IRS Ruling Wreaking Havoc On My Telecom Portfolio

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 |  Includes: CTL, FTR, T, VZ, WIN
by: Crunching Numbers

Summary

IRS ruling could impact telephone company taxes.

Shares of certain phone companies exhibit wild price swings.

As a result yields need to be re-assessed.

On July 29th, Windstream (NASDAQ:WIN) announced that it had received a favorable private letter ruling from the IRS. According to Windstream, the ruling would permit tax savings of $115 million by allowing Windstream to place certain assets in a publicly traded Real Estate Investment Trust or REIT. The market immediately jumped to the conclusion that other similar phone companies would be able to take advantage of the same tax treatment. The five largest wire-line phone companies all moved higher, and as a consequence, their dividend yields all moved lower.

Four of these companies - AT&T (NYSE:T), Frontier Communications (NYSE:FTR), Verizon (NYSE:VZ) and Windstream - are in my portfolio to generate income. In the past, I had also held the fifth, CenturyLink (NYSE:CTL), although I do not own any at the current time.

Below is a table showing the dividends and how the yields and share prices, changes from July 28th, the day before the announcement, to July 29th and through August 12. It should also be pointed out that in most cases the share prices spiked significantly higher than the closing prices on July 29th. As can be seen, some of these spikes proved short lived. Also, affecting some of the changes since July 29th were earnings releases or other announcements.

Company

AT&T

CenturyLink

Frontier

Verizon

Windstream

Date

Dividend

1.84

$2.16

$0.40

2.12

$1.00/$0.70*

July 28

Price

$35.65

$37.71

$5.94

$51.58

$10.53

Yield

5.16%

5.73%

6.73%

4.11%

9.50%

July 29

Price

$36.59

$39.90

$6.79

$51.97

$11.83

Yield

5.03%

5.41%

5.89%

4.08%

5.92%

August 12

Price

$34.64

$40.77

$6.485

$48.84

$11.31

Yield

5.31%

5.30%

6.17%

4.34%

6.19%

*Announced a new $0.70 dividend; $0.60 for the REIT and a cut to $0.10 for Windstream.

Click to enlarge

Even though all of these companies have significant residential wireline phone service, they are not equal in terms of business models, dividend growth history or risk. And, what also becomes clear when looking at the yields, is that the yield advantage of stocks like CenturyLink, Frontier and Windstream has narrowed considerably compared to "safer" investments like AT&T and Verizon.

Business Differences

AT&T and Verizon are the behemoths in the telecom sector, and are similar in several respects:

  • Both began as Regional Bell Operating Companies providing local service, or RBOCs, following the historic break-up of the original AT&T into a long distance company and seven RBOCs.
  • Both are leading cell phone service providers
  • Both have significant video businesses, and
  • Both have been increasing their dividend payouts

CenturyLink is the third largest telecommunications company in the US. Following the news release about Windstream, its shares traded as high as $45.67 on a more than 10-fold increase in volume before closing at $39.90, up nearly 6% on the day. Last week it reported revenues and earnings that beat expectations, and the shares have continued to tack on gains. CenturyLink and Windstream have both made efforts to diversify into cloud computing by building out data centers and support for hosted solutions.

Frontier has chosen to focus on improving its networks and providing higher speed broadband solutions in its territories. It also agreed to acquire AT&T's Connecticut business in late 2013 and is continuing to go through the approval process. Yesterday Frontier it reached announced an agreement with the office of the Connecticut Attorney General and Office of Consumer Counsel, so the approval of the Connecticut Public Utilities Regulatory Authority appears to be the last remaining major approval necessary to complete the acquisition.

The Dividends

The most important reason I have invested in telecom companies is their dividend income. AT&T has the longest history of consecutive years of dividend increases. Verizon is the only other company in the group that has not cut its dividend in the past few years. As noted in a prior article:

AT&T may be the most attractive of the group from a dividend perspective. It has a current yield of 5.3% and has been increasing the annual payout each year for almost 3 decades. While some of those increases have been quite small, the [dividend] amount has doubled in the past 16 years.

Verizon has the lowest yield at 4.4%, and for quite some time its dividend had not been increased at all. Over the past 7 years, however, its quarterly dividend has increased just over 30%.

The others have all cut their dividends as their residential customers cut the cord. These dividend cuts were expected by the market as the yields were driven into the high single or low double digits. And like many investors, I was ready to balance the risk and depth of the potential dividend cuts with attractive yields. I also would sell covered calls against the long positions to effectively reduce my cost basis and increase the yield.

Frontier has cut their dividend twice in the past few years. First, as part of a merger with a large portion of Verizon's rural telephone assets in mid-2010 it cut the dividend from $1.00 to $0.75. Then, after repeated claims about the safety of its dividend, it further cut the dividend to $0.40 in early 2012. CenturyLink cut its dividend from $2.90 to $2.16 last year. And, Windstream, after repeated statements about the importance of maintaining the dividend (that were very similar to those made by Frontier), took the opportunity of splitting the company into a REIT and an operating company to effectively slash the dividend from $1 to $0.70. That $1 dividend at Windstream had been in effect since 2006.

The IRS ruling wasn't enough to permit Windstream to retain its $1.00 dividend, and the combined dividends of $0.70 have me reconsidering my position in the company. I am also considering liquidating my position in Frontier and reallocating funds to AT&T and Verizon. (Obviously I should have sold out of both Frontier and Windstream - and possible all four positions - shortly after the markets opened on July 29th as the shares respectively climbed to peaks of $7.24 and $13.30.)

To be clear, I believe that the dividends of both Windstream and Frontier are more sustainable following the recent developments. The REIT set up by Windstream will have guaranteed revenues, but I'm not sure I want to own this particular REIT, and price freezes would seem to prevent it from increasing that dividend for several years. What bothers me the most about this dividend cut is that the $115 million in tax savings is not going to the shareholders in the form of maintaining the dividend.

With Frontier, I expect that the Connecticut acquisition will increase the sustainability of its dividend, but some of the restrictions to be imposed as part of the approval process would seem to hamper Frontier's ability to significantly grow revenues. The Attorney General review process had Frontier agree

... that for a period of not less than 36 months after the closing of the transaction (I) there will be no increases in the basic primary residential rate in effect for transferred exchanges as of the closing date; and (ii) where available, Frontier has agreed to offer its basic broadband and stand-alone basic broadband product at or below Frontier's current prices.

In addition, Frontier has committed to incremental capital investments totaling $63 million over 2015, 2016 and 2017 to expand and improve broadband in Connecticut. ...

These restrictions would seem to limit Frontier's ability to raise its dividend.

Summary

Entering the year I was very comfortable with my telecom positions, more than willing to take on the risk of a dividend cut by Windstream and minimal prospects for any dividend increase at Frontier in exchange for higher yields compared to those available with AT&T or Verizon. At the time, Windstream was trading at approximately $8 per share and its $1 dividend yielded 12.5%. Frontier - even after the announcement about the acquisition of Connecticut assets from AT&T - was trading at about $4.65 and its $0.40 dividend was yielding 8.6%. I was happy to sit back and collect the dividends and not worry too much about share prices.

With the yields on Windstream (6.19%) and Frontier (6.17%) now much closer to that of AT&T (5.31%), and to a lesser extent, Verizon (4.34%), the prospects of dividend increases from the two giants in the industry have become more attractive. A final decision has not been reached about whether to sell both Windstream and Frontier and re-allocate the money to AT&T and Verizon. Part of that decision will depend on the premiums I can receive by selling out of the money covered calls on my holdings in Frontier ($7 FEB 2015's) and Windstream ($12 JAN 2016's). Right now I am leaning in the direction of selling those calls. This would, in effect, increase the yield spreads back up to more than three full percentage points above AT&T, and much closer to the spread at the start of the year.

Disclosure: The author is long T, FTR, VZ, WIN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. I have covered calls written against a portion of my FTR position and may open new covered call positions against WIN and/or Frontier at any time. I may also sell out of either/or both FTR and WIN and reallocate the funds to T and/or VZ at any time.