On the list of possible mistakes that an income investor can make, one of them is yield-chasing which refers to buying an ownership position in a business simply because it has a very high dividend yield. Absent a terrible recession like 1973-1974 or 2008-2009 in which the prices of even high quality businesses get cheap, companies usually only have yields like this because they are low-quality businesses with questionable long-term cash flows and/or a poor relationship between the company’s debt load and those cash flows.
One of those companies that regularly attracts the attention of income investors in Windstream. Windstream is a telecom company that runs the wirelines for people that need internet and phone service on the middle of nowhere, and it services 3 million customers across 29 states. It has caught the attention of many investors because it has maintained a $1 dividend since 2007, and people see the 11.5% dividend yield and get excited. They find themselves saying things like, “Even if the dividend gets cut in half, I will still be collecting almost 6% in annual income. I’ll take it.” That kind of attitude is hazardous to successful, conservative investing because it does not analyze the lengths to which Windstream must go to make those payments.
Back in 2006, Windstream made $1.03 in profits. Expecting a rosy future in which it would return nearly all of its profits to owners, the rural telecom decided to make $1 per share dividend payments. The logic assumed that future growth could be funded by new share offerings, and the realization of that growth would enable the dividend to be maintained over that time and maybe even grow.
This was quite the miscalculation. Windstream has high costs to operate wirelines through the middle of poorly populated American areas, and it can rarely charge customers the rate it finds fair because the competition in the telecom industry is intense among the company’s larger payers. This has led to non-stop declines in earnings power: Profits of $0.98 in 2007 and 2008 fell to $0.66 during the recession, and then continued to slowly fall to $0.38 per share in 2013, before falling again to $0.10 per share last year. A company that used to make almost $500 million in profits has been reduced to making only $80 million per year.
The big problem? The dividend has been maintained at $1 per share since 2007, even though the company’s profits have been tumbling and tumbling even more below that mark. To service the $1 dividend, the company has to make $600 million in annual payments to shareholders. That is a problem when you are making only $80 million in profits. That is a problem when you haven’t covered the dividend since 2006. That is a problem when pre-internet profit margins of 15% have dwindled into profit margins of 1.4%. When you’re paying out $500 million more in dividends than you make in profit, your balance sheets gets damaged.
Windstream carries $8.6 billion in debt. It makes $80 million in annual profits. That is a huge, huge red flag. It has a $1.2 billion pension that is only funded with $900 million so those 13,000 employees could realistically be looking at a 25% or more pension cut because of Windstream’s inadequate long-term planning.
It is amazing to me that some people would use their own hard-earned money—perhaps some of which they absolutely need to grow into something for retirement—on a company like this. The balance sheet is trash, and the profits have been deteriorating for a decade. The debt is 19x the equity, and the credit agencies have labelled Windstream’s debt as BB- minus which is a collegial way of saying “junk status.” It has $2 billion in debt payments to make in the next two years; the best year since coming out of the recession involved making only $300 million in profits. A reconfiguration of the debt is necessary for this company to avoid bankruptcy. Across the whole company, it has to pay $600 million in interest payments alone—even if profits rebounded to the best post-recession figure, the interest alone would consume 24 months of profit.
And yet, some people are still drawn to it. They see the REIT spinoff of the fiber and copper assets and get excited—figuring that REITs, spinoffs, high dividends, and what have you are exotic things worthy of excitement and a dice roll. Most likely, that is not the case. Today, Windstream announced a 1 for 6 reverse stock split which does what the name suggests. Every 6 shares of Windstream you own will be reduced to 1. A 6,000 share WIN portfolio will have 1,000 shares. Of course, the price will sextuple, so this is all cosmetic. The purpose for the cosmetics? It is anyone’s guess, but I would speculate that it would attempt to soften the blow of the inevitable cut.
This engineering aside, you cannot take a minimally profitable company with an extraordinary debt load, wave a magic wand, and get good results. In the past ten years, the S&P 500 has returned 7-8%. Windstream, despite its double-digit dividend payout, has only returned a little bit more than 3%. It’s just a bad asset. You have to really on the benevolence of creditors to avoid bankruptcy—essentially, their lawyers, accountants, and executives have to run a “Why option screws us the least?” analysis to determine what kind of refinancing would make the most sense. The dividend will almost certainly get cut because the $8 billion in total debt with $2 billion soon due in the next two years will inevitably involve a creditor saying, “Cut the dividend if you want to get serious about refinancing.” Windstream is a dividend stock, but it possesses many character traits that are the exact opposite of what I want you to seek in a long-term holding. For those studying the balance sheet, the signs that real trouble lies ahead couldn’t be any more clear.
Originally posted 2015-02-20 22:46:04.