Telecommunications stocks are often owned for their large dividends. In many cases, these companies pay out dividends higher than their net earnings. The dividend payout ratio, or the annual dividend divided by annual earnings, is often used as a measure of the safety of a company's dividend. In the telecommunications industry, because of large non-cash charges such as depreciation and amortization in excess of capital expenditures, the normal dividend payout ratio is an insufficient metric.
In these cases, owner earnings is a better metric. Owner earnings can be calculated by adding net income to non-cash expenses such as depreciation and amortization, and subtracting capital expenditures made to maintain the current business. While it's often difficult to calculate these "maintenance" capital expenditures, even a rough estimate gives an estimate of owner earnings that is useful in evaluating the ability of a company to maintain or expand its dividend.
Frontier Communications Corporation (FTR) just lowered its dividend to 10 cents quarterly from the previous level of 18.8 cents quarterly. In the last twelve months, net income has been $153 million, or 15 cents per share. That is a dividend payout ratio of 500%, clearly in the danger zone. Unlike many other telecommunications companies, however, the payout ratio based on owner earnings also indicates that Frontier was paying a dividend that it could not support. Adding depreciation and amortization to net income, while subtracting an estimate of maintenance capital expenses, gives owner earnings of $880 million, or 89 cents per share. The former dividend represents a dangerously high 84% of owner earnings, while the new dividend is a much safer 47%, in line with AT&T (T) and CenturyLink (CTL).
Windstream Corporation (WIN) is a company in a superficially similar position to Frontier. It has an annual dividend of $1.00 per share, and just reported 2011 net earnings of $0.33 per share. This is an alarming 300% dividend payout ratio. Owner earnings, however, gives a slightly different picture. Non-cash charges such as depreciation and amortization more than offsets maintenance capital expenditures. In Windstream's case, these non-cash charges in the past year include integration costs from its mergers and acquisitions, as well as a loss booked due to early extinguishment of debt. My estimate of owner earnings for Windstream in 2011 is about $1.50 per share. Dividends represent 67% of this figure, which is higher than other telecommunications companies but significantly below that of Frontier before its dividend cut.
Consolidated Communications Holdings, Inc. (CNSL) is the smallest of these companies with a market cap of just $570 million. Although CNSL reports full-year 2011 earnings in just one week, trailing twelve month earnings are 84 cents per shares while its annual dividend is $1.55 per share, for an indicated payout ratio of 185%. However, CNSL has had depreciation and amortization costs of $88.5 million over the trailing twelve months, while capital expenditures were less than half that. Adding net income, depreciation, and amortization, and subtracting an estimate of maintenance capital expenditures gives an estimate of trailing twelve months owner earnings of $2.70 per share. Consolidated's dividend is just 57% of this figure, which seems far more sustainable. Interestingly, Consolidated reports a non-GAAP measurement that it calls "cash available to pay dividends" or CAPD. Its most recent quarter indicates that its dividend is 56% of the company's calculated CAPD, strongly agreeing with my estimate of owner earnings.
These small-cap telecommunications companies generally have higher dividend payout ratios to owner earnings than the large cap domestic and international telecommunications companies that I have previously written about. And the test case of Frontier shows an example of an unsustainable dividend payout. The new dividend rate of Frontier, and the existing dividend rate of Consolidated Communications are safe. The dividend payout for Windstream is significantly lower than the previous dividend payout ratio based on owner earnings for Frontier, but only a few percentage points lower than an estimated payout ratio for Telefonica had Telefonica not reduced its 2012 dividend.
Windstream clearly has the dividend most at risk of the telecommunications companies I've looked at, and I would judge that it's in the range where management of the company has to determine whether its focus should be on paying a dividend or significant expansion. I believe that it can easily do either one or the other, but both is a challenge for a company that has seen slow revenue erosion recently. You can make your own judgment, but I hope that the metric of owner earnings helps you evaluate the ability of a company to pay a dividend.
Disclosure: I am long TEF.