At first glance, a stock that yields 9% seems like a dream come true for income investors. After all, with a yield like that, investors are virtually guaranteed a healthy return. That's exactly why Windstream Holdings, (NASDAQ:WIN) seems to be an ideal pick for those investors who love dividends.
It's likely investors instinctively flock to Windstream for its impressive dividend yield. Indeed, it's true that Windstream yields around 9%, which towers above Verizon (NYSE:VZ) 's 4.25% yield. But there's more to a company than just its current payout, and investors shouldn't simply chase yield. Windstream's quality of earnings is low, and the sustainability of its current dividend is questionable. That's why, for investors looking for yield in the telecom sector, Verizon is a much better choice.
Verizon's cash cow
You'll recall that Verizon purchased the remaining 45% stake in Verizon Wireless from Vodafone that it didn't already own for $130 billion. While that's certainly a whopping sum, it was actually a great deal for Verizon. That's because Verizon Wireless is an absolute gold mine, and should fuel years of strong growth thanks to the ongoing smartphone boom. Verizon Wireless is the largest and most profitable wireless carrier in the United States, according to the company.
Strong performance in the wireless segment propelled Verizon's results last quarter. Verizon produced 5% growth in total revenue, and 24% growth in adjusted earnings last quarter. The wireless segment outperformed Verizon's other services. Verizon Wireless increased operating profit margin last quarter, and grew revenue by nearly 6%.
Verizon has posted double-digit percentage growth in reported and adjusted EPS in nine out of the last 10 quarters. This allows Verizon to regularly increase the dividend.
Windstream in more trouble than meets the eye
On the other hand, regional, mostly rural, telecoms like Windstream are still reliant on traditional voice lines, which are slowly going away in the smartphone era. Windstream's total consumer connections dropped 5% through the first half of the year. Total business customers declined 8% during the same period. GAAP earnings fell 67%, to just $0.02 per share last quarter.
On the surface, it seems that regional telecoms like Windstream appear to be in good financial shape, because they generate free cash flow. Indeed, Windstream generated $440 million in adjusted free cash flow during the first six months, a 6% increase year over year.
But because companies in this business have a lot of fixed assets, they're credited with substantial depreciation expense that gets added back in the free cash flow calculation. Net income, or profits, comprises a very low portion of their free cash flow numbers. This is why, despite seemingly comfortable free cash flow payout ratios, Windstream can't raise its dividend. In fact, it appears Windstream is planning on reducing its dividend payout once its major strategic initiative is completed.
Windstream's major growth initiative going forward is to spin off assets into a separate, publicly traded real estate investment trust, or REIT. This caused shares of Windstream to spike on the day of the announcement.
But Windstream investors will likely be disappointed, because the new Windstream company and REIT will not maintain the current $1 per share dividend. As Windstream stated in its last 10-Q, following spinoff, the REIT will pay a $0.60 per-share annual dividend, and Windstream's annual dividend will drop to $0.10 per share. Collectively, that's a $0.70 per share dividend, which implies a fairly significant dividend reduction from its current level.
Better dividend stock: Verizon
For investors looking to the telecom sector for high yield, Verizon is a much better choice than Windstream or Frontier. That's because Verizon is a much more stable company, one that generates strong free cash flow that compares very favorably to the dubious financial conditions of the regional telecoms.
Yes, Verizon's 4.25% payout is several percentage points lower than the yields offered by either Windstream or Frontier. The trade-off, of course, is that you're getting a company that's in a much better financial condition, with far better future growth prospects.
Verizon will provide much better dividend growth going forward, as well as the likelihood of stronger capital appreciation, thanks to its growing business. Windstream's core services are in serious trouble, whereas Verizon is sitting on top of a gold mine in Verizon Wireless. Add it all up, and Verizon is the clear winner here.
Bob Ciura owns shares of Apple. The Motley Fool recommends Apple. The Motley Fool owns shares of Apple. 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.