High-Yield Telecom Stocks: The Short Sellers' Dilemma

by: Roger S. Conrad

No group of dividend-paying stocks has been more profitably shorted the past few years than high-yield telecoms. Companies within this niche have not only cut dividends eight times since 2009, but we've also seen a pair of bankruptcies as well.

Not surprisingly, many investors are betting disaster will continue to strike, and short interest in high-yield telecom remains near record highs. Savvier players, however, are taking bets elsewhere for three major reasons.

Reason No. 1: High-yield telecoms' operating results have improved throughout 2013, and are shaping up to be even better in 2014.

Companies' earnings and cash flow have tracked management's guidance and repeatedly beaten investor expectations.

Sustaining dividends is the key to wireline telecoms' stock prices. And the key metric for dividend safety is free cash flow. That's operating cash flow less capital expenditures, taxes and interest--essentially what's left over to pay dividends and service debt.

The four companies in my table generated enough free cash flow in the third quarter of 2013 to cover their dividends by a 1.9-to-1 margin. That followed a 1.6-to-1 margin in the second quarter.

Source: Bloomberg, Conrad's Utility Investor

And although investors shouldn't blindly accept management's forecasts as reality, all four companies project similarly strong coverage in the fourth quarter, and improving ratios in 2014 as well.

Sweet yields can bring sour consequences. And the super high current returns these stocks offer demonstrates a great deal of investor skepticism that their yields can be sustained. These results, however, clearly show these companies have the wherewithal to keep paying at these rates. In fact, revenue trends indicate they'll be able to for years to come.

The basic copper connections linking America for the past century have grown obsolete. The rap on wireline telecoms is their business will evaporate as consumers and businesses leave for broadband and wireless networks. And in fact, shrinking revenue and hefty debt are the primary reasons for the dividend cuts of recent years.

Consistently high free cash flow, however, has enabled some names to reduce their debt, while many have taken advantage of low interest rates to term out existing obligations and cut costs. Meanwhile, these four companies have worked hard to make the jump from traditional service providers into broadband service companies.

Both Consolidated Communications Holdings (CNSL) and Windstream Corp (NASDAQ:WIN) now draw less than 20 percent of their revenue from the traditional phone business. And as declining line loss rates attest, those operations may be nearing some sort of stasis, as remaining users resist cutting the cord.

Consolidated Communications' revenue actually grew 0.4 percent in the first nine months of 2013, and margins improved as well. The other three companies may take longer to realize revenue growth. But they're a lot closer now than a year ago.

CenturyLink's (CTL) revenue, for example, shrank 1.1 percent in the third quarter from year-earlier levels. That's a substantial improvement from the 1.7 percent decline rate of the second quarter. And it's directly attributable to the growth of broadband operations versus the shrinking traditional business.

Reason No. 2: Wireline communications bandwidth is increasingly valuable as wireless spectrum is stretched.

The emerging bidding war for Time Warner Cable (TWC) is just the latest step toward consolidation in the capital-intensive broadband communications business. And with the stock up better than 40 percent since takeover speculation began last summer, it's clear just how valuable wireline broadband assets have become.

These firms only need to augment the capabilities of wireless networks. The key reason Verizon Communications (NYSE:VZ) is buying out partner Vodafone (NASDAQ:VOD) is to better link Verizon Wireless with its FIOS fiber-to-the-home network. Consolidated Communications and Windstream are rapidly building fiber-optic cable connections to cellular phone towers for the same reason.

As of now, this is a fairly minor source of revenue for both companies. But as the trend of integrating landline networks to expand wireless potential grows, so will the value of these and other assets.

That could eventually make all these companies merger candidates, either among themselves or for the industry's spectrum-hungry giants. Either way, it promises a lift to these stocks, whose value has to now been reckoned solely by dividend yields.

Reason No. 3: The greater the short volume, the greater the risk to short sellers.

Falling stocks draw short sellers like rising share prices attract buyers. The irony is, both groups are buying into established trends that could reverse.

As the table shows, those on the short side of these four stocks have lost money this year, in addition to having to make good on generous dividends. That's particularly true of short sellers who've come on since Valentine's Day, when CenturyLink cut its dividend by roughly 25 percent and suffered an equivalent one-day drop in its share price.

Short interest has come down slightly for these stocks since mid-summer. That's demonstrated by the slight decline in "days to cover," which is total short volume divided by average daily trading volume.

Overall, however, it would take 11.7 average trading days to cover total short positions on these stocks. And short interest is also about 12 percent of total shares traded.

That's a lot of positions to close out, should any of these companies surprise to the upside. And when short sellers exit, they have to buy shares, pushing stock prices higher and heightening the pain on remaining short positions.

This is the essence of a short squeeze. We may already be seeing one in the works for Consolidated Communications, which is up almost 16 percent since the beginning of September and has returned better than 33 percent already in 2013.

The wild action this year in Frontier Communications Corp (NYSE:FTR) (short interest 20 percent of float) means it could be an even bigger loser for the shorts--should future results show broadband revenue growth overtaking traditional phone business decline. An analyst from JPMorgan Chase & Co. broached this possibility earlier this month.

A real move by Frontier Communications toward revenue growth would likely improve analyst and investor sentiment toward the stock. And with so much short volume as tinder, the resulting conflagration could set off an epic short squeeze.

To be sure, Frontier Communications faces significant hurdles to delivering year-over-year revenue growth on a consistent basis. So do the other high-yield telecoms in my table, with the exception of Consolidated Communications.

But expectations are low and, therefore, easy to beat. And in the meantime, these results indicate companies' dividends are better funded than they've been in some time.

Disclosure: I am long CNSL, WIN, VZ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.