Just Say Yes to This 12% Dividend Yield

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Windstream Corporation (NASDAQ: WIN) has a very high dividend – yielding close to 12% – that scares a number of investors, which has only exacerbated the telecom’s downside. The stock has lost close to 30% year to date. Despite the company’s 400% payout ratio on an earnings basis, the annual dividend payout is only $588 million, where the company expects to generate upwards of $950 million in free cash flow for the current fiscal year. Billionaire Ken Griffin - founder of Citadel Investment Group - does happen to be one of Windstream's top-name investors (see Ken Griffin's newest picks).

Windstream’s big acquisition of late was the purchase of Paetec in late 2011. Newly acquired assets are expected to generate 35% of total revenues. The acquisition is expected to help generate over $50 million in synergies this year, and reduce operating expenses by about $100 million and capital expenditure by $10 million annually over the next two years. The telecom has also gained significant momentum in its enterprise market with nationwide coverage of fiber network cables. Some of the biggest initiatives for Windstream have been fiber-to-the-tower deployment and data center expansion. Another key growth avenue will be broadband expansion, with a focus on enhancing coverage and speed in under-served areas.

From a valuation standpoint, Windstream appears expensive at 35x earnings, but its forward P/E of 15x is well below major peers. Our main thesis is that Windstream’s dividend is secure, where its free cash flow payout for 2012 is only 70%. Windstream is also expected to lower capital spending in 2013, which should further strengthen its dividend coverage.

Level 3 Communications (NYSE: LVLT) has been growing thanks to the acquisition of Global Crossing’s assets in 4Q 2011. Organic revenues are also expected to rise in the interim thanks to large enterprise and federal customer growth. The Global acquisition should help Level with revenue diversification and debt reduction, but the one downside that remains is debt. The telecom's debt ratio is a whopping 65%, which has put strains on liquidity. We also remain cautious on Level’s future growth prospects, where its 5-year expected EPS growth is at a negative 50% CAGR.

What about the rest of Windstream's competitors?

Telephone & Data Systems (NYSE:TDS) is a diversified telecommunications company paying a dividend yield that is well below major peers at 2.2%. Sales are expected to only be up 2% in 2012 and 2013, but it does own an 80% stake in U.S. Cellular. Future benefits should come from U.S. Cellular, where the mobile company expects a pickup in average revenues per user and higher mobile adoption. This, in part, will hedge the loss of physical lines that Telephone & Data is experiencing. Worth noting is that Steven Cohen was dumping over 80% of his shares last quarter (check out Steven Cohen's top picks).

TW Telecom (NASDAQ: TWTC), meanwhile, does not pay a dividend and trades at a rich P/E ratio of 50x. The data networking company expects revenues to be up to $1.59 billion in 2013, up from $1.47 billion in 2012. TW's Internet segment is driving growth, supported by the adoption of metro fiber Ethernet services by enterprise customers. Billionaire George Soros was one of TW's biggest fans after adding the stock to his portfolio last quarter (check out George Soros' new picks).

CenturyLink (NYSE: CTL) made a key acquisition in 2011, buying Qwest Communications, but the telecom is expected to continue to see pressure on voice services and land line losses. Much like Windstream, CenturyLink’s dividend appears questionable at first glance, being a 200% payout of earnings at a 7% yield. It does appear that the telecom has sufficient free cash flow to cover its dividend, though, as its payout is roughly 30% of cash flow from operations.

In short, we believe the interim growth for Windstream might be limited given competitive pressures, but we are confident in its ability to generate free cash flow to fund its dividend.

This article is written by Marshall Hargrave and edited by Jake Mann. Insider Monkey's Editor-in-Chief is Meena Krishnamsetty. They don't own shares in any of the stocks mentioned in this article.  The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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