Seeking Alpha
Long/short equity, growth at reasonable price, research analyst, deep value
Profile| Send Message|
( followers)  

With investors hungry for yield, should they jump into the very high 9.0% yield on Frontier Communications (FTR)? The answer might surprise you, considering the past of this long-suffering sector.

Having been an analyst in the telecommunications industry for 15 years, industry names such as Frontier, that focused on the wireline business, don't conjure up much excitement. Most wrote off those companies for the trash heap years ago.

A surprising thing happened on the way to total annihilation: the companies have been able to maintain a considerable amount of the wireline base while also dramatically reducing costs.

To my surprise, Frontier maintains a nearly $5B revenue base and a market cap of nearly $4.4B. This company is far from disappearing. In fact, it appears to have a few tricks left.

Q2 Earnings Highlights

The stock is surging today after the company reported Q2 earnings that generally matched estimates. The stock surged 12% as most investors are more comfortable that the dividend will remain save. Below are some of the main highlights:

  • Second quarter free cash flow of $285 million
  • Second quarter operating cash flow margin of 49%, as adjusted
  • Second quarter synergy cost savings of $9 million and $640 million since closing
  • Access line annual loss rate improved to 7.6%
  • Dividend payout ratio of 37% for the first 6 months of 2012

Though Frontier continues to lose voice customers it was able to add 5,400 broadband customers and 6,300 video customers to offset those declines. This continues to lead to year-over-year revenue increases in data and internet services.

Free Cash Flow

The biggest issue most investors miss when evaluating a company is that the key to a companies performance are the difference between revenues and expenses or the gross margin and operating margin. Too many times investors focus too much on revenue growth solely.

A company growing revenue extremely fast while also growing expenses should be no more attractive than a company with no growth that is able to reduce expenses faster.

Frontier falls into the later category but continues to be able to maintain strong free cash flow of $285M in the last quarter alone. This number was up compared to the roughly $250M reported in the prior quarter and year.

The main driver of the solid free cash flow is that the depreciation charge of $307M was substantially higher than the $168M spent on capital expenditures. As long as this pattern remains, Frontier should continue throwing off excess cash.

Dividend Safety

The dividend is currently only 37% of free cash flow for the first six months of 2012. This provides a lot of safety for maintaining this rate for a long time. Not to mention the company has been able to maintain strong free cash flow even in the face of slowly declining revenue.

Risk

The risks in the telecommunications industry might be some of the best known in the market. Wireline providers and services will quickly be replaced by wireless services. Right now companies such as Frontier are able to slowly add data customers.

If wireless ever became a viable alternative to either broadband or video, this company would face considerable problems as existing systems become obsolete. That's an even bigger issue as the company has debt exceeding $8B.

Valuation

After the 12% jump today, the stock appears expensive based on earnings expectations alone. Based on the free cash flow though, the stock only trades at roughly 4x the current run rate. With a solid 9% dividend, this stock appears cheap especially for anybody looking for a solid yield.

Conclusion

With interest rates at historic lows, this company makes an attractive investment option. This is especially true considering most other high dividend sectors such as utilities have risen so much that dividends are now half that of Frontier.

With free cash flow stability, maybe Frontier, CenturyLink (CTL), and Windstream (WIN) should now be considered a utility. The later two companies are ironically only seeing minor increases today on the back of the Frontier report. Both companies report next week so those results will be interesting to watch especially with Windstream still yielding over 10%.

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

Additional disclosure: Please consult your financial advisor before making any investment decisions.

Source: Surprising Free Cash Flow At Frontier Communications