Kiss Your Yield Goodbye

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I understand the attraction to high yield stocks. Much of my personal portfolio is made up of dividend paying companies and there is nothing wrong with collecting a dividend check every three months. However, there is a difference between smart investing for growth and income, and chasing yield. This was made abundantly clear to me in two cases in the past and I believe Windstream (NASDAQ: WIN) is about to get a similar education. If you own Windstream you should certainly read this, and if you are thinking about buying Windstream and its tantalizing 11.76% yield, please take advantage of my prior experience.

The GE and BB&T Lesson:

Unfortunately, I firmly believed that both General Electric and BB&T were going to keep their dividends in place. I owned both companies and as their shares dropped I bought more because I couldn't look past the yield staring me in the face. At one point BB&T was yielding more than 8% and General Electric was yielding more than 10%! These were and are two excellent companies and leaders in their respective industries. I simply couldn't believe that their dividends would be in trouble. Then reality struck, each of these companies was forced to cut its dividend because quite honestly the company couldn't afford its payout. The good news is since then both companies have increased their dividend again, but neither one pays the amount it used to. In a way, that's good news for investors because both companies are once again leading their industries, and investors have the security of knowing that though the yield isn't as high as it once was, at least it is safe.

But Look At That Yield!

In an article on, Rick Munarriz tackled the question of whether or not investors should jump on Windstream's huge yield. He made the points that investors who didn't already own Windstream probably were fine with the stock dropping about 10% after their last earnings report. His take was that earnings weren't “that bad.” He also said that an EPS miss is something investors should be used to, as Windstream has missed estimates for four straight quarters.

There were two statements that he made that I disagreed with. First, he said that the difference between Windstream and its local telecom competitors like Frontier Communications (NASDAQ: FTR) or CenturyLink (NYSE: CTL), was Windstream disappointed investors. He went on to say that to justify the company's high yield they needed to sustain their business and for now the company is, “mostly living up to its end of the bargain.”

3 Reasons Investors Should Stay Away:

If you ever want to compare companies in the same industry, take a look at their margins. If you are looking for a company to buy and hold you want one with higher margins than their competition. Of the three local telecoms, Frontier currently carries the highest EBITDA margin. I use this margin because the industry requires high capital investment and this takes into account the bare bones expenses each company has to pay. Frontier's EBITDA margin is 45.80%, CenturyLink comes in at 40.65%, and Windstream clocks in at 39.31% using this measure. In plain english, Windstream is the least efficient operator of the three local telecoms.

Even Verizon (NYSE: VZ), which does not have the benefit of a high-margin business as the others, reported an EBITDA margin of 33.27%. The bottom line is Windstream is losing the battle of efficiency. A second way to compare these companies is, by looking at their dividend and free cash flow payout ratio. In the telecom industry, earnings are nearly meaningless; it's cash flow that matters. Just as an example, Verizon routinely reports cash flow that is a multiple of its earnings. If you look at earnings alone you might believe the stock is overvalued, but looking at cash flow paints a different picture. Since cash flow is what should pay dividends, let's see how these four companies compare:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>FCF Payout Ratio</strong></p> </td> </tr> <tr> <td> <p>CenturyLink</p> </td> <td> <p>7.39%</p> </td> <td> <p>38.70%</p> </td> </tr> <tr> <td> <p>Frontier</p> </td> <td> <p>8.32%</p> </td> <td> <p>50.78%</p> </td> </tr> <tr> <td> <p>Verizon</p> </td> <td> <p>4.71%</p> </td> <td> <p>23.21%</p> </td> </tr> <tr> <td> <p>Windstream</p> </td> <td> <p>11.76%</p> </td> <td> <p>147.74%</p> </td> </tr> </tbody> </table>

(Yield as of 12/4, FCF Payout calculated on most recent quarterly earnings) 

As you can see, Windstream has the highest yield, but its free cash flow payout ratio is nearly three times higher than its closest competitor. In addition, this trend has been getting consistently worse over time. In 2009, Windstream paid out 53.16% of free cash flow, by 2010 this percentage jumped to 68.39%, and in the last four quarters the average payout has been 103.32%. When a company's free cash flow payout jumps from 53% to 147% in the span of a few years, you know there is a problem.

Arguably one of the reasons that Windstream operates at a disadvantage, is because of their much weaker balance sheet. Comparing companies in the same industry using the debt-to-equity ratio makes sense, and allows us to see how much relative leverage each company has. The strongest relative balance sheet belongs to CenturyLink with a debt-to-equity ratio of 1.0. Verizon's debt-to-equity ratio is 1.23, Frontier's ratio is 1.93, and Windstream's ratio is a much higher 6.31. Think about those numbers for a minute. Frontier has already had to cut its dividend once, and yet the company's balance sheet is three times stronger than Windstream. When you compare Windstream to CenturyLink or Verizon, they aren't even in the same league.


The bottom line is this, if you already own shares of Windstream you may want to look for the nearest exit. With analysts calling for negative 1.9% EPS growth in the next few years, this is the only one of these four that is expected to see negative growth. Given the company's high payout ratio and highly leveraged balance sheet, if the dividend is cut the stock will fall. I don't believe it's a reach to say if the stock is worth $8.50 with an 11.76% yield, then the stock will likely fall in lockstep with whatever dividend cut occurs. Given that Windstream has a payout ratio three times its closest competitor, do the math for yourself of how much the stock would fall if the company's payout ratio went to 50%, it's not pretty. Given the alternatives, I can't come up with a reason investors should choose Windstream. If you believe in the local telecom business, either Frontier or CenturyLink is a better deal. If you want an even safer investment with better growth, then go with Verizon. 

MHenage owns shares of Verizon Communications and CenturyLink. 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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