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By Ahmed Ishtiaq

The aggressive acquisitions by Windstream Corp (NASDAQ:WIN) have helped the company to achieve solid growth. However, the company has funded most of the acquisitions with debt, which was $8.8 billion at the end of the second quarter of 2012. The size of the company has increased mainly through acquisitions since is formation in 2006. At that time, the company only offered services in 16 states. Windstrem now operates in 48 states and the District of Columbia. The company operates 22 data centers and a long-haul fiber network spanning about 115,000 miles.

Long Term Prospects:

The strategies followed by the company will continue to yield long-term growth. Nevertheless, the company faces challenges including falling wholesale revenues and continued decline in access lines. In the first quarter of 2012, wholesale revenues fell 6.3 percent or $15 million compared to the previous year. The fall was mainly due to the elimination of certain operations in the portfolio of PAETEC, which Windstream acquired last year for $2.4 billion in stock.

In its first quarter earnings report, Windstream reported a decline of 82,000 consumer lines or 4.1 percent during the 12-month period ending March 31. The company credited the losses to "the effects of competition." As a result of such line losses, the company has moved its sales to higher-growth areas. Windstream witnessed increases in sales in its business channels and broadband-areas in which the company is focusing. In addition, its entry into the cloud computing spectrum is expected to give Windstream another avenue to increase its revenues.

Acquisitions come at a cost:

Aggressive acquisition strategy and the entry into the high growth segments of the market have helped the company in achieving impressive revenue growth. However, the increase in revenue has come at a substantial cost.

In the most recent earnings announcement, the company reported net income of $54.2 million on sales of $1.538 billion. For the same quarter last year, Windstream reported $96.7 million on sales of $1.03 billion. The company has not yet been able to integrate its acquisitions, and integration costs have been a constant component of the company expenses. In 2011, the company reported over $71 million in integration and restructuring costs. By the end of the second quarter 2012, the integration and restructuring costs stood at $52.9 million.

Once again the company is likely to report hefty integration costs at the end of the year. The company is expected to report heavy restructuring and integration costs through 2013.

Free cash flows and the Payout:

At the moment, debt to OIBDA (operating income before depreciation and amortization) stands at 3.66 for Windstream. The company wants to bring down the ratio to between 3.2 and 3.4. However, the company will have to increase its earnings substantially to achieve the target; which seems a far cry after the mediocre earnings result of the second quarter. Windstream sometimes skates on thin ice regarding its dividend to the free cash flow ratio. As I mentioned in my previous article, Windstream's free cash flows provide a slim coverage to dividends.

For the six months ending June 30, 2012, the company reported $293.5 million in cash dividends and generated $296 million in free cash flows. At these levels of free cash flows and dividends, the company payout goes over 99% of free cash flows. Company management has been quite keen to reassure investors that they intend to carry on with the current levels of dividends, and the cash flows of the company are in a healthy condition.

However, a deeper look at the cash flows statement indicates otherwise, and the free cash flows of the firm are barely enough for dividends. A slight decline in free cash flows can bring the company in hot water and the dividends may suffer.

Summary:

Windstream has missed analyst expectations in each of the last two quarters. As a result, the stock of the company has suffered. Nevertheless, the prospects of the company are bright, and the revenue growth has been exceptional. As I have mentioned in my previous articles, my biggest concern is the elevated levels of debt. At the moment, the biggest attraction for Windstream investors is its juicy dividend yield. However, my analysis of the free cash flows of the company indicates that the dividends can come under threat in case of a small decline in the free cash flows.

Of course, the firm can borrow to meet its dividends. But will it be a good idea for such a debt-loaded company to borrow funds to keep up with dividend payments? Its peer, Frontier Communications (NASDAQ:FTR) had to cut its dividends to pay off some of the debt it incurred due to its acquisitions. I think that was a bold, yet a necessary move by the Frontier's management. Windstream is likely to follow Frontier's steps. The firm will still be going through transition for another year, and the danger of a dividend cut remains.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: EfsInvestment is a team of analysts. This article was written by Ishtiaq Ahmed, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.

Source: Windstream: Danger Of A Dividend Cut Remains