Click to enlarge
Frontier Communications beat both revenue and earnings estimates but the question on most investors mind is the high dividend yield safe or a red flag? The stock closed at $3.92 and at the time of this writing yielding 10.8%. The high yield represents the market's fear the dividend may not be sustainable. To answer the above question we need to take a closer look at the FCF (free cash flow) numbers.
Frontier Communications is reporting FCF of $285 million in the snapshot shown above. The dividend payout was about $100 million which converts to a FCF payout ratio of 35% as reported by FTR. Sounds like a very safe ratio but it is important to note it is accompanied by note 5 which states:
FCF as defined by Frontier, and excluding acquisition and integration costs and capex.
The traditional measure of FCF is defines as cash from operations minus capex which produces a different picture as opposed to management's definition. Here is how management calculates FCF:
Now we will compare the traditional FCF measurement with how management is calculating adjusted FCF as follows:
The red line represents the ttm (trailing twelve months) FCF as calculated by FTR. The generally accepted measure of FCF is shown by the purple line. The green line represents the dividend. Note the old dividend was over $700 million per year then reduced to about $400 million a year. According to management, the old dividend should have been safe when using its FCF calculations, but it becomes clear the old dividend was not sustainable when looking at the generally accepted method of reporting FCF. This is probably why many investors were shocked when the dividend was reduced. It is clear which method controls when calculating the safety of the dividend.
Using the control method yields $670.5million on a ttm basis and $195.6million for the quarter. The annual dividend is $400 million or $100 million on a quarterly basis. The FCF payout ratio using these numbers are 60% and 51%, not bad but higher than the 35% FTR reported. Based on this data the dividend appears safe, but what does the future hold? To answer this question, we need to look at guidance:
Based on the above 2012 guidance, we can project the control FCF vs adjusted FCF by management:
Based on 2012 guidance, FCF will decline somewhat. Note the gap between the control FCF and FTR's adjusted FCF is getting narrower. This makes sense since integration expenses are coming to completion as guidance indicates.
Finally, on May 16 Frontier Communications filed an 8-K in response to investor concerns, providing 2013 guidance as follows:
Revenue growth is a top priority in 2013 just like it is in 2012. We will roll out retention, win-back and upgrade initiatives for both residential and business customers. In addition, we will offer several new products primarily in the broadband category for businesses. We anticipate these activities to reduce our annual revenue decline to low single digits.
Operating on one set of systems and processes across all states and all markets should enable us to further drive cost reductions in 2013 of at least $100 million. Our capital expenditures in 2013 will be approximately $625 million to $675 million. (A decrease of $100 million from 2012)
With lower interest costs in 2013 and higher cash taxes we therefore expect to be able to once again generate very strong free cash flow.
It is important to note the 2013 capital expenditures have not changed. A reduction of $100 million will add directly to FCF.
Based on 2013 projections, the dividend appears safe through 2013. However, all this is predicated on the following:
- It follows through with the following statement in the 8-K: "We plan to have ample cash to pay down the 2013 debt and we will be opportunistic in refinancing all or part of the 2014 and 2015 debt." The current debt schedule is depicted below and has improved since the 8-K filing:
- There are no major pension surprises - i.e., it meets its expected return. The pension recorded a positive investment return of $83.5 million in Q1. This is a very high three-month return of 6.6%, but as we've learned in the past, this can quickly reverse. So far so good. Q2 will be reported when the 10-Q is filed.
- Additional integration costs actually end in 2012.
Finally, we need to restate part of the conclusion from a previous article because this will continue to be an overhang on management until they prove otherwise:
Management's credibility has suffered due to the dividend and free cash flow issues as previously discussed (in above link). Have they gotten the message? If yes, they have probably become more conservative with their projections and the dividend will continue to support the stock. If no, then management will continue to guide down, putting the safety of the dividend in question, i.e., today's price would represent a value trap. Unfortunately, the direction will not become apparent for several quarters.
The credibility issue overlaps past guidance and statements concerning the safety of the dividend that were proved to be inaccurate in the light of how Frontier Communications calculates FCF vs. the control measure discussed in this article.
Detailed financial data used in this article can be found here.
Disclosure: I am long FTR.