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Windstream (Nasdaq: WIN ) released its second-quarter earnings yesterday, and it wasn't pretty. Despite revenues increasing a whopping 49% from the same quarter a year ago, its net profit showed considerable, ahem, shrinkage of 44%.
How'd that happen? According to company executives, this counterintuitive performance was associated with the one-time costs that came with its 2012 acquisition of PAETEC and the large capital expenditures made to increase the company's fiber-to-tower infrastructure.
OK, those are the costs of doing business in the consolidating and capital-heavy telecom world. Windstream wanted to outgrow its regional footprint, and the PAETEC acquisition helped it do that. But growth doesn't come cheaply. That deal cost Windstream $2.3 billion and helped drive up the ratio of its debt to operating income before depreciation and amortization, or OIBDA, to 3.66. That's on the high side of optimal and could affect the interest rate on any future borrowing.
Windstream CFO Anthony Thomas addressed that issue during the earnings conference call, saying the company's "target leverage is 3.2 to 3.4, and we're trying to achieve the high-end of that leverage ratio by the end of 2013."
A pie in the sky?
However, that target number would require, as one analyst suggested during the call, an increase in earnings that didn't seem, well, doable. "... [I]t's not just a slight acceleration [of OIBDA], it's a pretty monumental acceleration, and obviously the Street is skeptical that it can really be accomplished," noted David Barden of Banc of America Securities.
CFO Thomas said: "[We have the conviction in] our sales organization ... to deliver results in the back half of the year ... [and] we've already taken the actions necessary to achieve a lot of our cost savings ... [O]bviously, we need to execute ... to achieve the lower end of our guidance range."
Let's cut to the chase
Not to put too fine a point on it, but all that seems to matter to Windstream investors is the company's dividend. That's what CEO Jeffery Gardner must think, anyway. One of the first things he did during the conference call was to toss this bone to investors:
The dividend is a key component of our strategy. Yesterday we declared our 25th consecutive dividend of $0.25 per quarter and the cash generation capabilities of this business will allow us to adequately invest in our network to support growth opportunities while paying the dividend well into the future.
Putting aside whether or not providing a dividend should be a major part of any company's business plan, let's look at the "cash generation capabilities" allowing a "dividend well into the future."
Free cash flow is customarily computed by taking the net cash provided from operations and subtracting capital expenditures. That is the amount of cash the company uses to pay off its debt and pay out its dividends. The lower the ratio of dividends to free cash flow, the greater the chance of dividend viability.
Windstream sometimes skates on thin ice regarding its dividend to free-cash-flow ratio. Two quarters ago, it had to tread very carefully indeed with a super-thin 96.7% payout ratio. Last quarter allowed more breathing room with a 69% ratio. But for this quarter, that ratio went through the ice, breaking 100%.
The company claimed an adjusted free cash flow of $135 million in the second quarter. But even with those adjustments -- which exclude the merger and integration costs from its expenditures -- the $147 million it paid out in dividends brought the payout ratio to 109%. The more commonly used unadjusted free cash flow computation drops free cash flow down to $122 million and brings the dividend to free-cash-flow ratio up -- to 120%!
This also raised the curiosity of analyst David Barden. "[T]he payout ratio looks like it was very, very high right now ... how does that dividend get more comfortable for you guys relative to the first half if I ignore the adjustments and just look at the cash flow statement?" he asked.
"[W]hen you look beyond 2012 and 2013, the M&I expense is significantly less and we do not anticipate any significant restructuring expenses ... I think taken in totality, we're very comfortable with the cash flow generation capabilities of this company," replied CFO Thomas.
Investors, though, may not have the same confidence in Windstream being able to keep its current 10.75% dividend for much longer. The memory of that other high-dividend-paying second-tier telecom Frontier Communications (Nasdaq: FTR ) having to cut its dividend in half probably helped drop Windstream's share price by 8.6% after the earnings release.
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