Uncertainty Threatens Windstream Dividends

Since its incorporation in 2006, Windstream has been shifting its business model away from the shrinking land line market and toward other, more profitable, telecommunication avenues.

But its latest financial quarters haven’t exactly thrilled some analysts, and there’s a growing worry that the changes haven’t been effective enough, potentially threatening the company’s attractive dividend.

For example, after the Little Rock company — which recently reorganized under the name Windstream Holdings Inc. — released its third-quarter 2013 financial results earlier this month, Morgan Stanley Wealth Management of New York City downgraded the company’s stock to “sell.”

Analyst Simon Flannery explained his reasoning for the downgrade in a report.

“While management has demonstrated a strong commitment to the dividend, we believe that soft quarterly results, rising cash taxes and debt obligations may pressure the board to consider cutting the dividend in February 2014,” Flannery said.

The company’s dividend pays out $1 per share per year, a yield of 12 percent or better at its current stock price in the low $8 range.

He also said that the company’s third-quarter earnings didn’t signal a turning point in the company’s shift to business services revenue.

The company’s third-quarter income was $31 million, down 34 percent in the same quarter of 2012. Revenue for the quarter was $1.5 billion, down 2 percent.

Similarly, second-quarter 2013 revenue was $40 million, down 21 percent from a year earlier, on revenue of $1.51 billion, a decline of 2 percent from the second quarter of 2012.

“Our revenue has decelerated,” CFO Tony Thomas admitted last week at a Wells Fargo conference in New York City.

Thomas said some of that has to do with the economy in general, but, he added, “that shouldn’t be a hindrance to our success. Overall, we had a solid quarter with some good signs of growth, but clearly I think we can do better.”

Still, Thomas said the company’s transition to a broadband and enterprise services company is nearly complete, with 60 percent of revenue coming from Internet and managed services for businesses.

“Clearly, this transition enables Windstream with the most sustainable cash flow going forward,” he said.

But much of that transition stems from the company’s spate of acquisitions during the past several years. Those acquisitions have piled up expenses, particularly the $2.3 billion purchase of Paetec Holding Corp. of Fairport, N.Y. While those acquisitions have allowed Windstream to maneuver into the managed services market, they’ve also built up debt and necessitated drawn-out integration processes. Paetec, for example, won’t likely be fully integrated until 2014 at least, Thomas said.

That’s why, in the company’s latest earnings release, CEO Jeff Gardner said one of the company’s three major goals is optimizing its cost structure or, more to the point, paying its debts.

Its other two goals, Gardner said, are to invest in capital growth opportunities and keep increasing revenue.

That increase, Thomas said, is going to come from how well Windstream can dress up its business services.

“A lot of companies can sell a pipe,” he said, referring to broadband connections. “A pipe is just a pipe.”

What’s being sold on top of the pipe, he said, is key.

“Whether it’s cloud or security or so forth,” Thomas said, “bandwidth is very simple. What we’re seeing is a confluence of IT and telecom. When they come together, we’ll have a different skill set in the marketplace to be successful.”

Access is still important, Thomas said.

“Windstream has the fifth-largest fiber network in the country,” he said, noting that it’s also key for Windstream to connect its disparate fiber networks and add managed services to those networks.

The company’s many new data centers tie into its shifting focus as well.

“We’re using our pipes to provide data center services,” Thomas said. “That’s an opportunity. From a larger perspective, this overlap of IT and telecom, this macro-trend, is ultimately what we’re trying to capture. That combination of IT and pipes. The confluence of network and managed services.”

Analysts Weigh In

So, given the company’s lackluster earnings and Morgan Stanley’s downgrade, how well is that confluence working for the company?

Donna Jaegers, an analyst at D.A. Davidson of Great Falls, Mont., said the cash flow generated by growth in Windstream’s business services sector fuels the company’s high-yield dividend. (See Dividend Changes below.)

But that growth hasn’t been too great.

“That was actually a little weaker in the last few quarters,” she said.

Pressure is coming from other cable-focused companies, like Earthlink and Time Warner, aggressively growing their small-business customer base — customers with billings of $750 or more per month.

“They’ve been preparing for that, but that continued pressure from the low end continues to erode the cash flow Windstream is getting from smaller business customers,” she said.

Jaegers, however, still rates Windstream stock as a “buy.”

“The thing people aren’t looking at, with the broadband builds done in the last few quarters, Windstream is going to be marketing to 75,000 households that haven’t had broadband access,” she said. “The next few quarters should have a lot better tone because of growing the DSL adds.”

She said the company is managing itself well in that area, and even though it was losing broadband customers, it was working on scaling up existing customers with faster speeds and more add-on services.

Barry McCarver, an analyst for Stephens Inc. of Little Rock, also still considers the hometown company a “buy.”

“I look at the third-quarter results as a meaningful headway moving the company in the right direction,” he said.

Windstream, McCarver said, is all about single-digit growth in its revenue and cash flow, as well as continuing to pay that dividend.

“Third quarter could have been better, but it was within range of my expectations,” he said.

Capital expenditures have fallen, he said, and though the company’s consumer business revenue was falling, its business services revenue was growing.

“Again, as I said before, it’s single-digit growth,” he said. “They’re not going to grow their top line 10 percent. It’s going to grow 1 or 2 or 3 percent.”

He said he expects that growth to happen organically in two or three quarters.

“They lost a lot of small businesses but they gained large enterprise,” he said. “I can understand that: One large enterprise makes up for the small business losses.”

And as for CFO Tony Thomas’ view: “We’re making progress, and there’s more progress to come in 2013.”

Last week, Windstream stock was trading between $8 and $8.25, down from $8.75 in late September.

Dividend Changes

Windstream Holdings Inc.’s dividend, $1 per year, is one of the most attractive parts of that company’s stock, and executives have repeatedly reassured investors that the dividend isn’t going to change.

But the dividend’s taxability did change earlier this year, something that few analysts are talking about.

Windstream announced that, starting in July, only about 66 percent of returns from the dividend would be considered non-taxable income.

Why?

Mary Michaels, vice president of investor relations at Windstream, said it has to do with how tax is calculated for Windstream’s earnings.

The dividend yield comes from Windstream’s free cash flow. At the moment, more than half of that cash flow goes toward paying a dividend.

“What determines the taxability in the dividend is a calculation based on Windstream’s earnings,” she said. “What that calculation does is determines an amount that, if we distribute over that amount, it’s considered a return of capital.”

It started surpassing that amount earlier this year, Michaels said. She said that when Windstream spun off from Alltel in 2006, the company had some retained earnings.

“We had an accumulated balance from when we formed; each and every year we were using a little of that accumulation and also generated a portion of it from our current earnings,” she said. “We reached a point where the accumulated portion had been used, and so now we’re at a point where, with such a large dividend out of free cash flow, part of it will be taxable and part of it will be considered a return of capital.”

The “return of capital” portion is essentially money invested in the stock that’s returned to the buyer. So from one angle, it could be construed that it’s not actually a dividend. But Michaels said that the change is purely clerical.

“From Windstream’s perspective, it’s still a dividend,” she said. “It’s cash. Cash is cash. But the change is only from the taxability standpoint of the individual receiving it.”