Beware of High Dividend Yields?

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

When investing for income, a high dividend yield may look tempting. However, the dividend yield may reside in the stratosphere for a reason. The stock price could have taken a beating due to fundamental degradation. A dividend cut may simply lag due to the fact that the board doesn’t want to send such an obvious negative signal to markets highlighting its troubles.

The double digit dividend yield

Telecommunications company Frontier Communications (NASDAQ: FTR) currently pays $0.40 per share per year. Based on its roughly $4 per share price, as of this writing, this equates to a 10% dividend yield. You may think that is great. Where else can you get a 10% dividend return?

However, looking at Frontier’s fundamentals will make you want to think twice about making the leap into this company’s stock. First, it should be noted that Frontier’s dividend shrank (emphasis mine) from $1.00 per share in 2009 to its current $0.40 per share. In 2011 and 2012 Frontier paid out 100% and 53%, respectively, of its free cash flow in dividends.

This correlates to a steady decline in Frontier’s profitability. Frontier’s income from continuing operations shrunk from $156 million in 2010 to roughly $153 million in 2012, translating into a decline in continuing operating margins from 4% in 2010 to 3% in 2012.

In addition, Frontier sits on a terrible balance sheet. While Frontier possesses cash equating to 32% of its equity base, thanks to a debt offering, its long-term debt to equity ratio stands at an astounding 203% of stockholder’s equity. Its operating income can barely meet its interest obligations, exceeding it by only 1.4 times as of the end of 2012.

Industry trends don’t favor Frontier. The company’s main focus lies in providing rural customers with landline telephones and broadband Internet at a time when the marketplace increasingly favors wireless communications. In 2012, Frontier experienced a decline in its residential and commercial customer base to the tune of 7% and 8% respectively. Frontier’s broadband segment showed a little more sunshine with a 1% gain in its customer base.

Frontier’s 10% dividend, as well as the company itself, may not last long given the continuing market shift away from landlines. This company may well cut this dividend further. Better fish lie in the sea.

Ma Bell

AT&T (NYSE: T), a telecommunications company, whose name goes back over 100 years, currently sports a dividend yield of 5%. AT&T, thanks to its participation in the wireless industry, stands on more solid footing than Frontier.

Unlike Frontier, AT&T steadily raises its dividend. In 2012, AT&T paid out 50% of its free cash flow out in dividends. Currently AT&T pays $1.80 per share per year in dividends.

AT&T currently shows a little better future than Frontier. Its wireless segment, which comprises 52% of its 2012 revenue, grew 6% last year, stemming from a 4% increase in its wireless customer base.

Contrast that with AT&T’s wireline (more commonly known as landline) segment, which showed a 1% decrease last year. Its voice segment (representing its traditional talk business) revenue has shown a steady decline for quite some time with it decreasing 10% in 2012.

AT&T possesses a slightly better balance sheet than Frontier. Cash on hand only calculates to about 5% of its stockholder’s equity. Its long-term debt to equity stands at 72% of its equity base. Its operating income exceeds its interest expense by four times.

AT&T’s size limits the company’s revenue and cash flow potential and consequently its dividend. AT&T’s wireless segment will provide some growth while revenue declines in its wireline segment will wipe most of that growth away like an eraser on a chalkboard.

Frontier’s loss is this company’s gain

Another telecommunications giant, Verizon (NYSE: VZ) currently provides its investors with a 4% dividend yield. This company provides the highest margin of safety with operating income exceeding interest expense by five times. It only paid out 46% of its free cash flow in dividends, currently paying $2.06 per share per year.

In a prudent strategic maneuver in 2010, Verizon sold a huge portion of its landline assets, specifically in rural regions, to Frontier. Currently, Verizon’s wireless segment comprises 66% of its overall revenue, growing 8% in 2012. Contrast that with the revenue decline of 2% in Verizon’s wireline segment.

Verizon also sports the best balance sheet in terms of debt load. Its long-term debt to equity ratio stands at 56%. However, its cash only calculates to 4% of stockholder’s equity.

Like AT&T, Verizon’s wireline segment will serve as a future drag on overall growth in revenue and cash flow.

Conclusion

You should look for Frontier’s 10% dividend yield to disappear altogether due to crushing debt and a declining market for wireline services, even in rural areas, as companies such as AT&T and Verizon make inroads into those markets with wireless products. Moreover, look for AT&T and Verizon to garner small amounts of overall growth from their wireless segments. If you invest in these two companies expect them to function more like bonds with basically a flat line stream of dividend income with small to no increases. If you want growth, look beyond the old telecommunication bellwethers.

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