In the current stock market climate, a large dividend isn't always rewarding to shareholders. If the payout ratio is large, the market tends to discount any excessive payouts due to the fears of a future dividend cut. One needs to look no further than the collapse of Seadrill (NYSE:SDRL) following the recent dividend suspension. The market doesn't take kindly to dividend cuts.
For this very reason, the previous investment thesis on Frontier Communications (NYSE:FTR) recommended that the company modify the capital structure in favor of something more flexible. With high interest expenses and a concerning debt profile, it only makes sense to divert the dollars used for dividend payouts to reduce the debt load. With that recommendation and the already high 6.1% dividend yield, it comes as a big disappointment that the company chose to raise the dividend further.
Starting with the Q115 dividend, the BOD of Frontier Communications approved a 5% dividend hike. The company will now pay a quarterly dividend of $0.105, an increase from $0.10. The first increased dividend will be paid in late March 2015.
The slight dividend increase follows a couple of years of stable dividend rates after several large cuts in the prior years. Not surprisingly, the stock tumbled along with the previous dividend cuts.
FTR data by YCharts
The dividend hike comes after Frontier announced last week an increase in 2014 guidance following the Connecticut acquisition. The company increased the leveraged free cash flow to a range of $755 million to $780 million, an increase from $725 million to $750 million.
The dividend increase amounts to roughly $20 million in annual payments to a total of $420 million.
The biggest frustration with Frontier choosing to hike the payout to shareholders is that the company could use some flexibility to selectively pay down debt and lower interest expenses. As the above analysis and Seadrill examples suggest, the lack of flexibility to selective increase and decrease dividend payouts makes the option unattractive for a company with a high debt load. The flexibility of share buybacks provide a more attractive option with the dividend yield already over 6%.
For Q314, Frontier spent another $163 million on interest expenses that quickly ate up the $219 million of operating income. Even worse, free cash flow dropped to only $149 million from $232 million last year.
The most concerning part of the story with Frontier is the market cap sitting at $6.5 billion and the enterprise value that jumps to over $15 billion due to the debt load. The telecom company continues to watch net leverage rise and is now at 3.4x.
Source: Frontier Q314 presentation
Logic would suggest that Frontier use any excess free cash flow to pay down debt and reduce the net leverage. An expected jump in interest rates would have a negative impact on the company and disadvantage shareholders.
Though Frontier Communications recently increased guidance for 2014, the increase in the dividend payment makes no sense. The company has substantial debt that could use extra payments in order to reduce future risks. In addition, the lack of flexibility from a dividend program suggests it isn't advantageous for shareholders to raise the dividend payout. The extra payments will provide limited benefit to shareholders until the net leverage and interest payments decline.
With the stock down 5% at mid-day trading, the market agrees that higher dividend payments aren't attractive to new investors.
Disclosure: The author is long SDRL.
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