Investing After The Dividend Cut

In an article written at the end of last year titled Frontier Communications: A Top Income Idea For 2012, a covered call strategy for Frontier Communications was outlined that would generate dividend and/or capital gains income with a reduced level risk. The market had already priced a dividend cut into the price of the shares, even though I had erroneously chosen to believe management's statements about their intent to maintain the dividend. It will be a while previously the total return will be known for certain, nevertheless considering the magnitude of the recent dividend cut, an update and review of the suggested strategy is warranted.

Recent article

In a recent article, David Klein pointed out issues around pension funding that could cause a drain on current and future free cash flow needed to cover the dividend. There are aggressive capital investment programs that Frontier is continuing, favoring these investments over preserving the prior dividend. Aggressive cost saving programs continue, however they were not sufficient to protect the dividend. And, there are questions about FCC changes to the Universal Service Fee and the future of interconnect earnings and a new Connect America fund.

What is likely to happen to the share price?The answer to this question is tied to the company's ability to deliver on its guidance, especially as it pertains to revenue. The company continues integrating the assets acquired from Verizon Communications and expects to convert the remaining nine states over to Frontier's legacy systems in the first half of this year. As this undertaking winds down, the company will concentrate on growing revenue by focusing on sales to business and selling broadband and combination service bundles to residential clients.

What are the risks?

What are the risks?The risk, quite simply, is that management may be unable to deliver on guidance. The risks are that the revenue falls short, that the pension plan performance drains company resources and that revenues and cash flow will be insufficient to maintain the dividend and the share price declines.

Current Investment AlternativesThe covered call strategies suggested last year, and more recently on Valentine's Day will no longer work as then. The reduction of the dividend and the decline of the option premiums for the calls have made these alternatives far less attractive. There is the opportunity of selling a $5 January 2013 for $0.35, and that will reduce one's cash outlay to about $4.25 based on the current stock price of $4.60. A $0.40 dividend on a $4.25 net cost is a 9.4% yield, however I think there is now a bit more risk.

The communications industry is intense

Competition in the communications industry is intense. We experience competition from many communications service providers, including cable operators offering video, data and VoIP (Voice over Internet Protocol) products, wireless carriers, long distance providers, competitive local exchange carriers, Internet providers and other wireline carriers. We believe that as of December 31, 2011, in broad outline 93% of the households in our territories could receive voice, data and video services from a competitive provider.

Residential and business customer behavior is affected by the ongoing economic uncertainty. Clients have reduced their spending by not purchasing our services or by discontinuing some or all of our services. These trends may continue and may result in a continued challenging revenue environment.

As I noted above, I as well see minimal risk in a furthermore dividend cut within the straightway 18 months. Those hungry for current income could try buying the shares and selling the $5 January 2013 call to reduce their cost and increase their yield to 9.4%, though I would limit this to a small portion of your speculative holdings. I would as well suggest paying careful attention to management presentations at investor conferences, the revenues releases and the conference calls for any hints that the company is not performing in line with company guidance and analyst expectations.