"The dividend is a key component of our investment thesis, and we believe it is the best way to provide returns to our shareholders."
-- Jeff Gardner, Windstream CEO, Nov. 8, 2012
Windstream (WIN +0.00%) is a company not shy about promoting its dividend at every opportunity, and why not? That dividend currently yields over 11%. With 10-year treasuries still paying well under 2%, to income-hungry investors that Windstream yield is an oasis in the middle of the Sahara.
Or could it be just a mirage?
Is Windstream's dividend a sustainable return reaped from the carrier's successful business practices? Or is the company using the cash it needs to grow its business -- or worse, going further into debt -- to lure investors and keep its stock price higher than it would otherwise deserve?
Windstream maintained in its third-quarter earnings statement that its cash position gave it cushion enough to maintain its business and reward its investors with a sizable dividend.
By Windstream's accounting, it had $182 million of free cash flow and paid out $147 million in dividends by the end of the third quarter. The company maintained that would equate to an 81% dividend-to-FCF payout ratio for the quarter.
I wouldn't call 81% particularly comforting, though it does provide more confidence than the 96.7% dividend-to-FCF Windstream skated on for the fourth quarter of 2011.
That other high-yielding telecom, Frontier Communications (FTR +0.00%), after just slithering by with an even thinner 99.8% dividend-to-FCF ratio for 2011, decided to cut its dividend in half.
Windstream has not given any indication it would do what Frontier did. However, the truly discomforting thing about Windstream's payout ratio is that if it had used the usually accepted method of calculating free cash flow, its dividend-to-FCF ratio would have been a truly unsustainable 148%.
Windstream's own FCF figure of $182 million was derived using its operating income of $247.7 million instead of its net profit of $53.7 million as a starting point. After correctly adding back in non-cash expenses such as depreciation and amortization, it then subtracted what it called "adjusted capital expenditures."
The more universally used 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. Subtracting that number from the $147 million in dividends gives the 148% dividend-to-FCF ratio.
So the big question for a potential investor would be: Would the chance of Windstream cutting what appears to be an unsustainable dividend -- with the inevitable fall in share price – be worth the risk?
Since fourth quarter earnings won't be out for another two months, we'll have to look at Windstream's last quarter.
Windstream's revenue stream was then up 52% over the same quarter last year, but much of that came from revenue from its PAETEC acquisition. But that increased revenue didn't translate to larger margins. That picture looks like this: Operating margin for Q3 2012 was 16%; for Q3 2011, 27%. Profit margin for Q3 2012 was 3.5%; for Q3 2011, 7.6%.
Windstream has had to assume a large amount of debt to acquire PAETEC and the other companies it has bought recently. That has raised the company's debt-to-EBITDA to an uncomfortably high 3.7. The company had targeted reaching a ratio of 3.2 to 3.4 times EBITDA before the end of 2013, but has backed off on that timeline. Before its acquisitions, that ratio was around 3.0.
Windstream is a fixed-line phone company, a segment of telecommunications that has been in decline for years as the wireless market has been growing. But Windstream has been pushing its Internet access business, which now accounts for almost two-thirds of its residential customers. That residential base is mostly in rural and smaller markets where cable competition is much less.
The Windstream acquisitions have given it cost-cutting opportunities and the ability to expand into other telecom segments. PAETEC brings Windstream the potential of getting deeper into the business services market and the capacity to compete against companies like AT&T (T 2.11%) and Verizon (VZ 0.06%) in that area.
But no matter what the growth potential for the company, and in spite of Windstream management's declaration that it has the free cash flow to continue paying such a high-yielding dividend, it just doesn't seem like that can be maintained. When an already-heavy debt load and the need for capital expenditures go up against dividend payouts, which do you think will win?
