Windstream (WIN) is being hit by a few negative tailwinds - that is, pundits questioning whether its five-year run on dividend payments will continue. In the competition to meet growing demand for high speed services and infrastructure, telecommunication service providers are incurring high capital expenditures. Following high speed network buildouts and acquisitions, Windstream is feeling its share of pressure on profit margins and cash flow. As capex projects wind down, though, the profit squeeze is expected to ease up.
Having grown from an Alltel Communications spin-off into a leading provider of voice and data, Windstream has the operating mettle to manage through a more capital-intensive stage for telecoms. But first, the company has to deal with the aftermath of an acquisition spree. After expanding from a rural telecoms to a provider of business and broadband services through acquisitions, it is encumbered with debt and integration issues.
While the growing pains are real, Windstream's critics are shortsighted. The telecom's capital spending on two major fronts - acquisitions and high speed network buildouts - will soon turn into revenue streams. In the business market, where it competes in the competitive unified communications (UC) space, telecoms are sweeping in on the most advanced communications technologies as soon they come on the market to win over service providers and enterprises. Windstream's decision to buy a cloud computing company, Hosted Solutions, rather than pay for the service as many of its competitors are demonstrates its agile strategy. The company will not only save on IT costs but also capture revenue from the high demand for cloud services. Windstream says the new business is growing revenues at 18% a year. Nexcom has just signed onto its cloud services to more securely manage the increase in data it sells to mobile workforces, which are rapidly increasing demand on bandwidth, in small and mid-sized businesses.
In early October, Windstream expanded its carrier switched Ethernet service to 300 CLEC markets nationwide to meet the demand for higher bandwidth to transport more video, music and high resolution images. The company's recent partnership with Lifesize Communications to provide high definition video conferencing to its customers is an example of the broadband hungry services carriers are delivering to the doorstep. On its fiber-to-the-tower strategy to move more mobile data for enterprises, it is completing construction on 5,000 towers
The major investments in high speed networks have put profits under pressure. Profit margins have fallen by more than half from around 8.56% in 2010 to under 4% in 2012. The cost of the high speed buildout is rising as service providers seek to acquire Internet, voice and videoconferencing services with the most innovative features and user friendly interfaces. Windstream has experienced a 29% increase in the cost of products sold, and a slightly higher cost of services over the past year.
As part of the transition to higher speed networks, the industry overall has been experiencing sliding profit margins. Windstream is holding its own next to its competitors, the big telecoms. The company's operating margins at 0.18 compare favorably to AT&T's (T) 0.14, Verizon's (VZ) 0.13 and Sprint's (S) 0.01, and an industry average of 0.15.
Since its 2006 spin-off from Alltel Corporation, Windstream has executed well on a strategic and operational level, bucking the trend of spin-offs trading down over the long term. The rationale behind a spinoff is to let a nimbler, more entrepreneurial company loose to compete, and Windstream has not disappointed. In August, the company declared its 25th consecutive 25-cent dividend since its spin-off. Over the same period, the third largest US carrier Sprint has posted five consecutive years of losses.
Remaining nimble, even at $6 billion in revenues, Windstream continues to pursue an aggressive expansion strategy. Changes in the competitive landscape are likely to further test Windstream's business model. Softbank's acquisition of 70 percent of Sprint for $20.1 billion in mid-October while Sprint was in the midst of a $7 billion network upgrade places a fortified competitor in Windstream's key markets. Sprint now has more cash and less debt but Softbank still has to execute to get Sprint out of its slump. The normally acquisitive Softbank has been growing its broadband and cloud strategy through strategic alliances, most recently partnering with Verizon Business for access to its IP network in Japan and VCE on cloud computing. Meanwhile, Verizon is seeking to get a jump on mobile data by building out its 4G LTE network. With LTE, Verizon expects to bring in higher revenues per customer.
The economics of delivering competitive broadband may also be changing. Windstream and AT&T recently won a key victory over incumbent local exchange carriers by having the special access fees waived to gain access to commercial buildings in San Francisco, California and San Antonio, Texas. The legal maneuver by the telecoms is putting pressure on national regulators to change special access rules nationwide, by lowering the fees to connect to the circuits of landline carriers, which create billions of dollars in annual revenues for the companies who own and sell access to the backhaul circuits. These fees are high for telecoms delivering broadband to rural areas.
On the revenue front, as revenues start to come in from the expanded Ethernet business, Windstream expects to experience earnings momentum going into 2013. Free cash flow is expected to get a boost through cost management measures, revenue improvements and acquisitions. As a number of huge capital projects are winding down, including the buildout of its 5,000 broadband towers, capital investments in its fiber strategy will decrease. Synergies from sales and operational integration, meanwhile, are expected to produce around $150 million in savings by 2014.
Far from becoming sluggish, the nimble spin-off that has grown rapidly through acquisitions is focused on streamlining operations. With too much fat around the middle after its acquisitive spree, a major management restructuring planned for the third quarter aims to eliminate up to 400 jobs to produce $30 to $40 million in cost savings.
A leaner organization is expected to emerge as revenues start to kick in from its new broadband and cloud services in 2013. Investors should consider buying shares of Windstream now to take advantage of this.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.