The rapidly changing telecommunications sector has long been favorable for investment. The first two months of 2012 have been significant for investors in Frontier (NASDAQ:FTR). The big, immediate news was a large reduction in the quarterly dividend amount announced in February. Going further into the first half of the year, the continued integration of the 2010 purchase of networks from Verizon (NYSE:VZ) will drive the company's performance in the second half of the year and on into 2013. Additionally, companies like Windstream (WTL) are targeting commercial broadband services for growth. In this article, I will focus on Frontier, and make comparisons to Windstream and CenturyLink (NYSE:CTL) to see if investors should buy these stocks right now.
Frontier management provided a valid set of reasons for the dividend reduction. First, the lower rate makes the dividend more sustainable. However, the new 10 cent quarterly dividend does represent 42% of projected 2012 free cash flow, down significantly from a payout ratio of 75% at the old dividend rate. The big dividend was not getting the company where it wanted to go. The second reason given to reduce the dividend was to have cash available for strategic investments such as developing new products or network upgrades.
The final reason is to get a handle on the company's leverage and level of debt. At the end of 2010, the level of debt was just under 3 times equity. At the end of 2011, the leverage ratio had climbed to 3.18, moving away from the 2.5 times leverage target. On top of the increasing debt to equity ratio, the company has about $2 billion of outstanding debt coming due between 2013 and 2015, fairly equally divided over the three years. Reducing the dividend provides the company with an extra $1.4 billion in cash flow over the next four years. The stronger balance sheet will allow the company to pay down some debt and refinance some at better rates than it could currently obtain.
The other big factor currently affecting Frontier is the ongoing integration of the networks and customer base purchased from Verizon. Of the 14 state networks included in the deal, five have been converted from the Verizon operating system to the Frontier system. The states were converted in batches, and the last nine will all be converted by the middle of 2012. The conversion process is a major undertaking and requires the bulk of management's focus. With the majority of customers from Verizon still on its system, it has been difficult to market and expand services in the acquired states. Once the conversion process is complete, the game shifts for Frontier.
Once Frontier has all of its territories and customers on a uniform operating system, the company will be able to grow revenues and profits. The challenge here is that the landline based telecom business is at best stable, and could see declining revenue. Frontier's revenues have been shrinking by about 2% per quarter, although, in the fourth quarter of 2011, it was down only 0.6% from the third quarter. In the second half of 2012, Frontier will need to gear up marketing efforts to get more customers signed up and have existing customers enroll in more services. This is a big job with no guarantees, and there is good reason why Verizon sold the business it did to Frontier. Verizon saw better profit potential in its wireless businesses.
Another competitor to Frontier in the telecom sector is Windstream. The company currently yields 8.2%, compared to Frontiers 9.3%. Windstream has been on an acquisition spree over the last several years, buying eight companies. The major difference between the two is that Windstream has put a bigger effort into going after companies offering commercial broadband services. Windstream has been able to stabilize its revenue and seems poised for some level of growth. Frontier has tied its wagon to the Verizon purchase and the future results depend on how well the company manages those assets.
The stock is down about 17% so far in 2012. In comparison, Windstream and CenturyLink are a couple of percent to the positive. The market has not been pleased about the dividend cut, but this action will be positive for the company in the long run. At the current 9% dividend yield, investors will be well paid to wait and see if the company can starting putting management growth plans into action after all the conversion issues are behind them.
There is plenty of cash flow to keep the company in business for a long time. What investors will want to see is a pattern of revenue stability. They will want to see that stability turned into revenue growth, which will lead to increased cash flow. If Frontier reaches that point sometime in 2013, the stock would have been a very good investment in early 2012. Investors just have to remember that the desired scenario may not come to pass and to not give management too many quarters to show they can bring revenue and profit growth to the business.
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