Qwest: Dividend Dynamo or Disaster?

Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as Corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.

Let's examine how Qwest (NYSE: Q) stacks up in four critical areas, to determine whether it's a dividend dynamo or a disaster in the making.

1. Yield
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.

Qwest yields 5.7% -- moderately high, but less than the industry median of 7.3%.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.

Qwest's payout ratio is 126%, which means the company is appears to be paying out $1.26 for every dollar it earns! But this analysis ignores the fact that Qwest generates considerably more free cash flow than net income; the company's actual free cash flow payout ratio is a much more manageable 30%.

Dividend investors should ensure that Qwest can sustain its cash-generating ability, especially once it completes its merger with CenturyTel.

3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than five is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.

Let's take a look at how Qwest stacks up next to its peers:

Data from Capital IQ, a division of Standard & Poor's. Median is of medium- and large-cap U.S. industry components.

Qwest's balance sheet isn't in awesome shape, to put it mildly. It should be able to continue meeting its interest obligations, assuming sustainable operating earnings, though those obligations are considerable. Negative equity is another sign of trouble; Qwest has more liabilities than assets, which could make it more costly to borrow to expand or meet future challenges.

4. Growth
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.

Qwest dividend has been somewhat stagnant at $0.32 per share. Earnings have recently declined somewhat, though free cash flow has improved.

The Foolish bottom line
At first glance, Qwest exhibits several dividend warnings signs: a fairly high yield, a high payout ratio, a large debt burden, and no dividend growth. The saving grace is the company's prodigious free cash flow. If I were considering investing in Qwest for its dividend, I'd want to feel comfortable with its competitive position, and thus its ability to keep cranking out cash, in the face of a considerable debt burden. Just remember, the company's only getting bigger once that CenturyTel merger closes.