Just before the beginning of 2013, I pointed out three dividend stocks that I thought were dangerous for investors to invest in. My reasoning was simple: the underlying businesses were deteriorating to the point where there wouldn't be enough free cash flow to continue paying out high yields.
Today, one of those three stocks, Windsteam -- a rural telecom player -- is down by as much as 9%. The fact of the matter, however, is that there's been no substantial news regarding Windstream to explain such a dip.
Read on to find out why Windstream, and its smaller telecom brethren, are suffering today. I'll fill you in on what this means for these companies moving forward, and at the end, offer access to a special premium report on one of these high-yielders.
It's all about CenturyLink
Yesterday, after the market closed, telecom player CenturyLink announced that it would be taking a different approach to its capital allocation. Among those changes included a $2 billion share repurchase program, and a 25% cut to the company's quarterly dividend.
As many telecom investors know, there's usually not a great chance for the price of a stock to skyrocket; the main reason investors choose telecoms is because of their steady free cash flow streams, and the outsized dividends that those streams produce. Any cut in the dividend can cause for investors to run for the exits, as we're seeing today with CenturyLink's 20% drop in share price.
Operationally, the company reported a 19.7% increase in revenue, but when special items were excluded, earnings came in 6.2% lower for the year than they did in 2011. And when it came to the company's dividend, the payout from free cash flow was a very healthy 58% -- meaning there was no danger of CenturyLink running out of money to pay the dividend. Instead, it appears that management has, as it said, changed its allocation strategy.
What's this got to do with the other companies?
In essence, it appears that CenturyLink's decision to cut its dividend has created a scare among telecom investors. Shares of Windstream have fallen by as 9%, while shares of another rural telecom player -- Frontier Communications -- have also taken a 7% hit.
I always think that the best way to investigate whether a company's dividend is sustainable is to check out how much free cash flow is being used to pay shareholders. Currently, Windstream is paying out more in dividends than it is generating in the form of free cash flow.
That, along with an underlying business that I'm not totally confident in, is why I suggested staying away from Windstream. The company will be announcing earnings before the market opens next Tuesday, so investors should keep their eyes peeled to see if Windstream will be announcing any similar cuts.
As far as Frontier goes, the company has suffered a decline in revenue over the first three quarters of 2012, and earnings have stayed flat. Of course, this wouldn't be a huge problem if the dividend was safe. Over the first three quarters of 2012, Frontier has only used 49% of its free cash flow to pay out its dividend -- meaning that, on paper, its dividend should be safe.
It probably doesn't hurt that today's dividend payout is roughly half of what it was for Frontier shareholders over a year ago.
The company is scheduled to release earnings after the market closes next Thursday. While its juicy dividend is tempting, every Frontier investor has to understand that it's not a sure thing.
A huge acquisition has transformed the company forever. Will the move bear fruit, or are investors destined for another disappointing dividend cut? In this premium research report on Frontier Communications, we walk you through all of the key opportunities and threats facing the company. Better yet, you'll receive a full year of updates to boot. Click here to learn more.
The article Dividend Cut Causes a Run on Small Telecoms originally appeared on Fool.com.
Fool contributor Brian Stoffel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.
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