When a company's management makes a statement in an earnings report, investors sometimes accept it on blind faith. However, what the company wants to accomplish, and the reality of its competitive position, may be on opposite ends of the spectrum. When Windstream's (WIN +0.00%) management claims that it's confident in its strategies, investors should take this statement with a grain of salt. Just because management has a vision for what the future could hold doesn't mean these dreams will be achieved.
When competition is growing and your company isn't, investors should worry
In the last several years, as customers have gravitated toward cell phones and away from landlines, local telecommunication companies have had to adjust. These companies have turned to high-speed Internet, digital video, and business customers to make up for landline losses.
Some of Windstream's competitors, like Frontier Communications (FTR +0.00%) and AT&T (T +0.62%), have been relatively successful in growing one side of the business, while voice line use continues to decline. Unfortunately for Windstream investors, the company is losing ground in both areas.
Compared to both Frontier and AT&T, Windstream underperformed in high-speed Internet and video growth.
|
Company |
High-Speed Internet Net Additions (3Q 2013 vs. 3Q 2012) |
Annual Video Net Additions (3Q 2013 vs. 3Q 2012) |
|---|---|---|
|
AT&T |
4% |
5% |
|
Frontier |
5.1% |
15% |
|
Windstream |
(3%) |
(5%) |
Source: SEC filings
As you can see, two of Windstream's major peers are growing these two categories, while Windstream reported losses. While these results are troubling, this isn't one of the main reasons to sell Windstream.
Maybe "generous" has two different definitions?
With a yield of more than 12%, Windstream investors are very interested in the company's ability to maintain the dividend. It seems every earnings report mentions how the dividend is supported. The company certainly wants to reassure investors and said in their quarterly report, "Windstream generates substantial free cash flow which supports our dividend."
The bad news is Windstream's cash flow situation doesn't appear as strong as management suggests. Weak free cash flow is the first reason to sell the stock. It's not unusual in the telecom industry to see a payout ratio of 60% or more. However, investors should be cautious, as both CenturyLink and Frontier have been forced to cut dividends in the past. Beyond standard free cash flow, investors might consider using something I call "core free cash flow."
On the cash flow statement, there are non-cash items. Using net income, plus depreciation, then subtracting capital expenditures generates an apples-to-apples comparison across companies in this industry. Using this metric, Frontier carries a payout ratio of 67%, while AT&T clocks in at 75%.
Windstream's "substantial free cash flow" generates a core free cash flow payout ratio of 97%, based on the current quarter's numbers. While this is better than the 143% payout ratio last year, a near-100% payout ratio leaves very little room for error. With declining sales, it's hard to imagine how the payout ratio will improve in the future.
Confidence is key, but this borders on delusion
In Windstream's earnings release, management stated, "We are confident that our strategy to transform Windstream into an enterprise-focused company enhances our growth opportunities and positions us for continued success." This statement sounds great, until you dig into the revenue composition of the company. If Windstream's management believes that the enterprise business will save the company, investors are being given a second reason to sell the stock.
The problem Windstream faces is even though enterprise customers grew by 6% year-over-year, the company's small business customers shrank by 9% during the same timeframe. Enterprise customers make up just 31% of all business customers. In total, enterprise represents less than 5% of total customer connections.
Final thoughts
The bottom line is Windstream will have to undergo a massive transformation to become "enterprise-focused." If management is betting the future of the company on 5% of its customers, investors should be very concerned.
With losses occurring on the high-speed Internet and video side of the business, the company looks weaker than some of its competition. When combined with weaker core free cash flow, the stock's future looks even worse. Turning 5% of customers into the future of the company is a transformation that will take years to achieve, if ever. Though the company's 12% yield looks tempting, unless the company can generate real growth, investors should probably avoid the stock.
