Dividend-paying stocks have become increasingly popular in recent years, fueled by an older investing base’s desire to turn accumulated wealth into a reliable income stream and an extended period of ultra-low interest rates and bond yields.
However, investors shouldn’t automatically assume that dividend-paying equities are inherently safer than tech stocks or other cyclical fare. When an income-oriented stock cuts or eliminates its dividend, investors not only suffer a diminution of income but also a significant loss of principal during the subsequent selloff. Understanding a company’s underlying business and its growth prospects are essential to separating the winners from the losers.
While avoiding names at risk of a potential dividend cut is an important component of building a winning portfolio, short sellers can reap outsized returns by identifying and betting against these stocks.
Short sellers have long targeted smaller-capitalization telecommunication stocks–and for good reason.
Beginning with industry deregulation in 1996, the primary owners of local phone lines–the so-called Baby Bells–began to focus on building wireless and broadband networks to replace older copper lines. In this environment, a number of ambitious companies sought to consolidate older networks, betting that traditional telephone services would phase out gradually and generate enough cash to fund the construction of broadband networks and reward investors with huge dividends.
This strategy worked up until the credit crunch and Great Recession, when these companies faced elevated capital costs and unexpectedly high rates of customer attrition from traditional business lines.
FairPoint Communications (NSDQ: FRP) was the first to fall, filing for bankruptcy protection in 2009. The reconstituted company then slashed its dividend in mid-2010 and again in early 2012 when expected synergies from rural-telephone systems that the firm acquired from Verizon Communications (NYSE: VZ) failed to come to fruition.
Competitive pressures forced Alaska Communications Systems (NSDQ: ALSK) to slash its dividend by 77 percent in late 2011 and eliminate the payout entirely a year later. Otelco (NSDQ: OTEL) also zeroed out its dividend last year and filed for bankruptcy protection earlier this year. CenturyLink (NYSE: CTL) likewise delivered a Valentine’s Day shock to investors, slashing its dividend by 25 percent.
The rural telecommunications companies that have managed to maintain their dividends over this period fall into two categories: Names such as Shenandoah Telecommunications Company (NSDQ: SHEN) that pursued conservative payout policies; and operators such as Consolidated Communications Holdings (NSDQ: CNSL) that have offset customer attrition in their traditional telephone business with broadband and wireless services.
Betting against the worst of these companies has generated a windfall for short sellers. Given the success of these trades, it’s no surprise that many of these names face heavy short interest. Although the bears have a good case against many of these companies, this story is well understood at this point; potential upside for short sellers appears limited.
Where should the bears go for fresh meat? Investors looking to avoid ticking time bombs or make money on the short side should focus on names that exhibit certain red flags:
One name that fits the bill from my extensive coverage universe of essential-services companies, Canadian energy stocks and master limited partnerships (MLP): NuStar Energy LP (NYSE: NS).
Although the publicly traded partnership sold a 50 percent interest in its struggling asphalt business and deconsolidated this joint venture from earnings, its subsequent investments in pipelines and other fee-generating assets have yet to offset this lost cash flow. NuStar Energy suffered another cash flow shortage in the second quarter, forcing the partnership to rely on borrowings to fund its distribution.
Management continues to emphasize the potential of NuStar Energy’s current slate of projects. But Moody’s Investors Service downgraded the company’s credit outlook to negative in mid-August. The timing couldn’t have been worse: NuStar Energy was forced to issue 7.5-year notes at the lofty interest rate of 6.75 percent. To worsen matters, management no longer talks about the MLP generating enough cash flow to cover its distribution before 2014. And the partnership’s ratio of debt to cash flow has climbed to 4.3-to-1.
NuStar Energy’s stock price has tumbled to the low $40.00s per unit from almost $55.00 per unit in late April. At the current quote, the stock yields more than 10 percent, suggesting that the market has priced in a distribution cut. That being said, if NuStar Energy slashes its payout by 25 percent or more could depress the unit price into the low to mid-$30.00s.
Short interest in the stock is equivalent to about 1.13 percent of the float, equivalent to about 3.2 days of trading volume. Management vehemently denies any plans to cut the MLP’s distribution, but quarterly results haven’t been encouraging. Conservative investors who haven’t done so already should sell NuStar Energy LP.
Roger S. Conrad is founder and chief editor of Capitalist Times, Energy & Income Advisor and the recently launched Conrad’s Utility Investor.
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