Few industries dish out dividends as generously as telecommunications. Shares of industry leaders Verizon Communications (NYSE: VZ) yield 4.1 percent, while AT&T’s (NYSE: T) stock offers a current return of 5 percent.
Names further down the food chain offer even bigger yields: CenturyLink (NYSE: CTL) yields almost 7 percent, Consolidated Communications (NSDQ: CNSL) yields 8.7 percent, Frontier Communications Corp (NYSE: FTR) yields 9.8 percent and Windstream Corp (NSDQ: WIN) yields more than 12 percent.
But sweet yields can bring sour consequences in this highly competitive industry. Shares of CenturyLink, for example, lost a quarter of their value on Valentine’s Day 2013, after the company slashed its dividend by 25 percent. Frontier Communications has cut its payout by 60 percent since summer 2010–the primary reason that the stock lost almost half its market value over this period. Add Alaska Communications Systems (NSDQ: ALSK) to the list of cautionary tales; the company lowered its dividend in December 2011 and then eliminated the payout completely.
But FairPoint Communications (NYSE: FRP) and Otelco (NSDQ: OTEL) have been the worst performers. Both of these former high yielders eliminated their dividends and filed for bankruptcy protection. Although both companies have emerged from bankruptcy, neither has restored its dividend and the stocks themselves have turned in a dismal performance: Shares of the reconstituted Fairpoint Communications has tumbled 60 percent, while Otelco has given up 26 percent since swapping its debt for equity in May 2013.
Whereas short interest in AT&T and Verizon Communications hovers at levels that are fairly usual for a blue-chip stock in this environment, investors are betting heavily on the likelihood of further downside for rural telecoms.
Source: Bloomberg, Conrad’s Utility Investor
The relatively scant short interest in Alaska Communications and Otelco reflects these names’ relatively small market capitalizations and the fact that both have already eliminated their dividends, limiting the potential for further downside.
Short sellers definitely have dividend-paying telecoms in their sights, especially names that offer the highest yields. There are good reasons to expect a crackup at some of these companies.
Day of Reckoning
Telecommunications has always been a game of scale. Larger companies have more money than smaller ones and can afford to deploy better technologies. And every day, the capital gap between the sector’s fabulously wealthy–AT&T, Verizon Communications and cable giants Comcast Corp (NSDQ: CMCSA) and Time Warner Cable (NYSE: TWC)–and everyone else widens.
Second, the landline telephone business is fading a lot faster than many expected, myself included. Verizon Communications’ effort to take a storm-battered New York town entirely wireless is the most dramatic development so far. But it’s estimated that more than a quarter of Americans have already cut the cord on the old network, relying instead on wireless, cable broadband or fiber optics-based systems such as Verizon Communications’ FIOS network.
All the smaller operators on our list still generate some revenue from landlines. These companies are betting that they can reduce costs and grow their broadband networks at a fast enough rate to offset the erosion of their traditional business. The dividend cuts and bankruptcies afflicting the industry serve as a reminder that not every company is up to this challenge.
The day of reckoning for most telecom companies comes with the release of disappointing quarterly earnings, which usually coincides with the announcement of a lower dividend. Accordingly, the approach of earnings season brings heightened volatility to these stocks–mostly to the downside. Here’s when the companies discussed in this article will report their second-quarter 2013 numbers.
Source: Bloomberg, Conrad’s Utility Investor
Investors should expect the most heavily shorted names on our list to struggle in the lead-up to announcing their second-quarter results. If these companies post a solid three months of operations, their stock prices will recover until the next earnings date approaches.
This pattern, which has held for about two years, will persist until either the short thesis plays out or these companies grow their quarterly revenue to the point that the market no longer questions the sustainability of their dividends and business models. In this scenario, the survivors will reward their shareholders with outsize capital gains, while investors in the ill-fated names could face a total wipeout.
Safety in Numbers
As earnings season approaches, here’s a refresher course on the metrics that investors should use to assess these companies’ health and outlook.
Yields: The Sweet and the Sour
What telecom names boast the safest dividends? The industry’s Big Four–AT&T, Comcast, Time Warner and Verizon Communications–take that title, hands down. Among the smaller fry, Consolidated Communications is in the best shape–one of the reasons short interest in the stock is lower than its peers that trade with reasonable liquidity. CenturyTel also has some breathing room after slashing its dividend earlier this year, though at least another year of declining revenue appears to be in the cards. The stock holds some interest for aggressive investors on dips.
Analyst opinion on Windstream is divided down the middle, with five buys, five sells and 10 holds. I’ve been bullish on Windstream in the past, but the company will need to deliver higher revenue growth while continuing to diversify its business–only then will the stock earns a buy rating. Windstream rates a hold for those who can stomach the uncertainty.
Based on analyst opinions, Frontier Communications appears to have enjoyed some success regaining credibility lost in early 2012, when the firm halved its payout after earlier guidance assured investors of the dividend’s safety. The stock currently garners nine buy ratings, three sells and eight holds.
However, the company will need to reverse the decline in revenue before our opinion changes. Although the company added broadband business at a solid clip in the first quarter, overall sales fell 5 percent year over year and 2.2 percent sequentially.
Frontier Communications’ free cash flow covered the dividend by a more than 2-to-1 margin in the first three months of 2013, but local and long-distance service still accounts for 43.6 percent of the firm’s revenue. This figure increases to 55.4 percent when you add in switched access and subsidy revenue.
In contrast, Consolidated Communications–our favorite smaller telecom name–generates only 26 percent of its revenue from the landline business. And thanks to many investors’ tendency to paint the industry with the same broad brush, shares of Consolidated Communications trade at an unwarranted discount.