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The Income Investor’s Unicorn

By Ari Charney on June 10, 2016

Every income investor loves the idea of investing in high-yield stocks.

After all, even though the Federal Reserve is nominally in rate-hiking mode, interest rates remain near historic lows, leaving a lot of retirees scrounging for income and, therefore, yield.

That can make high yielders look like the answer to all of your problems. But as many income investors have come to learn (or re-learn) in recent years, the reality is that high yields often come with high risk—or at the very least, higher risk than the average dividend payer.

And if you’re a risk-averse investor, the high-yield pickings are slim. The high-yield equity space is far more concentrated than most would imagine, particularly in areas that most conservative investors should avoid.

The four main high-yield categories include energy-oriented master limited partnerships (MLPs); specialty financials, such as business development companies (BDCs) and mortgage REITs (an ultra-leveraged real estate investment trust that holds pools of mortgage-backed securities); Canadian companies that have attempted to maintain their high yields even after converting from income trusts back to corporations; and busted companies or other turnaround plays whose yields jumped following a steep selloff that portends a dividend cut.

In most of these areas, the high payouts are bought and paid for with leverage. I don’t mean that they’re literally borrowing to fund their dividend, though there are companies that are in such straits. Rather, their business model entails using leverage to build or acquire new infrastructure, such as what midstream MLPs do, or enhance returns on investments, an approach that both BDCs and mortgage REITs use.

Many of these operations employ leverage quite skillfully. But that leverage can bite even the best when the business cycle turns.

At Utility Forecaster, some of the high yielders that we get asked about most often are a couple of telecoms: CenturyLink Inc. (NYSE: CTL) and Frontier Communications Corp. (NSDQ: FTR).

But these two shouldn’t be mistaken as higher-yielding versions of AT&T and Verizon. Both CenturyLink and Frontier are essentially turnaround plays, though the former has been far steadier than the latter.

Equally important for income investors, unlike the two telecom giants, both CenturyLink and Frontier have shown that their dividends are hardly sacrosanct: The former cut its payout by more than 25% in 2013, while the latter slashed its dividend by 25% in 2010 and then a further 47% in 2012.

We used to track these firms in our wider How They Rate coverage universe, but jettisoned them last year because we didn’t believe these “hold”-rated entities would merit a “buy” again anytime soon.

Basically, these companies, like some other telecom also-rans, are trying to find a way to offset the slowly eroding earnings from their legacy wireline assets by pushing into higher-growth areas.  

The problem is that many of these higher-growth areas already have well-entrenched incumbents that can easily afford to outspend CenturyLink and Frontier. Meanwhile, both companies have taken on higher debt in search of new growth.

In 2011, for instance, CenturyLink acquired Qwest Communications in a $10.4 billion all-stock deal that included the assumption of $11.8 billion in debt. That, along with other deals, has boosted the firm’s net debt to EBITDA (earnings before interest, taxation, depreciation and amortization) ratio to around 3.0x from the 2.0x level that preceded the deal.

Frontier has also been involved in similar strategic acquisitions, particularly the piecemeal purchase of Verizon’s wireline business. The first major deal was in 2010 for 4.8 million of Verizon’s rural access lines, a transaction that included the assumption of $3.3 billion in debt.

The next major deal was completed earlier this year: The $10.5 billion acquisition of Verizon’s wireline operations in California, Texas and Florida. The all-cash transaction was funded in part with a $6.6 billion junk-bond offering, with yields ranging from 8.9% to 11.0%. Consequently, Frontier’s leverage ratio has, at least temporarily, ballooned to 5.0x from 4.0x.

Shareholders are counting on each company’s management team to have the strategic vision, timing, discipline, and perhaps even luck to make these deals work. In particular, the beleaguered Frontier has finally peeled away some high-quality assets from Verizon, albeit at significant cost.

Nevertheless, both stocks have relatively high short interest: 9.6% of CenturyLink’s publicly traded shares are held short, while about 12.3% of Frontier’s float is held short. That suggests the market believes both firms face long odds of success.

And while both stocks yield north of 8%, their payouts lose their attraction once you see that CenturyLink and Frontier’s share prices have dropped by 33.0% and 35.7%, respectively, over the past five years. So on a dividend-reinvested basis, their shareholders are still in the red.

Even so, we’ll continue to monitor CenturyLink, Frontier, and other high-yielding telecoms. In the event that their management teams appear on the verge of unlocking long-term shareholder value, then we’ll add them back to our coverage universe.


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