Does Frontier Communications Pass Buffett's Test?

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We'd all like to invest like the legendary Warren Buffett, turning thousands into millions or more. Buffett analyzes companies by calculating return on invested capital, or ROIC, to help determine whether a company has an economic moat -- the ability to earn returns on its money above that money's cost.

In this series, we examine several companies in a single industry to determine their ROIC. Let's look at Frontier Communications (NYS: FTR) and three of its industry peers, to see how efficiently they use cash.

Of course, it's not the only metric in value investing, but ROIC may be the most important one. By determining a company's ROIC, you can see how well it's using the cash you entrust to it and whether it's actually creating value for you. Simply put, it divides a company's operating profit by how much investment it took to get that profit. The formula is:

ROIC = net operating profit after taxes / Invested capital

(Read more on the nuances of the formula.)

This one-size-fits-all calculation cuts out many of the legal accounting tricks (such as excessive debt) that managers use to boost earnings numbers and provides you with an apples-to-apples way to evaluate businesses, even across industries. The higher the ROIC, the more efficiently the company uses capital.

Ultimately, we're looking for companies that can invest their money at rates that are higher than the cost of capital, which for most businesses is between 8% and 12%. Ideally, we want to see ROIC above 12%, at a minimum, and a history of increasing returns, or at least steady returns, which indicate some durability to the company's economic moat.

Here are the ROIC figures for Frontier and three of its industry peers over a few periods.

Company

TTM

1 Year Ago

3 Years Ago

5 Years Ago

Frontier Communications4.2%3.2%6.4%7.9%
Windstream (NAS: WIN) 5.1%6.6%9.8%8.9%
CenturyLink (NYS: CTL) 2.9%6.5%6.3%6%
AT&T (NYS: T) 3.2%5.5%*(0.5%)*2.9%

Source: S&P Capital IQ.
TTM=trailing 12 months.
*Because AT&T did not report an effective tax rate, we used its 32.4% rate from five years ago.

Windstream has the highest returns on invested capital of these companies, but its ROIC has steadily declined over the past three years. Frontier was also seeing steady declines, which started five years ago, but that ended after a small upward trend began at TTM. CenturyLink and AT&T have current returns close to 3%, and both have seen their returns declined significantly from last year. However, AT&T's current margins are a bit higher than they were five years ago, while CenturyLink's have declined by more than half in the same time period.

These telecom players are well loved for their dividends, which are 8.3% for Windstream, 7.5% for CenturyLink, and 5.7% for AT&T. But Frontier just announced a steep dividend cut, moving its quarterly payout from $0.1875 to just $0.10 per share. That puts its effective yield at 9.2%.

Frontier's landline business has begun to suffer with the increasing popularity of cell phones. However, the company has acquired some of Verizon's legacy customers for its landline business and has managed to grow its broadband-services business. In addition, Frontier recently announced a three-year deal to resell AT&T's wireless services. Things are still tough for the company, which projects 2012 free cash flow at $900 million to $1 billion.

Businesses with consistently high ROIC show that they're efficiently using capital. They also have the ability to treat shareholders well, because they can then use their extra cash to pay out dividends to us, buy back shares, or further invest in their franchise. And healthy and growing dividends are something that Warren Buffett has long loved.

So for more successful investments, dig a little deeper than the earnings headlines to find the company's ROIC. Add these companies to your Watchlist:

At the time this article was published Jim Royal, Ph.D., owns shares of AT&T and Frontier. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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