Shares of Windstream Corporation (WIN) have declined by 29.2% over the past 12 months. At $8.30 per share, the stock is currently trading fairly close its 52-week low of $7.86, but offers a lofty dividend yield of 12.0%. Will the current selloff momentum continue, or has an opportunity emerged to buy on the dip? In this article, I will elaborate on my valuation analysis, which may assist you in formulating an investment decision.
From a relative valuation perspective, Windstream's valuation appears to be somewhat stretched based on the company's financial performance relative to its peers' (see comparable analysis chart below). Sell-side analysts on average predict the firm's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 0.0%, 0.5%, and 20.7%, respectively, over the next 2 fiscal years. The consensus revenue and EBITDA growth estimates are considerably below the averages of 1.4% and 3.7%, respectively, for a peer group consisting of Windstream's primary competitors such as CenturyLink (CTL) and Frontier Communications (FTR).
Similarly, the company's EBITDA margin is forecasted to expand by only 0.4% over the same period, compared to a higher peer average at 1.1%. On the profit side, Windstream's various profitability margins are fairly in line with the peer averages, and the firm's capital return metrics such as ROE and ROIC are above the par. In terms of leverage and liquidity, Windstream has a significantly higher debt level, as reflected by the company's above-average debt to capitalization and debt to EBITDA ratios. The firm's trailing free cash flow margin is above the par, which may help in mitigating some impact from the heavy debt burden. Due to the significant leverage and the mediocre margin performance, Windstream's interest coverage was only at 1.6x, less than half of the peer average at 3.8x. Both the firm's current and quick ratios are markedly below the group averages, reflecting a somewhat illiquid corporate balance sheet.
To summarize the financial comparisons, Windstream's weak growth potential and heavy leverage should be the primary drag on the stock's valuation. Despite the company's above-average ROE and free cash flow margin, I would expect the stock to trade at a discounted valuation relative to the peer-average level. Nevertheless, the stock's forward EV/EBITDA and P/E multiples of 5.6x and 15.6x are trading very close to the peer averages of 5.9x and 15.2x (see chart above), respectively, suggesting that the stock price is somewhat expensive.
To support my view, I also performed a DCF analysis which incorporates the market's consensus revenue and EBITDA estimates from fiscal 2012 to fiscal 2016 (see DCF chart below). Other free cash flow related items including depreciation, tax expense, capital expenditure, and networking capital investment are projected based on their historical figures relative to the revenue, as those ratios have been trending fairly stable over time. To be conservative and reasonable, the terminal revenue growth rate is assumed to be 0.25%, and the terminal EBITDA margin is forecasted to be consistent with the average estimated EBITDA margin from fiscal 2012 to fiscal 2016. A company-specific risk premium of 2.0% is used in the cost of equity calculation in order to account for the financial projection risk. It should be noted that the model implies a terminal EV/EBITDA multiple of 5.3x, which is just slightly below Windstream's current EV/EBITDA multiple at 5.6x.
As such, based on a WACC of just 7.3% (a conservative discount rate in my view) and the terminal growth rate of 0.25%, the DCF model yields a stock value of $7.57, which is still 8.8% below the current share price at $8.30. Based on the sensitivity table shown above and my assumed WACC at 7.3%, the current share price roughly implies a terminal revenue growth rate of above 0.45%, which I believe is a somewhat aggressive assumption as the average estimated revenue growth rate from fiscal 2013 to fiscal 2016 is only 0.25%.
From a dividend perspective, it appears that the stock's lofty 12.0% dividend may provide a solid price support. However, I am of the view that the company may not be able to sustain the current dividend level. From a historical free cash flow and dividend chart shown below, it can be observed that Windstream's annual dividend payment represented a significant portion of the company's annual free cash flow in the past few years. As Windstream's free cash flow decreased in recent years, the capacity to support the current dividend payout has become more constraint and thus deteriorates the margin of safety on the stock's dividend yield.
The stock was recently downgraded by the senior research analyst, Christopher M. Larsen, at Piper Jaffray. The analyst had the following comment (sourced from Thomson One, Equity Research):
We are downgrading Windstream to Underweight as we believe there is limited upside to owning the stock. The company has failed to meet expectations in 2012, with management having lowered guidance on the 3Q print. Investors remain concerned about dividend sustainability, which continues to weigh heavily on the shares. Not only is Windstream failing to get credit for one of the highest dividend yields, we believe the high dividend yield makes it even more vulnerable to any dividend taxation policy changes. We do believe that trends can improve at Windstream, but probably not fast enough. In our opinion, Windstream is less attractive than other rural wireline operators.
Bottom line, given Windstream's expensive valuation and the concern on the company's ability to sustain the current level of dividend payment, I am of the view that the stock is poised for a further downside. As such, I recommend avoiding this stock or taking a small short position.
Disclaimer: The comparable analysis and DCF charts are created by the author, other charts are sourced from Capital IQ, and all historical and consensus estimated financial data in the article and the charts are sourced from Capital IQ unless specified.