Back in November, Stone Fox Capital wrote how, despite the big sell-off in the stock, the Windstream (NASDAQ:WIN) dividend was likely safe. Unfortunately months later, investors still question the high yield as the dividend payment absorbs most of the free cash flow. While the market is obsessed with dividend payouts, the company would be fiscally sound if it would cut the dividend and use that cash to pay down debt and buy back stock down the road.
The company is a leading provider of advanced network communications to businesses nationwide while also offering broadband and phone services to consumers in rural areas.
In order to maintain the current juicy 12% dividend, the company must produce enough free cash flow to cover the cash distribution. Lately that equation has come into question with a flat revenue base as capital expenditures have soared.
On the Q412 earnings report, the company was adamant that earnings and adjusted cash flow supported the $1 annual dividend. A dividend rate investors fear will be cut considering the outsized 12% yield.
The fear is for good reason as the company operates in a cutthroat telecom business and had a dividend payout ratio of 77% in 2012. Windstream generated $768M in adjusted free cash flow in 2012 and paid out $588M in dividends. Not only was the margin small, but also the company excluded PAETEC integration costs and capital expenses of over $100M that impacts the cash on the balance sheet to pay those dividends.
For valuing the long-term value of the company, excluding those charges is definitely appropriate. Unfortunately, the company spent more on dividends than even the free adjusted cash flow in two of the last three quarters.
A key to 2013 will be the ability of the company to lower capital spending as suggested in the Q4 earnings report. Windstream forecast a $200M reduction in capital expenditures for the year to the range of $800M to $850M. This decline in capital expenditures is expected to lead to an increase in the adjusted free cash by anywhere from 15% to 25%. The combination will lead to a more reasonable dividend payout ratio of possibly as low as 61%.
That dividend payout ratio is much more appropriate, but if the company only reaches the low end of guidance, the ratio will hit as high as 68%.
The insistence on paying a $1 dividend that the market doesn't respect isn't adding up. Windstream has a high level of debt and a low priced stock that a more flexible capital allocation plan could help eliminate. The recent CenturyLink (NYSE:CTL) plan (see Did CenturyLink Just Become A Gold Mine To New Investors?) to cut the dividend and implement a massive buyback plan would be very attractive. Not only can Windstream allocate capital between debt repayment and buybacks on a quarterly basis as needed, but it could also fluctuate the amount spent from quarter to quarter. Even possibly allowing the company to increase capital expenditures as some question whether the current levels are enough to keep the company competitive.
CenturyLink investors initially reacted negatively to the dividend cut and the new capital allocation plan. Back in February, the company announced plans to slash the quarterly dividend to $0.54 from $0.725 per share. It also authorized the repurchase of up to $2.0 billion of the company's outstanding stock along with repaying debt to maintain leverage at less than 3.0 times EBITDA. The stock cratered 26%, but it has reclaimed a large portion of the loss in the two months since the cut.
Frontier Communications (NASDAQ:FTR) cut the dividend nearly in half in early 2012. The company didn't provide an aggressive capital allocation plan to include repurchasing shares allowing the stock to sink further over the next few months. Ultimately, the stock is now higher than before the dividend cut and investors have been reaping an average of a 10% yield during that time period.
Both of those companies have declining revenue bases suggesting maybe the level of expenditures might not be high enough to maintain the revenue base. Are these two companies under-spending on network upgrades? The lower dividend payout provides the flexibility to pay down debt or increase capital spending.
The stock has gone nowhere over the last 3 years though investors would've collected $3 of dividends. If an investor bought the stock above $11, then the total return has been very disappointing during that period.
The results over the last 3 years and especially as the stock peaked over $11 at the end of 2010 are very clear. Investors ultimately lose when a company overpays on a dividend. The stock tends to lose more than the dividend pays during that time period. As much as investors clamor for a high dividend, the typical investor actually prefers a company that prudently spends its capital.
In case of the telecom sector, investors clearly prefer more reasonable dividends with a larger focus on paying down debt. In that context, Windstream should immediately slash the dividend and funnel the extra cash into repaying debt. New investors would be a lot more confident of the future dividend payments though at a lower rate. Existing investors might not be as happy if the stock craters similar to when CenturyLink initiated a similar plan, but in the end those investors will win from a stock with a more flexible capital allocation strategy.
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