How Safe Are Your Telecom Dividends?

Yesterday's absolute collapse of Alaska Communications (NAS: ALSK) on news that it might cut its dividend was quite the wake-up call for investors. Back in August, I warned that the dividend might be in trouble; though no official cuts have been made, the prospect of losing a sizable payout sent shares tumbling 28%.

With this story as a backdrop, I set out to see how safe the rest of the large dividends being paid out by domestic telecoms really are.

Our first measure: payout ratio
One of the most popular metrics for measuring the sustainability of a dividend is the earnings payout ratio, which essentially measures the amount of earnings a company dedicates to paying out dividends against its net income. As the theory goes, the lower the payout ratio is, the more sustainable the dividend is.

The following table includes six more telecom stocks, their current yield, and their payout ratio.

Source: Yahoo! Finance.

At first blush, this might appear to show that Verizon's and AT&T's dividends are safe. Fool dividend guru James Early states that he looks for companies with payout ratios below 80%, and these two come close to this bar.

And the rest of them? Well, they look pretty awful.

But wait -- there's more!
This is where things get tricky. Because earnings are reported using the accrual method, companies may not yet have collected all of the money that they say they've earned. Things like accounts receivable and payable, depreciation, and goodwill are included in earnings -- and they don't immediately affect the amount of money a company has in the bank.

The good news is that there is a way to see how much money a company has put in the bank: free cash flow. This number is very important -- some Fools would say more important -- in evaluating a company's dividend sustainability. Ultimately, dividends are paid from free cash flow, not from earnings.

Check out the free cash flow payout ratio for these companies, and the story changes considerably. These numbers show how much free cash flow was used to pay out dividends so far in 2011.

Source: SEC filings.

Clearly, this changes things in a big way. All of the companies look like they have much more sustainable dividends. Verizon, AT&T, CenturyLink, and Consolidated all fall well below the 80% threshold.

Frontier and Windstream, however, seem to fall in the danger zone. Fellow Fool Jim Royal recently took a deep dive into Frontier's dividend. His conclusion: "Frontier pays a hefty dividend, but it's had to cut it in recent years, and its cash-cow business -- fixed line telecom -- is facing serious headwinds from the move to mobile telephony. It's hard to see this business thriving in 15 or 20 years."

Meanwhile, Fool Dan Radovsky recently gave a rundown of Windstream's competitive position, and its planned acquisition of PAETEC. He notes that "smaller telecoms have seen their ability to keep paying those dividends threatened by the steady shrinking of their core fixed-line phone service revenues. To halt these declines, those companies have eagerly pursued acquisitions in order to transition into other telecom areas."

Needless to say, if you're investing in Frontier or Windstream, do it with your eyes wide open -- and an eye toward dividend sustainability.

A few more excellent dividend ideas
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At the time thisarticle was published

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