It's appropriate that Windstream (NASDAQ:WIN) has the word wind in its name, because to be blunt, this company is full of hot air. When a company pays a yield of more than 12%, investors may lose sight of the challenges facing the business. While no business is immune to competitive pressures, Windstream faces challenges of its own making. The truth is, this company is slowly spending itself into oblivion.
A tough business with huge competition
Unless you live under a rock, you probably know there are just a few companies that want your money when it comes to telephone, high-speed Internet, and video (i.e. television) services. In most areas the competition is fierce, but limited to just a few players.
Local telecommunications companies like Windstream, Frontier Communications (NASDAQ:FTR), and CenturyLink (NYSE:CTL), all have similar challenges. Each company is trying to grow its high-speed Internet and video offerings at a rate fast enough to offset declines in their traditional voice services. To attract investors, each company pays a relatively high-yield.
On the other side of the coin, you have larger players like Verizon (NYSE:VZ). The company not only competes with the local guys for telephone, video, and Internet access, but of course also has a huge and growing wireless business as well. While Verizon doesn't pay as high of a yield as the rest, I think few would argue that Verizon's dividend is far safer than their smaller competition.
The difference between an opportunity and hot air
There is no doubt that investors can benefit from a nice dividend yield, as studies have shown that dividends can provide almost half of a stock's total return. However, a dividend is only as attractive as the company writing the checks.
Anyone who has ever tried to work with a budget understands the challenges of having to make payments on a debt. Imagine if your debt payments took all but $0.29 of each dollar you made. In essence, this is the situation Windstream finds itself in, and the first reason the company's dividend promises are just hot air.
In the last quarter, the company used 71.15% of their operating income to meet interest expenses. By point of comparison, Frontier used 62.57% of their income, CenturyLink used 45.45%, and Verizon used just 7.84%. With such a large amount of money being used on interest payments, investors should correctly question if Windstream can afford the current dividend.
Given the company's high interest expense, it should come as no surprise that Windstream has the worst dividend payout ratio of the group as well. If you are looking for the second reason Windstream's dividend is full of hot air, look no further than their payout ratio.
When looking at cash flow, using a metric called core free cash flow (net income + depreciation – capital expenditures) helps to eliminate some of the accounting changes on the cash flow statement that can be manipulated by companies.
Using this measure, we find that Windstream's payout ratio was 103.35% in the last quarter. As you might guess, none of Windstream's competition has a payout ratio quite as high. Frontier used 69.56% of their core free cash flow, CenturyLink used 47.32%, and Verizon used just 27.52%. Clearly Windstream has a problem affording its current dividend.
The snowball effect
Like a snowball rolling down a hill, Windstream's high interest expense causes a high payout ratio, and the company's high payout ratio causes the company to leverage up their balance sheet. Windstream's significant leverage is the third reason this dividend is full of hot air.
What's ironic is Windstream's CEO Jeff Gardner said, "...we continue to strike a prudent balance among reinvesting in the company, paying an attractive dividend and reducing debt over time." Unfortunately for the company's investors, this "prudent balance" includes more debt not less.
In fact, Windstream's balance sheet shows significant leverage with a debt-to-equity ratio of 9.37. In a recurring theme, none of the company's competition struggles with this relative amount of debt. Frontier's debt-to-equity ratio is 2.01, CenturyLink sits at 1.1, and Verizon comes in at just 0.48. What should really scare investors is the story is getting worse and not better.
Just a few months ago, Windstream's yield was 11.43% and their debt-to-equity ratio was 7.92. Today, investors get a higher yield at 12.2%, but the company's balance sheet is in worse shape. The bottom line is, this business is in trouble and the dividend is anything but safe. Income focused investors should steer clear of this dividend cut waiting to happen. The company's dividend promises seem to be full of hot air. If the dividend is cut, it will be investors' hard earned money that could blow away with the wind.
Chad Henage owns shares of Verizon Communications and CenturyLink. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.