The evaluation of high yield dividend stocks such as Windstream (NASDAQ:WIN) requires looking at a different set of data compared to the tools many investors use to evaluate stocks. Typical stock evaluation involves looking at earnings per share, earnings per share growth, price to earnings ratios and similar metrics. With a high yield stock, the amount of annual dividend often is greater than the reported earnings per share. A dividend higher than earnings does not work using traditional stock value techniques, where a dividend payout ratio of 50% would be seen as an upper limit. With a company like Windstream, the first thing an investor must find out is where the money to pay the dividend comes from.
A search for high yield stocks will bring up three mid-cap telecommunications stocks: Windstream, Frontier Communications (NYSE:FTR) and CenturyLink (NYSE:CTL). These three telecom stocks have a market cap of $6.40 billion, $4.14 billion, and $23.35 billion, respectively. As a mid-cap stock, CenturyLink does not play in the same league as competitors AT&T (NYSE:T) and Verizon (NYSE:VZ), which have a market cap of $177.60 billion and $107.38 billion, respectively. The three high yield mid-cap telecom stocks have extended histories of paying large dividends and yields are often at 8% or higher.
Let us evaluate Windstream using factors important to high yield investors. Windstream reports a low net earnings per share, due to a high level of depreciation and amortization on the capital assets of the company. For example, in Q3 2011, the company had net income of $71 million, while non-cash depreciation and amortization charge was $204 million. A better measure of the cash available is operating income before depreciation and amortization (OIBDA). For the third quarter, Windstream reported operating income of $490 million. Free cash flow - money available to pay dividends - is OIBDA minus capital expenditures, pension contributions, interest and taxes. In 2011, Windstream generated about $225 million per quarter in free cash flow, or about 45 cents per share. This level of free cash flow handily covers the 25 cent quarterly dividend.
The next point to evaluate is whether the dividend coverage can be maintained or increased. From 2007 through to 2010, Windstream went on an acquisitions spree, buying eight smaller telecom companies. A larger merger with commercial broadband service provider Paetec was announced in 2011, to be completed in early 2012, which will increase revenue by 50%. Through 2007 to 2011, the company's free cash flow steadily increased and the payout ratio declined from 69% to about 55% of free cash flow, depending on the final 2011 numbers.
Finally, the dividend investor must evaluate whether the company paying the high dividend will sustain the cash flow necessary to pay the dividend. There is a question here, since Windstream has experienced a trend of declining revenue. Over the last seven quarters, the company reported year-on-year revenue declines of 1.0% to 2.5%. The primary reason is the company shift from providing basic telephone service to a large number of customers, to selling broadband Internet and business telecom services to a smaller number of customers. The revenue for these two sectors has been growing, even as overall sales have been declining. Corporate focus on maintain growth of free cash flow indicates the 25 cent quarterly dividend is safe for the foreseeable future. Part of the Paetec merger announcement was a management commitment to maintain the 25 cent quarterly dividend.
Investors interested in picking up shares of Windstream will find an interesting pattern on the share price chart. Each quarter, the share price will climb significantly before the ex-dividend date and drop by a similar amount usually within the first two weeks after the ex-dividend date. The price swings are significantly larger than the amount of the dividend, often swinging $1 or more around the ex date. A cynical market watcher might assume the smart money is working to make trading profits on the backs of the not-so-smart, dividend-capture money. The point is, an investor looking at Windstream shares for the long run should study the price chart and wait for the price drop after the ex-dividend date to make purchases.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.