Windstream's Accounting Wizardry

Not to put too fine a point on it, but I am not comfortable with Windstream's (Nasdaq: WIN  ) just-released third quarter earnings report. The company includes in it what seems like a manipulation of a key dividend-sustainability metric to its own advantage.

I'm talking about the calculation of Windstream's free cash flow. By the company's accounting, FCF comes out to $182 million. A dividend payout of $147 million to its shareholders gives a dividend-to-FCF ratio of 81% for the quarter.

That's not such a great payout ratio, but it's much better than what I came up with, which I'll get to in a moment.

This is what Windstream did: Instead of using the company's net profit of $53.7 million for its free cash flow computation, it used its operating income of $247.7 million.

It then, correctly, added back in depreciation and amortization -- and some less significant figures -- to come up with the sum of $603.1 million for its "adjusted OIBDA," or operating income before depreciation and amortization.

Subtracting what it called "adjusted capital expenditures" from that gave it an "adjusted free cash flow" of $182.4 million.

The usually accepted method of computing free cash flow -- capital expenditures subtracted from net cash from operating activities (found in the cash flow section of the earnings statement) -- would give a quite different number for free cash flow: $99.5 million.

Using that FCF number paints a totally different picture of Windstream's ability to continue to pay its dividend. Now that ratio becomes an unsustainable148%.

I can see why Windstream wants to downplay the payout ratio problem. Its CEO, Jeffery Gardner, knows investors look to its stock for its dividend, which is well-known for its generous yields. He made sure to mention the sustainability of the dividend near the beginning of Windstream's earnings conference call: "I'm confident in our ability to deliver strong stable free cash flow support to our dividend, which is a key component of our investment thesis and we believe is the best way to provide returns to our shareholders."

And at the very end of the call: "I'm confident in our ability to deliver strong stable free cash flow to provide long-term support to our dividend. "

And in the middle, CFO Anthony Thomas made sure to drive that point home, too: "We produced very strong free cash flow and returned a significant portion of it to our shareholders in the form of a dividend. "

I wasn't the only one to scratch my head over Windstream's free cash flow computation. The very first question in the Q&A portion of the conference call came from Michael Rollins of Citigroup, who asked, "What's happening in the variance between the normalized free cash flow and the reported free cash flow...?"

CFO Thomas answered, "Michael there is a variance between Windstream's definition of adjusted free cash flow and the GAAP, the generally accepted accounting principal definition of free cash flow. The difference in the third quarter was $83 million. Importantly the items that make up that difference are temporary items and will disappear."

Thomas is referring to charges related to Windstream's acquisition of PAETEC last year and the ongoing integration of the two companies' operations.

Still, I would have been more comfortable if the earnings statement and the company executives had been more up-front about its free cash flow. Unfortunately, this has been glossed over before, and it looks like the market today isn't comfortable, either. At the time of this writing, Windstream stock is down over 9%.

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