1.5 billion to follow during the following two years. This could take a huge bite out of free cash flow (currently $748 million), though making debt payments shouldn't be an issue, since the company has historically had enough cash on hand (it currently has about $326 million).

What I am concerned about, though, is the potential for more dividend cuts.

Besides having to divert more cash to debt service, Frontier is expected to have less cash coming in. Analysts project yearly revenue will decline at a 4% rate for the next three to five years, dropping by nearly a billion dollars to $4.3 billion by the end of 2016. A major factor in this may be steadily eroding loyalty among the customers acquired in the Verizon deal. Verizon had long neglected these markets before selling to Frontier, making it easier for competitors to swoop in and poach customers. "Frontier may be so far behind in many of these markets that rebuilding isn't possible, at least not without severely punishing returns on capital," cautions analyst Michael Hodel of Morningstar.

Based on this, further dividend reductions may well be in the cards. According to analysts, the dividend could decline by 4% a year for the next three to five years, falling to $0.33 a share by the end of 2016. Earnings per share projections look weak, too, calling for only a 4% growth during the next three to five years.

In addition to the problems I described, there's also the question of where Frontier is headed. It may have bitten off more than it can chew, both in terms of debt load and managing a large, newly acquired base of primarily dissatisfied customers. There's a big risk that this may be a declining company with a lackluster future.

Risks to Consider: Just because the outlook for this company isn't bright doesn't automatically mean it’s a stock you should short. You should do further research and understand the risks involved with shorting before committing to this kind of strategy.

Don't be taken in by Frontier's high dividend yield. It may be enticing, but the reason it's so high is the stock has taken such a beating, falling 36% in the past 12 months. If that hadn't occurred and the stock was still in the $7.25 range like a year ago, then the yield would be 5.5% ($0.40 / $7.25 = 5.5%), not 9%. If the stock had kept pace with the market, which rose 6% during the past 12 months, then the share price would be $7.69 and the yield would be closer to 5% ($0.40 / $7.69 = 5.2%).

The point is, Frontier's dividend yield is high not because the company is strong, but because it's weak -- and getting weaker. Even at the current share price, which is more than 70% below the five-year high of about $16, shareholders are apt to suffer negative returns as the company flounders, the dividend continues to shrink and the stock price drops even further.

Disclosure: Tim Begany does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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