When Big Dividends Mean Playing With Fire

As a beginning investor, I was fascinated with the concept of dividends.

"Own a piece of the company, and get paid for it? Don't mind if I do!"

I searched the Internet up and down looking for companies that were paying huge dividends.

Things have changed for me since then, as I've refined my own personal investment strategy. I wouldn't be surprised, though, if several other beginning investors do the same thing -- endlessly search for big payouts.

Last month, I highlighted three extremely dangerous  dividend stocks. As it turned out, one of them -- Radio Shack (NYSE: RSH  ) -- didn't even offer a dividend, but many popular finance sites were showing that it did. Another one of the stocks, Roundy's (NYSE: RNDY  ) , just cut its dividend by a whopping 48%, sending the company's shares into a nosedive

The third culprit of this triumvirate was Windstream (Nasdaq: WIN  ) , a domestic telecom company. Read on to find out why shares of this company are also down about 20% since early October. Read all the way to the end, and I'll offer some much more reliable ideas for dividend investors.

Lipstick on a pig
I don't think there's too much to be impressed with coming out of Windstream's most recent earnings release. But I also know that some Fools  think Windstream may have a solid bullish case.

The company led off its press release by saying that business service and consumer broadband revenues increased by 3% and 4%, respectively.

That's great, but it masked some pretty concerning trends. Overall revenue for the company was down 1% year over year. And while service and product sales are up about 51% so far this year, those gains have been far outpaced by expenses. The cost of service alone -- which doesn't include depreciation and amortization -- has increased 80% this year. That means net income is actually down 16% on the year. 

Adding insult to injury, the number of new high-speed Internet additions has slowed 80% so far this year. That doesn't necessarily mean customers are being lost -- it's just that more aren't signing up.

But what about that dividend?
President and CEO Jeff Gardner tried to assuage fears by saying, "The dividend is a key component of our investment thesis, and we believe it is the best way to provide returns to our shareholders." Apparently that wasn't enough, though, as shares dropped about 10% when earnings were announced.

If we look at the company's current 11.9% dividend yield, we might see why there's some cause for concern. The company's dividend payout ratio for the first three quarters of 2012 is 255%. In plain English, this means that the company is paying out far more in dividends than it's taking in from income.

But that statistic can be a little misleading, since earnings are calculated using some esoteric measures. A better measure would be to look at how much free cash flow the company has brought in, compared with how much has been paid out in dividends.

So far in 2012, Windstream has paid out $440.5 million in dividends and generated $434.2 million in free cash flow. So even though this metric looks more favorable, Windstream has still paid out more money in dividends than it has brought in this year.

That either means that Windstream is going to need to generate more free cash flow, or it's going to have to cut its dividend it give itself a little financial breathing room. I certainly won't be putting my money behind the stock anytime soon.

If you're looking for some long-term investing ideas that are much safer, let me invite you to read the Fool's brand-new special report: "The 3 Dow Stocks Dividend Investors Need." It's absolutely free, so just click here and get your copy today.


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