The telecom industry has supplied some wonderful returns for the past few years. AT&T (T), for example, has provided a dividend yielding in excess of 5.5% since October 2008. Ditto for Verizon (VZ). Over the same period, Windstream's (WIN) yield has not fallen below 7% and ranged as high as 12%. Frontier Communication (FTR) currently has the juiciest yield on the S&P 500. However, I do not believe the numbers back up these hefty payouts. The dividend party in this industry is coming to a close; the telecoms have run out of cash with which to pay the dividends and cuts are imminent.
Windstream is least able to sustain its current dividend out of the four. The current payout is $1 per share annually, but Windstream only earns $0.33 per share. Simple math dictates that company cannot pay out 303% of its earnings forever. It has just $249 million in cash, but has to come up with over twice that to cover the $581 million it will pay in dividends this year. The company's debt adds up to over $9.2 billion. In other words, its huge 9% dividend is merely financed; Windstream will have to come up with actual dollars for it someday.
In Windstream's 2011 annual report, CEO Jeff Gardner was quick to call the year a "remarkable success" as revenues grew to $4.3 billion compared to prior year's revenues of $3.7 billion. With its $891 million acquisition of PAETEC included, revenue totaled $6.2 billion. He did not however, mention that net income steadily fell from $399 million in 2009 to $172 million in 2011. He also neglected to mention the $1.4 billion in debt Windstream acquired from its PAETEC purchase.
Windstream's cash flow numbers for the year seem fine at first glance. The company added $184 million to its coffers in 2011. However, the company posted $1 billion in negative cash flow from both its investments and its financing activities, which it merely offset with depreciation. Ultimately, the majority of Windstream's net cash gain was through borrowing, as the company financed another $142 million in debt.
Frontier Communications finds itself in a very similar situation. The company pays a steep $0.40 per share dividend that yields 10%, yet it earns just $0.15 per share meaning it pays out 267% of its profits as dividends. The company has not experienced shrinking net income like Windstream, however, its net income is essentially flat and stood at about $150 million in both 2011 and 2010, and totaled $127 million in 2009.
Its cash flow picture is much the same. 93% of the company's $1.57 billion in cash inflows was depreciation and this amount was more or less offset by capital expenditures and dividend payouts, which totaled $762 million and $735 million, respectively. Frontier was left with just $75 million in positive cash flow. Frontier is still saddled with debt from its 2009 deal to buy rural wireline infrastructure in 14 states from Verizon. Frontier paid for the $8.6 billion deal with a combination of cash and common stock sold to Verizon.
I am very sour on the prospects of these two companies, not only of their dividends, but their chances for long-term of success in their current form. Both companies have acquired billions of dollars worth of rural infrastructure to better serve the broadband and voice over IP demands of their customers, but their customer base is shrinking relative to the rest of the country. Rural American accounted for 21% of the population in 2000, but after the 2010 census, that percentage shrank to 16%, the lowest share ever recorded. Frontier and Windstream both serve primarily low-margin, rural customers. These two companies incur high costs due to their expensive, sprawling systems which serve low-density areas. Windstream, for its part, is attempting to gain an urban foothold to offset the high expenses of its rural network.
In the future, the two companies will rely on cell phone service to boost their incomes. Cell phone calls are mostly routed over telephone lines, only hitting the airwaves for the mile or so between the tower and the cellular phone itself. Windstream and Frontier can rent out their networks to mobile carriers who lack large networks, such as T-Mobile, through roaming agreements. I see merger potential here-Frontier and Windstream have networks that would complement each other very well if they chose to join up. Windstream's network serves 46 states with a large eastern US presence, including select urban areas, and Frontier could fill in a lot of the gaps in western US coverage if the companies merged.
AT&T and Verizon do not possess secure dividends either. AT&T pays a $1.76 dividend on $0.67 earnings. Verizon pays a $2 dividend on $0.85 earnings. Depreciation accounts for a large part of AT&T's cash flows, which totaled $1.7 billion. AT&T's net income decreased substantially between 2010 and 2011, falling from $19.8 billion to $3.9 billion. Depreciation also accounted for a large share of Verizon's cash flows and the firm's net income fell to $2.4 billion in 2011, down 6% from 2010 and 51% from 2009. It managed to net $6.7 billion in cash 2011.
Positive cash flow coupled with shrinking net income is not good news. Sure, the companies have some money coming in the door, but it was not acquired from their business activities. Rather, it was generated through the tax deductions the companies were able to claim from the depreciated value of their assets. That might be able to net money for a short duration, but it is not a sustainable flow of cash. Shrinking net income indicates that rising costs and the accelerating death of residential landlines have caught up with the telecom industry.
The telecommunications industry will thrive long-term, but the dividends will not, at least in the short-term. All four of these companies will be forced to cut their payouts, the only question is when. Their share prices will likely fall as a result, as buy-and-hold investors head for the exits. The reality these companies face is continuing massive capital outlays to upgrade their mobile and broadband networks. These projects come with billion dollar price tags and no one has cash on hand to pay for them outright. Large dividends such as the ones found at present can only resume once this vast debt accumulated paid down and the industry shakes out its unprofitable players.
My suggestion is to look to different stocks within the technology sector to provide more stable dividend growth prospects. A great place to start is Intel (INTC) which offers a 3% return on its dividend, has plenty of cash with which to pay it, and offers exposure to the mobile market through its new K800 smartphone. The stock has higher upside potential in the near-term than any of these four as it penetrates new markets. Another great tech company with a hefty payout is Garmin Ltd. (GRMN). Its dividend yields 4% and, as with Intel, Garmin has the earnings to maintain it.
Don't get me wrong, I am long-term bullish on telecom companies. However, the short-term looks a little less rosy and I believe the industry is only beginning to sort out its winners and losers. Look for more acquisitions, increasing debt, and maybe a bankruptcy or two in the next few years. Put AT&T on your long-term watchlist. In my opinion, it will be the strongest of the four once all is said and done. Until the dust settles, pick a high-yielding tech stock and accumulate capital for a future move in this industry.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.