This isn't What I Would Call a “Terrific” Report

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'm sorry, but I expect a lot more from an earnings report when someone refers to it as “terrific.” Such was the case in an article by Anders Bylund of The Motley Fool who said, “Yes you can count on this massive dividend.” He was referring to Frontier Communications (NASDAQ: FTR) and their yield which exceeds 8%. While I agree that at least for now the company's dividend looks safe, I think his take on the company needs a dose of reality.

There were a few points of Anders' article that I thought were just a little too optimistic. He also said that revenues came in slightly higher and adjusted earnings were much better than estimates. Where revenue is concerned, it was down on a year-over-year basis which is really the only comparison that makes sense. Saying a company increased revenue on a quarter-to-quarter basis only makes sense if the company has been consistently growing revenue on this basis before, which is clearly not what has been happening at Frontier. Where adjusted earnings per share are concerned, for many telecommunications companies you can pretty much throw out EPS completely. Most of these companies have such a high depreciation allowance that looking at EPS is foolhardy in the first place. Just as an example, last year Frontier had ten times the depreciation allowance compared to its reported net income. Looking at net income is a start, but free cash flow is a different story.

Where Frontier's free cash flow is concerned, that is the part that Anders and I agree on, but for different reasons. He looks at free cash flow up 18% to $285 million and draws the conclusion that investors can count on this dividend. I only draw the conclusion that investors can count on the dividend for now. Looking at a company's free cash flow for one quarter and assuming that a dividend is safe is a very dangerous practice. In fact, a more important measure is operating cash flow as it measures what the company made versus free cash flow, which is a relationship of what the company made versus what it spent on capital expenditures. Operating cash flow during the quarter was down 2.12%. Since the direction of operating cash flow is down, the company isn't necessarily doing better, they are just spending less to create free cash flow growth. Even with this higher free cash flow, there are better options if you are looking for a safe dividend compared to free cash flow. Take a look at how Frontier compares versus several of their competitors:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>Free Cash Flow Payout Ratio 1</strong><sup><strong>st</strong></sup><strong> Q</strong></p> </td> <td> <p><strong>Free Cash Flow Payout Ratio 2011</strong></p> </td> </tr> <tr> <td> <p>Frontier</p> </td> <td> <p>8.49%</p> </td> <td> <p>35.04%</p> </td> <td> <p>99.80%</p> </td> </tr> <tr> <td> <p><strong>Winstream</strong> <span class="ticker" data-id="206063">(NASDAQ: <a href="">WIN</a>)</span></p> </td> <td> <p>10.75%</p> </td> <td> <p>68.88%</p> </td> <td> <p>96.74%</p> </td> </tr> <tr> <td> <p><strong>CenturyLink</strong> <span class="ticker" data-id="203234">(NYSE: <a href="">CTL</a>)</span></p> </td> <td> <p>6.81%</p> </td> <td> <p>49.94%</p> </td> <td> <p>39.77%</p> </td> </tr> <tr> <td> <p><strong>AT&T</strong> <span class="ticker" data-id="205637">(NYSE: <a href="">T</a>)</span></p> </td> <td> <p>4.71%</p> </td> <td> <p>49.81%</p> </td> <td> <p>69.97%</p> </td> </tr> <tr> <td> <p><strong>Verizon</strong> <span class="ticker" data-id="206030">(NYSE: <a href="">VZ</a>)</span></p> </td> <td> <p>4.50%</p> </td> <td> <p>23.78%</p> </td> <td> <p>41.04% </p> </td> </tr> </tbody> </table>

You can see that some of these company's current payout ratios are lower than Frontier and in the future this will likely be the case as well. Before you make the argument that in the meantime you get the higher yield, remember where that argument got Frontier shareholders before – a dividend cut. The fundamentals of the business have to be considered before assuming that one quarter of better free cash flow tells enough of the story.

Where Frontier's fundamentals are concerned, the numbers still don't look very good. In the company's traditional landline business, the company saw a drop of 8.4% in customers and the number of residential lines dropped 8.71%. With other local telecoms they were able to offset these losses with high-speed Internet subscribers and new video subscribers, but Frontier saw growth in these two categories of 2.45% and 2.51% respectively. Where business customers are concerned, the company saw 9.27% less customers and lines down 5.77%. When two of your main businesses are running off at 5.77% to 8.71% and your growth categories are growing at about 2.5%, you are going to see a negative impact on the bottom line. So what should investors do?

There are a few choices, investors can buy or hold Frontier and hope that the company can turn the business around and not just spend less to create free cash flow. Of the bunch, I would avoid Winstream because of their long-term debt, which at last count totaled over 62% of total assets. Between CenturyLink, Verizon, and AT&T the two I like and personally own are CenturyLink and Verizon. The reasons are simple. CenturyLink seems the strongest of the local telecoms. The company's payout ratio is reasonable and they carry less long-term debt relative to assets than either Winstream or Frontier. The reason I favor Verizon over AT&T is simple, Verizon is growing at a better pace than AT&T by nearly every metric. Since investors only give up a small difference in yield, and get Verizon with a much lower payout ratio (23.78% for Verizon vs 49.81% for AT&T), the dividend should be able to grow faster in the future. No matter how you slice it, the Frontier dividend just doesn't seem like one investors should “count on.” There are better opportunities available and betting on a dividend from a company that recently had to cut its dividend is just not a bet I'm willing to make.

MHenage owns shares of Verizon Communications and CenturyLink. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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