At first glance, there doesn't seem to be much about Windstream Holdings (NASDAQ:WIN) that investors can sink their teeth into. One might think that Windstream were nothing but a fat dividend yield married to an obsolete business model. The company mainly deals in hardwired voice and data connections, all of which seems quaintly outdated these days.
There is some truth to this line of reasoning, but then you would have to wonder how the stock managed to deliver a market-crushing 42% gain over the last six months. Let's leave Windstream's potential downside for a future article. Today, we'll have a look at three big reasons why Windstream shares may be able to continue growing from here.
Windstream's management has a very clear focus nowadays. The stated company vision is "to be the premier enterprise communications and services provider in the United States." On the other side of the fence, Windstream would settle for "maintaining our strong, stable consumer business."
This is not just an empty vision, but a serious strategy that's delivering real results. Four years ago, business revenues accounted for just 55% of Windstream's total sales. Today, that ratio has grown to 73%.
And there's more to come. "We continue to transition revenue streams away from traditional consumer voice services to our strategic growth areas of business services and consumer broadband," management said in a recent 10-Q filing. "The diversification of our revenue streams is key to our success in accelerating revenue growth opportunities."
Becoming "the premier provider" of business-class data services on a national level is an ambitious goal for sure. Competition is fierce in that market; simply grabbing a respectable slice of it would be enough for many companies.
And Windstream may indeed fail. Even so, reaching for this stretch goal is likely to land one of those "respectable slices" that I mentioned a minute ago. Looking at Windstream's shifting business mix, that's exactly what's happening right now. The company is not number one nationwide yet, and may never get there, but it's a goal worth pursuing.
The REIT game changer
At the end of July, Windstream announced plans to package up and spin off a real estate investment trust, or REIT. Expected to close in the first quarter of 2015, the deal will create a second company with its own tradable ticker. Current Windstream shareholders will keep their existing shares and get shares in the new REIT to match.
The asset-heavy REIT will then lease its network of properties back to the original Windstream, starting at an annual rent of $650 million.
Many companies get into the REIT business model because they want to save on taxes. These entities don't have to pay income tax as long as they distribute at least 90% of their taxable income in the form of dividends. Windstream's REIT will follow this model of course, and this will be the Windstream ticker that income investors will choose in the future. It's not about keeping profits away from Uncle Sam this time.
You see, Windstream is already a very tax efficient operation. In 2013, the company paid just $5.7 million in cash taxes on $340 million in pre-tax profits. Windstream recently reported results for the second quarter of 2014, including another tiny $2 million cash tax payment. Looks like the tax accountants here are already doing a great job, so this REIT has a different purpose.
"This transaction will make Windstream a more nimble competitor in today's increasingly dynamic communications marketplace and accelerate deployment of advanced communications services," said CEO Jeff Gardner when the spin-off was announced.
So never mind the tax effects, which will be minuscule anyway. The deal will make a big impact on Windstream's financial structure, moving more than $3 billion of its $8.7 billion long-term debt load over to the REIT.
The new entity then becomes a very traditional income stock with large dividends backed by a big bucket of physical assets that generates dependable cash flows.
The other half of Windstream gains financial flexibility from the lower debt load, not to mention a 35% reduction in quarterly interest payments. Crucially, the new structure should unlock capital to be invested in what management calls "strategic initiatives," bringing high speed broadband to more of Windstream's customers.
So if you wait a while, assuming that the REIT transaction is approved and executed, you get to choose between two very different Windstream stocks:
- An asset-loaded REIT paying annual dividends of $0.60 per share, but with limited growth prospects -- or,
- A low-dividend front-end service provider in the middle of the business to business transition that we discussed above, with the potential for high-octane growth.
This idea is a game changer, and a clever one at that. And if you own Windstream shares before the split, you will participate in both of the diverging businesses with the option to tap out of either one.
Rebooting the dividend
Let's assume that the REIT split actually happens. Then, what happens to Windstream's stalled dividends?
Windstream hasn't adjusted its quarterly dividend payments since 2006. And even then, total payments ended up lower in 2007.
Yes, Windstream's current yield of 8.9% is the highest dividend return on the S&P 500. Bar none.
But with a totally flatlined dividend growth trend and barely any headroom to increase pay out today -- 79% of Windstream's free cash flows already go into dividend checks -- Windstream isn't exactly an ideal income stock.
So, how does that change in the split?
Current shareholders will get new REIT shares in proportion with their existing holdings. Windstream didn't say anything about retaining ownership in the spun-off operation. Against this background, it looks like the company is effectively splitting in half.
Windstream's total dividend budget will actually decrease. Add up the quarterly payouts of the two paths, and you only end up with $0.70 a year compared to the current annual payouts of $1.00 per share. Management also expects to pocket about $120 million of additional free cash flows per year.
But the dividend math changes.
For the service portion, the effective payouts will drop by 80%. The effective yield for shares bought today drops to about 1.8%.
But on the REIT side, the effective yield actually increases by 20%. For shares bought at current prices, that results in a 10.7% annual yield.
So yeah, there is some sleight of hand going on here. Overall, Windstream is actually lowering its total dividend payouts -- but investors can enjoy an effective increase for the first time in forever on some of their existing shares.
And keep in mind that the REIT isn't joined at the hip to Windstream's service operations. The company is actually expected to look for other tenants to keep its networking assets as busy and lucrative as possible.
Windstream hasn't been very clear on the financial details of its REIT plans. But all things considered, this could be the start of a sustainable dividend growth trend.
Dedicated income investors will be free to dump their holdings in the service business and focus on the REIT's promising dividend structure. So Windstream may not be the perfect dividend stock today, but half of it is clearly headed in that direction.