Is This Company the Next in Line?

Is This Company the Next in Line?

Usually being next in line is a good thing, if you are waiting for a movie, waiting for a table at a restaurant, or holding on for a customer service representative, being next is a good thing. However, if you are an investor and your company is next in line for a dividend cut, that is no fun position to be in. Unfortunately for Frontier Communications investors, they know this feeling all too well.

Deja vu all over again
I bet for some this feels like January 2012. At that time, Frontier stock was cruising along with a nice high yield for investors to hold onto. However, by February the company beat earnings estimates, but decided to cut the dividend.

In hindsight, Frontier's dividend cut was necessary as the company's last six month core free cash flow (net income + depreciation - capital expenditures) generation was just $287 million. If Frontier had kept its old payout, the company would have spent about $373 million on dividends. Clearly Frontier couldn't afford its old dividend payout. The question is, how is Frontier doing today, and what does it mean for the company's current yield?

Shouldn't this be a good thing?
A company with good margins is usually something long-term investors are looking for. However, when it comes to Frontier, investors should probably worry that their company is already performing well. If a company has a high margin and can't produce enough cash to pay its bills, investors should worry. Frontier isn't quite there yet, but it's getting close.

Frontier operates in the commoditized business of providing voice, high-speed Internet, and video services. The company's main competitiors are the two other big local telecoms. CenturyLink and Windstream , as well as larger companies like Verizon . Each company provides services that can be easily replaced by their competition. In this tough competitive environment, Frontier's operating margin coming in at 22.36% should be impressive.

By comparison, CenturyLink reported an operating margin of 15.8% and Windstream did even worse with a margin of 15.12%. Even Verizon Wireless, with its terrific wireless division, couldn't match Frontier's margin with an operating margin of 22%. If this sounds like a good thing, ask yourself, how does Frontier expand its margin further if it already leads its peers?

This number has to improve
One of the biggest problems with Frontier is their operating cash flow is moving in the wrong direction. When comparing companies in the same industry, using core operating cash flow (net income + depreciation) is a great way to find out how each company is performing. What is even more instructive is, determining whether the company's core operating cash flow is growing or declining on a year-over-year basis.

Unfortunately for shareholders, Frontier's competition outperformed the company by a significant margin. Verizon reported core operating cash flow up by 12.08%, and CenturyLink performed well by reporting an increase of 4.35%. Windstream barely reported an increase with operating cash flow up just 0.03%, but Frontier performed the worst with a decline of 14.37% compared to last year.

This should be no surprise
Given Frontier's challenges growing operating cash flow, it should come as no surprise that the company is struggling in other areas as well. For instance, the company pays the second most in interest relative to their operating income among their peers. In the last quarter, Frontier paid 62.57% in interest relative to operating income. While Windstream did worse at 71.15%, both companies are in a difficult position.

When a company uses more than 60% of their operating income just to meet debt expenses, there isn't going to be much left over for dividends, capital expenditures, and share repurchases. By comparison, CenturyLink uses about 45% of their operating income on interest expense, and Verizon uses just 8% of their operating income.

Another issue is, the company's lower cash flow and high interest expense makes meeting their already lowered dividend more challenging. Frontier's dividend payout ratio dropped to less than 50% after their dividend cut. In the last quarter, Frontier used nearly 70% of its core free cash flow (net income + depreciation - capital expenditures) on the dividend. By comparison, only Windstream performed worse with a payout ratio above 100%. CenturyLink and Verizon did better with payout ratios of 47.32% and 27.52% respectively.

The bottom line is, Frontier investors should feel like it's 2012. The company's payout ratio has climbed back to where it was before the last dividend cut, and they are paying out a significant amount of income in interest expense. I wish the news were better, but this near 9% yield isn't safe and could be next in line for a dividend cut.

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Chad Henage owns shares of Verizon Communications and 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.

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