One Telecom with a Big Yield…and a Wild Ride

10/04/2011 8:30 am EST

Focus: STOCKS

Carla Pasternak

Editor, The Income Investor

Most of the major telecoms you think about have the image of stability and predictability even in precarious times but not all the big players have this boring reputation says Carla Pasternak of High-Yield Investing.

After more than doubling its size by acquiring Verizon’s (VZ) wireline assets in mid-2010, Frontier Communications (FTR) is now the largest rural telecom provider in the US.

The company pays a quarterly dividend of 18.8 cents, which amounts to a yearly distribution of 75 cents per year—one of the highest yields in the S&P 500 at over 12%. (And payments are taxed at the reduced dividend rate of up to 15%.)

The dividend appears secure. For the first six months of 2011, the company generated free cash flow of $484.2 million and paid out $373.2 million, for a sustainable payout ratio of 77%.

Management is committed to maintaining its dividend. Chairman and CEO Maggie Wilderotter stated in May that Frontier planned to add 575,000 customers in the next two years to its current base of 1.72 million subscribers, thereby "maintaining healthy cash flow to support our dividend."

Thanks to the acquisition of Verizon’s landline customers, revenues mushroomed between the first six months of 2010 and the comparable period in 2011.

In percentage terms, revenues grew 157%, from $1.04 billion in the first half of 2010 to $2.67 billion in the first six months of 2011.

Net income of $86.97 million rose 12% over the year-ago period. However, earnings per share dropped substantially from 25 cents in the first half of 2010 to 9 cents in the comparable period of 2011. There were three main culprits.

  • First, operating expenses more than tripled from $737.71 million in the first half of 2010 to $2.18 billion in the first half of 2011, mainly due to severance pay and early retirement costs.
  • Second, interest expense nearly doubled from $187.76 million to $334.28 million between the two periods, reflecting the additional $3.3 billion debt assumed from Verizon.
  • Finally, the per-share numbers were significantly reduced, as the company’s share count more than tripled due to the issuance of 678.5 million shares in connection with the acquisition.

For full-year 2011, the 15 analysts following the company see revenues growing a healthy 39%, to $5.26 billion. But earnings per share (before one-time items) are projected to fall to 26 cents, compared with 48 cents in 2010.

Still, the company should be able to cover its dividend based on free cash flow. And in 2012, analysts project earnings per share will grow 19% from 2011 levels to 31 cents, as the Verizon acquisition starts to accrete to the bottom line.

As of June 30, Frontier had $7.99 billion in long-term debt and $4.93 billion in equity, for a high but manageable debt-to-equity ratio of 1.6 times. The company covered interest expense 1.4 times, which is low but also manageable.

Again, Frontier’s ambitious goal is to add 575,000 customers by mid-2013, and at the same time cut operating costs. If the company does not achieve this goal, earnings could suffer, and the free cash needed to cover the dividend could be compromised.

If you can stomach the volatility in return for a double-digit yield, the recent pullback to a new 52-week low may offer an entry opportunity.

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