These 3 Numbers Say To Stay Away

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

My first thought when I see a high yielding stock is, can the company afford the dividend? There are a few sectors of the market known for their high yields, such as telecommunications and utilities. In the local telecommunications space, companies like CenturyLink (NYSE: CTL), Frontier Communications (NASDAQ: FTR), and Windstream (NASDAQ: WIN) are all offering significant yields. However, looking at Frontier's recent earnings report, I see multiple challenges that need to be addressed.

Landlines, Broadband, and Video Oh My!
It's no surprise that home telephones (aka. landlines) are being cancelled in favor of cell phones. This happened in my own house about a year ago. With companies like Verizon, Sprint, and AT&T (NYSE: T) offering plans with unlimited minutes, the home telephone is becoming less of a necessity. 

The challenge each local telecom faces is, trying to sign up enough broadband and video customers to offset these landline losses. With the increase in video and music streaming, as well as cloud storage options, the need for broadband Internet is increasing. When it comes to offering video solutions, local telecoms are stealing business by taking advantage of customers frustration with their local cable company. In theory, if these local telecoms. can sign up enough broadband and video customers, they won't have to worry as much about the decline in landline, at least that's how it's supposed to work.

Data, Data, Who Took The Data?
High-speed Internet is becoming almost as necessary as a landline once was. Many people who have high-speed connections can't imagine trying to go back to life without this service. If you look at most of the telecom. industry, broadband net additions are an area of strength. 

In the last few months, both CenturyLink and Windstream added about 1% to their broadband subscriber base. AT&T on the other hand, reported a loss of 0.23% of its broadband connections during 2012. However, the company has a strong wireless business which added 3.59% more subscribers. Frontier's recent quarter, shows a revenue decline of 1.82% in data and Internet services. As you can see, Frontier was one of the only companies among their peers to report such negative growth.

This Isn't The Direction Cash Flow Is Supposed To Go
Another challenge facing Frontier is, their full year operating cash flow was down on a year-over-year basis. Specifically, the company saw a nearly 9% decline in operating cash flow during the last year. This wouldn't be a huge deal, but the company's forecast for 2013 says this is an ongoing issue. 

Frontier suggested that for 2013 the company's free cash flow will be between $850 million and $950 million. The problem is, for 2012 the company reported free cash flow of $975 million. This means not only did the company see an almost 9% drop in free cash flow in 2012, but in 2013 they are forecasting another drop of between 2.59% and 12.84%.

The Company Is 2nd Worst According To This Metric
If Frontier had a pristine balance sheet, maybe I wouldn't worry as much about free cash flow. If the company can more than cover its dividend, then who cares right? Unfortunately, Frontier does not have a debt free balance sheet, and according to one measure, the company is facing real challenges going forward. 

One way to gauge the debt level at a company is, to compare their interest expense to their operating income. I find this measure useful because to be blunt, if a company can't cover their interest payments with operating income, investors need to stay away. Windstream appears to be in the most precarious position, with 93% of their operating income covering interest payments. Coming in a close second is Frontier at 75.89%. When the company only has $0.24 out of each dollar of income after paying interest, you know there isn't going to be much left for capital expenditures and dividends. By comparison, CenturyLink's percentage is 44.29%, and AT&T comes in at just 13.65%.

To Buy Or Not To Buy?
Among the companies we've looked at, we can sort them into two categories. The first category contains Frontier with a yield of 9.78%, and Windstream with a yield of 11.79%. Both companies have a high level of interest expense to their operating income. These two companies also have relatively high debt levels, with debt-to-equity ratios of 2.03 at Frontier and 7.35 at Windstream. The bottom line is, their dividends are just waiting to be cut. 

The second category includes AT&T and CenturyLink. While it's true CenturyLink just cut its dividend, the company simultaneously instituted a $2 billion share buyback. While CenturyLink's yield of 6.24%, and AT&T's yield of 5%, may not look as good as the others, at least their dividends are safe. AT&T's free cash flow payout ratio was 78% in the last quarter. In addition, with a debt-to-equity ratio of just 0.60, the company's balance sheet is much stronger than the competition. CenturyLink's adjusted free cash flow payout is 67%. The company's balance sheet was already stronger than Frontier or Windstream with a debt-to-equity ratio of 0.97.

The bottom line is, you can't just look at yield and buy the shares. Investors enticed by Frontier's 9.78% yield may get paid for now, but the company's declining cash flow, high interest cost, and negative data growth are major concerns that can't be ignored.

MHenage owns shares of CenturyLink. The Motley Fool has no position in any of the stocks mentioned. 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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