Playing the Big-Yield Short

By David Dittman • February 22, 2013

What to Buy: Windstream Corp (NYSE: WIN)

Why now: Windstream Corp (NYSE: WIN) has been paying a quarterly dividend of USD0.25 per share since January 2007.

During this timeframe the stock has traded north of USD15, in February 2007, and south of USD7, in March 2009.

After reaching a recent peak of USD14.21 in December 2010 Windstream has been in a long downtrend, trading as low as USD8.18 in mid-November 2012.

It’s already been a volatile year for the stock, which opened 2013 at USD8.28, rallied to USD10 on Jan. 14 and cratered to USD8.39 as of Feb. 21.

But Windstream closed at USD9.81 as recently as Feb. 13. The recent swoon is all about the Feb. 14 announcement by the largest independent telecom, CenturyLink Inc (NYSE: CTL) that it was cutting its distribution by 26 percent.

CenturyLink went from USD41.69 to USD32.27 within a single trading session.

And its announcement immediately led to speculation that other high-yielding stocks–particularly high-yielding independent telecoms–are headed for dividend cuts. Hence Windstream’s and several other similar companies’ steep declines.

This speculation also manifested itself in a sharp rise in the “short interest” in other high yield stocks, particularly in the communications sector. Frontier Communications Corp (NYSE: FTR), for example, has short volume equivalent to more than 21 percent of its shares outstanding.

Windstream’s short interest is now up to 11 percent. That’s despite the fact that the company reported solid fourth-quarter and full-year operating and financial results for 2012. Management also, rather forcefully, reiterated its commitment to the current dividend rate.

Opportunity is knocking for aggressive Big Yield Hunters. Buy under USD11.

The Story

Short sellers essentially borrow shares of a company to sell them, with the intention of buying them back at a lower price. They make money when a stock’s price falls and lose when it rises.

Utility stocks aren’t historically known for high levels of short selling. That’s in large part because of the steady nature of their essential-services businesses.

It’s also because short sellers must make good on the dividends for the stock they borrow and sell. Holding shorts too long can be quite painful.

There’s some logic to the trend. Sluggish US economic growth has stressed high-dividend business models for several years. And that’s before the impact of US austerity this year.

The CenturyLink cut has raised the market’s anxiety enough to induce disaster-fearing investors to throw in the towel on stocks that lose ground, even if there is no cut.

The chief danger for short sellers is that if momentum shifts positive they can be caught in a “short squeeze,” resulting in huge losses as they’re forced to pay higher prices to close positions. Herein lay the rationale for aggressive investors to buy heavily shorted stocks.

As the aftermath of the 2008-09 crash has proven, even the worst damage to stocks will reverse, so long as underlying companies are viable.

If the past proves prologue, some of today’s high yielders will indeed fail. But most will recover. And if momentum shifts quickly enough, shorts will get squeezed and shareholders will see windfall gains.

And Windstream itself provides evidence of what the stock of a solid underlying company can do once fear abates: From a mid-crisis low of USD6.31 on March 9, 2009, it rallied to USD9.05 by May 8, 2009, and eventually to USD11.61 before 2010 dawned.

All the while–and to this very day–it’s maintained its USD0.25 per share quarterly dividend.

David: The first thing that jumped out at me as I was reviewing the transcript of Windstream Corp’s (NYSE: WIN) fourth-quarter and full-year 2012 earnings conference call was this quote from Jeff Gardner, the CEO of the company:

First, if you take one thing away from this call today, let it be this: Windstream’s management team and Board of Directors unanimously support continuing to pay our dividend at its current rate and believe it is the best way to create value for our shareholders.

OK, so I guess I’m taking away the one thing Mr. Gardner wants me to take away. But I have to confess that reading this only aroused my skepticism. As we’ve discussed, I’m a big telecom guy–and by that I mean I’m more “big telecom” guy, rather than a “big” telecom guy.

It’s occurred to me lately that Verizon Communications Inc (NYSE: VZ) and AT&T Inc (NYSE: T) have advantages that are insuperable for smaller players. I don’t know that those guys, along with Comcast Corp (NSDQ: CMCSA), will leave room for anyone else to build for the long term.

Communications is a game of scale, and, by definition, most independent telecoms lack scale.

But the deeper I waded into the transcript, the more I could see that Windstream seems to be preserving and expanding a niche that will continue to generate pretty decent free cash flow.

And it seems to me the key to maintaining and growing this niche is the success of its fiber-to-the-tower effort and it success securing mobile backhaul business.

Roger: The more you look at the markets from the ground up rather than from 30,000 feet down, the more clear it becomes that one size doesn’t fit all.

One of the best calls I’ve ever made in this business was back in the 1990s: forecasting the rise of the Baby Bells.

And that call was made primarily because they had the best chance to utilize the advantage of scale, which AT&T, Comcast and Verizon have done to perfection ever since.

Readers of Utility Forecaster will note that we’ve had “sell” recommendations for the vast majority of the industry for some time, in large part because everyone outside the Big Three really lacks the scale to compete long term.

But I’ve viewed Windstream as different for one big reason: It isn’t simply a regional telecom. It’s now a national broadband communications player. And rather than competing with the big boys, it’s filling a niche that’s complementary to them.

Obviously, the regional telecom group has taken some big hits lately. The CenturyLink Inc (NYSE: CTL) dividend cut on Valentine’s Day was bad enough. But it’s far from the worst thing to hit this industry.

Remember Otelco Inc (NYSE: OTT)? They’re about to go into what they call a “pre-packaged Chapter 11” that will basically convert the income deposit securities into common stock–and I wouldn’t hold my breath for a dividend any time soon.

The problem all of these companies have is their primary asset is copper wire–the same stuff that’s been carrying phone calls since Theodore Vail got his AT&T monopoly in 1907.

And people are cutting this cord, either by going to cable television or wireless connections.

When CenturyLink cut its dividend last week, it was essentially admitting that it was losing these customers faster than it could replace the revenue by attracting broadband business.

But here’s where this really gets fun.

Basic phone service now accounts for less than a quarter of Windstream revenue, and more than 90 percent of the network now has broadband coverage. This is a completely different company from CenturyLink, Otelco, Frontier Communications Corp (NYSE: FTR) or any of the other companies it typically gets lumped in with, with the exception of Consolidated Communications Holdings Inc (NSDQ: CNSL).

The result is revenue is basically stable. And free cash flow covers the combined outlay for dividends and capital spending by a healthy margin.

In fact, revenue is about to turn up, as the shrinking basic phone service becomes progressively less important to the overall picture. And the company continues to expand its technical and geographic reach with acquisitions, the latest being the PAETEC Holding Corp acquisition.

The PAETEC deal brought coast-to-coast presence, and Windstream now has nearly half a million businesses using its 100,000 miles of fiber that spans the country and reaches major cities and small towns.

This is not your grandfather’s rural telecom. But investors still seem determined to treat it like it is. And that’s where the opportunity is.

David: I’m also impressed by the fact that management was able to invest in its fiber-to-the tower program and at the same time strengthen the balance sheet by refinancing credit lines and high-cost notes.

Roger: That’s a good point. Windstream reduced the average cost of debt by approximately 70 basis points to 6.4 percent. And there are now no significant maturities until 2018. That’s supportive of the dividend.

Operationally things are solid as well. Business and broadband revenues–the main growth pillar of Windstream’s long-term strategy–now represent 70 percent of overall revenue; combined business and broadband service revenue grew 3.4 percent during the fourth quarter.

The company also improved its cost structure by realizing the targeted PAETEC synergies and completing a company reorganization designed to streamline processes and improve efficiency, at the same time lowering expenses.

Management reported that it realized about USD110 million in annual run-rate savings from these initiatives. And cost management–which has helped stabilize margins as management repositioned the company to focus on business and broadband–remains another key part of the company’s long-term strategic plan.

And note that the major CAPEX for the fiber-to-the-tower project will wind up by the end of 2013. That too is good for dividend safety.

David: Mr. Gardner, at the conclusion of his remarks during the conference call, went to great lengths to differentiate Windstream from other independent telecoms that “have made changes to their capital allocation strategy,” without naming CenturyLink, of course.

He noted that Windstream is already well along its transition path and that its revenue mix distinguishes it from others that are still focused on the consumer side of the telecom business–competing, in other words, with Verizon and AT&T.

And even on the consumer end, Windstream’s customers are concentrated in rural areas, where there’s less competition. It’s not a growth area, but Windstream’s consumer business is a source of stable cash flow.

And the company’s alliance with DISH Network Corp (NSDQ: DISH) has allowed to bundle video services in a low-cost way.

He described the company’s service delivery model for business as “efficient” and “less capital intensive” compared to competitors, as Windstream serves enterprise customers through a mixture of owned assets and leased facilities, which demand less capital.

Most important, as we noted earlier, Windstream is at the end of a major CAPEX cycle, winding down investments in fiber-to-the-tower and other growth projects. A big reduction in CAPEX will boost free cash flow that is already significant and appears to be sustainable.

I think he makes a sound case, and, crucially, Windstream’s operating and financial numbers support as well the proposition that this company is no CenturyLink.

Roger:  I wonder how many people were really listening on that call. But as you and I both know, the stock market is ultimately a weighing machine. And eventually, so long as the company continues to perform as a business, this stock is going to move to a higher level.

One point the bears on the call seemed to cling to is the fact that Windstream will start paying cash taxes in 2014.

If you remember taxes were the reason we heard over and again from CenturyLink management during its quarterly call for its “capital reallocation” strategy that cut its dividend. And they were the crux of every negative opinion we heard following Windstream’s earnings announcement.

The inflection point for Windstream stock could be when it becomes more apparent what these cash taxes will be and how willing and able management is then to continue paying that USD0.25 per share quarterly dividend.

But in the meantime a yield of nearly 12 percent is not only generous, but it also indicates a very low bar of expectations that this company continues to hurdle.

I don’t want to kid anyone that this company doesn’t carry some risk. All of our high-yielding positions in Big Yield Hunting do. But this seems to me like a situation where a lot of people are trying to push a square peg into a round hole.

Windstream is no CenturyLink. And when people come to realize that, we’re going to see a nice gain.

David: So you like my idea?

Roger: How could I not?  And let’s use the same buy target we do in other advisories. Windstream–yielding 11.8 percent as of midday Friday, Feb. 22–is a buy up to USD11.

David: Done. Now let’s talk about our other positions.

We’ve finally seen some upward momentum–and then a little downside movement–from Australia-based copper producer Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF).

The stock popped to a post-recommendation high of AUD0.57 on the Australian Securities Exchange (ASX), which is about USD0.59 based on the prevailing exchange rate. It’s backed up to AUD0.51 as of Friday trade Down Under, or about USD0.53.

Management reported solid quarterly production results for the last three months of 2012, a “scoping study” for its key Mt. Gordon mine project was very encouraging and broader trends for copper demand have held up.

The company will report full financial and operating results for fiscal 2013 in early May, at which time it will declare its annual dividend.

I think the wise move is to make this a hold through the dividend declaration, and then we’ll collect that payment and, ideally, a modest capital gain and call this one closed.

Our other Australia-based Open Position, Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF) is rallying again. The gaming stock hit an ASX high of AUD3.33 (USD3.52) in early August 2012, about three months after our initial recommendation, when the stock was trading at around AUD2.95 (USD2.97).

It fell as far as AUD2.63 (USD2.73) in mid-November 2012 but is now trading above our USD3.15 buy-under target again.

Tabcorp is basically in line with the S&P 500 during our holding period, with a total return in US dollar terms of about 19 percent. But it has substantially underperformed its home benchmark, the S&P/ASX 200 Index.

The market has digested a small cut in the interim distribution–Australian companies set their payouts to a percentage of profits or cash flow rather than a predetermined rate–as well as re-basing of company revenues due to the loss of certain gaming contracts.

A potential AUD600 million-plus windfall in the form of compensation from the government of the state of Victoria still looms as well. This case, which concerns the premature cancelling of a license to operate in the state, will be litigated beginning in October.

I say we let this one run.

Roger: Sounds good. Given the bad press coal is getting and the hard knocks some industry players are taking, it may also surprise some of our readers to know the August-September 2012 twin coal play is also looking solid.

Natural Resource Partners LP (NYSE: NRP), the August pick, is actually above buy target as of Thursday’s close at USD22.25. That’s up from a close of USD17.14 on Nov. 15, 2012. The stock actually hit a post-recommendation high of USD22.95 on Feb. 19.

Fourth-quarter revenue came in above estimates, though guidance for 2013 was weaker than expected. That’s hard to imagine given the condition of global coal markets.

Distributable cash flow was solid, with the per-unit figure of USD0.69 covering the payout by a healthy 1.25-to-1 margin. Management had previously declared a distribution of USD0.55, in line with the previous five quarters.

Roger: Expectations are low, as a yield that’s still near double-digits attests. But Natural Resource is making headway in its effort to diversify revenue streams, and the global coal market should be at least approximating a bottom.

I see more upside, though it won’t be in a straight line. Opportunistic Big Yield Hunters who don’t have a position, however, will use a pullback to buy Natural Resource Partners under USD22.

And Rhino Resource Partners LP (NYSE: RNO) is up to USD14.30, still below the USD16 buy-under target and our USD15.35 entry price but up from a post recommendation low of USD12.39, which happened in mid-November.

Rhino reduced its distribution from USD0.48 to USD0.445 last summer before we entered the trade. But it’s maintained that rate in the three quarters since, including with the distribution declared in late January.

Management won’t announce fourth-quarter and full-year 2012 results until Feb. 28. We’ll have an update in the March Big Yield Hunting. For now, however, Rhino Resource Partners remains a buy under USD15 for new aggressive investors.

David: What about our energy related bets? It seems like speculation is running high that PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) is headed for a dividend cut, and we’ve already seen one at Bonavista Energy Corp (TSX: BNP, OTC: BNPUF).

Are those price differentials between Canadian and US oil going to doom these trades?

Roger: There’s no doubt this is a big deal.

North America is on track to be the world’s biggest oil producer by early in the next decade, even if you roll back some of those Energy Information Administration estimates to more conservative levels. But there aren’t enough pipelines in operation right now to get it to market, so you have all this energy just sitting there and really going begging.

We’re even seeing railroads and trucks pushed into service–not a really efficient way of getting production to market.

There is an end game here. Sooner or later the infrastructure will get built and the energy will flow. But in the meantime these price differentials are going to be a big factor in how profitable energy companies are.

That being said, this is yet another case of one size not fitting all. PetroBakken, for example, released some numbers on its reserves last night that clearly show it’s far less affected than the recent nosedive in its stock would have us believe.

The company continues to execute its development plans, replacing 229 percent of 2012 production with new reserves at a cost of CAD11.91 per barrel of oil equivalent in 2012. Proved-plus-probable reserves grew 10 percent and overall weighting was 82 percent liquids, while the ratio of proved developed rose to 39 percent of overall reserves.

January production came in at 49,700 barrels of oil equivalent per day, in line with projections and ahead of the 47,192 recorded a year ago. And management repeated its forecast that CAD675 million worth of planned capital expenditures would deliver year-over-year production growth of 8 to 12 percent.

The real news in the report, however, is the company is selling light oil at a differential of just 7 percent less than benchmark West Texas Intermediate crude (WTI). That’s far better than the 25 percent to 35 percent for heavy crudes produced by rivals.

And it’s also much better than the internal forecast issued by management for 2013 of a realized price at a 10 percent differential to WTI of USD90 a barrel.

The bears reacted to the report by saying the company “may” have to cut the dividend to bring down its debt.

But that begs this question: Why on earth would management consider a dividend cut when it’s actually beating the previous guidance that the current payout ratio was based on?

This is a commodity business, and by its very nature you can’t really count on producers’ dividends. But when a company does differentiate itself you have to take notice. And I think we have to stick with this one.

As for Bonavista, we got a brief pop following the dividend cut announcement in January, which in retrospect would have been a decent time to take a profit. But at this point there’s no dividend risk and a lot of downside momentum.

It seems obvious that the stock is trading down on overblown worries about natural gas liquids prices. And I think we need to stay in there, though as you’ve pointed out it does yield less than our benchmark of 10 percent now.

As for QR Energy LP (NYSE: QRE) and BreitBurn Energy Partners LP (NSDQ: BBEP), I have a two-word answer for the bears: dividend growth.

There’s no better sign of a company dealing with tough market conditions. And Breitburn’s increase announced in late January was its eleventh in a row–that’s 11 straight quarterly boosts. It’s boosting production and locking in favorable selling prices for it.

So is QR, and I see the consensus projection is for a boost in April.

That’s extraordinary for such an unsettled energy market.

The stocks haven’t performed badly but I think we can expect a lot more going forward and these are very much open positions.

David: Capital Products Partners LP (NSDQ: CPLP), on the other hand, hasn’t raised its dividend in more than two years. Shipping is a really battered industry that doesn’t really look like it’s going to get any better anytime soon.

Roger: I would agree with that.

There are still a lot of old ships out there that many people thought would be retired by now, even as we’re still seeing new building.

It’s important to note, however, that Capital Products is still coping pretty well. The company had better-than-expected distributable cash flow for its fourth quarter, despite the bankruptcy of a major customer that had leased three product tankers.

I think one thing they’ve done very effectively the past couple years is scale up, so they’re not so dependent on a single customer. And that more than anything else has been the difference. Even if they completely lose the cash flow from these tankers, they’re still going to be able to cover the distribution.

And management once again affirmed it intends to keep paying at the current rate during the fourth quarter conference call.

It’s also encouraging that we’ve seen a pretty sharp recovery in the unit price since the beginning of 2013, so we’re now pretty much back to the range of last year.

It’s a very interesting price chart by the way, looks something like a giant “W.” But, more importantly, Capital Products is executing and paying us to hold it.

David: I’m assuming you want to stay with Cushing MLP Total Return Fund (NYSE: SRV)?

Roger: Well, as the person who I work most closely with on this stuff, you know my opinion of most closed-end funds, particularly those of the bond variety.

They trade at steep premiums to net asset value and employ an obscene amount of leverage to maintain dividends. And if there ever is a reversal in the market for the assets they hold–or even a rise in interest rates that makes margining less economic–there are going to be dividend cuts and steep share price losses.

I can’t emphasize enough that conservative income investors are far better off focusing on buying individual master limited partnerships that we recommend in other advisories, or at the very least a more conservative fund such as Kayne Anderson Energy Total Return Fund (NYSE: KYE).

This fund is a nice speculation on the MLP group. But it’s also now above our entry price as well as our target buy price. I would not buy it now and in fact will be tempted to take a partial profit if this thing gets back up around USD9.

David: So essentially we’re staying with everything for now.

And our new readers should be sure to check out the Open Positions table at www.BigYieldHunting.com for more information.

Roger: There’s no doubt this is an environment where high yield stocks are getting beaten up. But I think we have a good lineup and it’s always best to buy when no one else wants to. Thanks, David.

David: Thank you, Roger. Closed Positions

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