Does A Safe Dividend Make This Stock A Buy?

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

With high-yield stocks there are essentially two classes of investors. The first type of investor is, one who hopes to buy the stock, collect the dividend for a certain period of time, and then sell when they believe the dividend is no longer safe. The second type of investor, buys the shares because of the dividend, but intends to hold the shares for a much longer period of time. This brings us to Frontier Communications (NASDAQ: FTR) and their seemingly safe 8.4% yield. However, any company that has already had to cut its dividend, should be viewed with extra scrutiny, as management has already proven the dividend is changeable and not set in stone.

The good news for Frontier investors is, the company's current payout ratio seems reasonable. Unfortunately, the same thing can't be said for competitor Windstream (NASDAQ: WIN) and its seemingly more attractive 11.8% dividend. In the same industry, other opportunities with decent yields are found in companies like CenturyLink (NYSE: CTL), Verizon (NYSE: VZ), and AT&T (NYSE: T). What each of these companies has in common, is they all offer services to both residential and business customers, and they all are struggling with the balance between growing divisions and slowly dying units. However, there is a huge difference between the expected growth rate at each of these five companies. Let's take a look at Frontier's competitive position in the industry.

In the local telecommunications space, Frontier, Windstream, and CenturyLink are the three major players. The two larger players in Verizon and AT&T compete for local services as well, but these two behemoths are more focused on their wireless divisions. In Frontier's case, the company saw revenue in the recent quarter drop by almost 3%, but EPS increased by 40%. Normally a big increase in earnings per-share would be great news, but this increase did not necessarily translate to growth in the company's cash flow. In fact, operating cash flow was actually down on a year-over-year basis.

On a positive note, customer losses have slowed down in the last three consecutive quarters. Three quarters ago, the company lost 72,000 customers and in the last three months, this number dropped to under 52,000. Frontier faces the same challenge as the other local telecom players. The company is trying to balance the loss of landline customers with growth in broadband customers. Where there is some separation in the local players is, in the fact that at the current time Frontier does not offer an integrated television solution. Instead, the company cross-sells other company's television services to bundle with its land line and broadband packages. This lack of and integrated television option caused Frontier to report video customers down over 30% in the last year. Much of this decline was due to the fact that Frontier is putting less emphasis on bundling DirecTV. While this may change over time, a 30% loss, in an area that should be showing growth, will be a difficult challenge for the company to overcome. What is even more disconcerting is the company's financials show that Frontier is performing at the low-end of its peer group in a few areas.

One of the most basic ways investors can compare companies in the same industry is, by looking at each company's gross margin. By this measure, Frontier has some work to do. In fact, of the five companies we have mentioned, Frontier carries the lowest gross margin of the group at 46.15%. By comparison, their local competitors in Windstream and CenturyLink show gross margins of about 53% and 57.5% respectively. The larger players in the industry, Verizon and AT&T, show the highest margins at 62% and almost 60%. For long-term investors, you have to immediately question Frontier's recent acquisitions and how much cost savings the company will be able to generate. The company is already lagging each of its competitors by a significant amount, and without an improvement in their gross margin, free cash flow growth will be hard to come by.

One number that investors in high-yield stocks should pay particular attention to is, their free cash flow payout ratio. Though Frontier’s payout ratio of 46% is better than it used to be, this is still the second highest among its peers. Only Windstream shows a higher ratio at over 147%, with Century link and AT&T at around 38%. One of my personal favorites in this group is Verizon, which shows a payout ratio of just over 23% in its most recent quarter. At least for now, Frontier's dividend yield looks safe, but does this make Frontier a buy?

Frontier's shareholders may not like my answer, as I honestly can't suggest that the stock is a good value at the current time. Of the five companies we looked at, Frontier carries the fourth highest growth rate but the highest P/E ratio. Given the fact that the company has the lowest gross margin, and the second highest payout ratio, there are multiple challenges standing in the way of the stock outperforming its peers. If investors are looking for a local telecom play, CenturyLink looks like a better option. The company has the highest gross margin among its peers, and its yield is within 1% of what Frontier is currently paying. CenturyLink also has the highest growth rate and lowest P/E ratio among the local players. If you are looking for a large telecom investment, Verizon looks like the best option. The company has the highest gross margin and the lowest payout ratio of the group. In addition, Verizon is expected to grow faster than any of their peers. While their yield is 4.6%, the company's low payout ratio suggests this dividend will grow over time. Sorry Frontier investors, but even your safe dividend doesn't make the stock a buy.


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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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