Revenue and earnings estimates were in line but the question on most investors' minds is the high dividend yield safe or a red flag? The stock closed at $9.30, down 7.46% the day earnings were released, increasing the yield to 10.75%. The high yield represents the market's fear the dividend may not be sustainable. To answer the above question we need to take a closer look at the FCF (free cash flow) numbers.
WIN is reporting FCF of $134.5 million in the snapshot shown above. The dividend payout was about $147 million which converts to a FCF payout ratio of 109% for the quarter. The payout ratio looks better on a six month basis or 60%. The payout ratios are based on how WIN reports FCF but it is important to note it is accompanied by note A which states:
Adjusted free cash flow is adjusted OIBDA, excluding merger and integration expense, minus cash interest, cash taxes and adjusted capital expenditures.
The traditional measure of FCF is defined as cash from operations minus capex which produces a different picture as opposed to management's definition. Here is how management calculates FCF:
Now we will compare the traditional FCF measurement with management's adjusted FCF both on a quarterly and TTM (trailing twelve month) basis:
The blue line represents the TTM FCF as calculated by WIN. The generally accepted measure of FCF is shown by the red line. The green line represents the dividend. Note the dividend has increased to a run rate close to $600 million indicating the TTM dividend will continue to rise due to an expanded share base.
Based on the traditional measure of FCF the payout ratio for the quarter is 120% and 88% for the first half of 2012. These numbers put the risk of a dividend cut as high.
Management Calls the Dividend Secure
Jeffery R. Gardner, Chief Executive Officer, President and Director, made this comment on the conference call:
I am confident in our strategy and our ability to execute on our plans. We see a clear path of growing free cash flow per share which will support our dividend well into the future.
The CEO is trying to put investors at ease concerning the dividend but David Barden of Bank of America questioned the CFO concerning the adjusted FCF method:
I think your average person probably doesn't understand the adjusted free cash flow, right. They're going to look at the cash flow statement and see that in the first half, you had operating cash flow of x, it was slightly higher than your CapEx and your dividends, and so the payout ratio looks like it's very, very high right now. Can you talk about how that is going to change in the second half? How does that dividend get more comfortable for you guys relative to the first half if I ignore the adjustments and just look at the cash flow statement?
Anthony W. Thomas - Chief Financial Officer: We do use the adjusted free cash flow model because it excludes certain, really, just a few things. The few things it excludes are merger integration expenses, which are costs we incur simply to integrate our acquisitions, and most of our costs here in the second quarter, as well as the first half of the year are related to PAETEC. And we do expect to continue to incur some M&I expenses in the back half of the year. And we're also -- we also exclude restructuring charges. And given the management reorganization that we're going through, we do expect to incur some onetime restructuring charges associated with that effort. And other item we exclude is working capital. But as we look to the back half of the year, I think there will be some pressure from M&I on the totality of the cash flows. But when you look beyond 2012 and into 2013, the M&I expense is significantly less, and we do not anticipate any significant restructuring expenses. So those are really discrete onetime items that are nonrecurring in nature. So I think ultimately, that's what gives us the confidence associated with the dividend payout ratio, plus just when we look into 2013, we're anticipating adjusted OIBDA growth.
A case study
Frontier Communications (FTR) recently went through a similar experience; changing from the traditional measure of FCF to an adjusted FCF measure to show the dividend was safe. Below is a visual for comparison:
It's easy to see the dividend looked very safe when using the adjusted FCF (in red), however the traditional FCF measure told a more accurate story. Many investors were surprised when the dividend was cut since management talked about adjusted FCF to assure investors the dividend was secure. Based on the graph the new dividend is safe by either metric.
Does the FTR case offer any lessons? First be wary of adjusted FCF or at the very least track both methods. The adjusted method based on what management calls one-time items that will eventually go away should start to converge with the traditional measure. So far that is not the case here.
The difference to date between WIN and FTR is that WIN's TTM actual FCF has not crossed the dividend line as did FTR's but it is in high risk territory. The recent quarter has crossed the line by both measurements but it's harder to draw any conclusions based on a single quarter. It's also important to note the TTM dividend will continue to rise to about $588 million from where it is shown above leaving very little cash to pay down debt or any other unforeseen problems.
Waiting to see how the second half develops may be the prudent path before allocating new or additional cash toward this investment.
Detailed financial data used in this article can be found here.