Big Dividends From Telecom Stocks

Once upon a time -- before the Internet, before the iPhone, before Skype -- Ma Bell ruled the phone world. She provided local and long-distance service and made most of the key equipment, too. American Telephone & Telegraph, Ma’s official name, was considered a utility, so regulators told her how much she could charge for her services. Ma wasn’t a fast grower, but she did expand at a steady pace and paid generous dividends. Investors saw her as a relatively safe bet and came to view her as the quintessential widows-and-orphans stock.

In 1984, however, Uncle Sam broke up the Bell System, helping to accelerate a transformation that would revolutionize the telecommunications industry -- a transformation that continues today. But one thing has remained constant. Telecom is still the go-to sector for juicy dividend yields. With money-market funds offering nothing, the overall stock market yielding 2.0% and ten-year Treasury bonds still paying only 3.4%, phone-stock yields of 5% and more are hard to pass up. In fact, of the 12 highest-yielding companies in Standard & Poor’s 500-stock index, five are telecoms. Their yields range from 5.5% for Verizon Communications (symbol VZ) to 7.8% for Frontier Communications (FTR).

Too good to be true? But a key rule of dividend investing is, don’t judge a stock by yield alone. Exceptionally high yields are often a sign that a company is in trouble and could soon cut -- or even eliminate -- its payout. Unfortunately, what dividend investors most want from a company -- safe and steady earnings -- is no longer a given in the telecom industry.

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Companies that mostly serve traditional land-line users are losing revenue as their customers go completely wireless. The wireless sector, meanwhile, continues to grow, but not at as fast a pace as it once did, and competition among carriers is fierce.Except for AT&T and Verizon, most of the highest yielders are rural, land-line-oriented companies trying to adapt in a shrinking market. Some are trying to raise revenues by selling “triple play” packages of Internet, phone and TV services to residential customers over their copper-wire networks, while others are focusing on providing services to business clients. “Being a land-line provider may not be as profitable and have the kind of growth prospects as a wireless provider, but it need not be a death knell,” says Lisa Pierce, president of Strategic Networks Group, a telecom-research outfit in Bradenton, Fla.

With customer loyalty a thing of the past, investors need to look at two key figures to evaluate a telecom company’s health: subscriber growth and churn rate. Subscriber growth tells how many new customers a company acquired during the quarter. The churn rate measures the percentage of subscribers who drop their service. A churn rate that is greater than the subscription growth rate is a bad sign.

Frontier’s lusty yield is a warning sign. The figure is high even though the Stamford, Conn., company last September reduced its annual payout rate from $1 per share to 75 cents. The move came in conjunction with Frontier’s purchase from Verizon of 4.8 million land-based lines in 14 states. Including assumption of Verizon debt, Frontier paid some $8.6 billion.

Because companies need actual cash to pay dividends, it’s important that they generate enough of the green stuff to cover their distributions. Rather than focus on reported profits, investors need to study a company’s free cash flow -- essentially earnings plus depreciation and other noncash charges, minus the capital expenditures needed to maintain the business. Free cash flow has to be sufficient to cover both dividend and interest payments. In the third quarter of 2010, Frontier generated $339 million in free cash. It paid $186 million in dividends, so its payout ratio -- dividends as a percentage of free cash flow -- was 55%. Below 60% is ideal for telecom companies. But a payout ratio above 75% is a danger sign.

After the Verizon deal, however, Frontier’s quarterly interest payments soared 72%, to $166 million. Add those interest payments to the dividend distribution, and cash needs now exceed free cash flow by $13 million, making the current payout rate look iffy. And with Frontier’s stock up nearly 41%, to $9.58, since June 30, the risk is too great. Best to avoid the shares (all prices and related data are through the December 27 close).

Waiting for iPhone. A shortage of cash is not a problem for Verizon. For the nine months that ended September 30, the New York City-based Baby Bell generated $13.4 billion in free cash flow, and it paid $4 billion in dividends, for a payout ratio of 30%. Verizon closed at $35.50.

Verizon Wireless, 55% owned by Verizon and the rest owned by Britain’s Vodafone, is the nation’s largest wireless carrier measured by the number of subscribers. Growth is slowing, however. In the third quarter of 2010, the number of new wireless subscribers fell 28.8% from the second quarter.

Things could change quickly in 2011, when AT&T (T) loses its exclusive arrangement with Apple (AAPL) to sell the iPhone. Combining one of the hottest-selling electronic products on the planet with the Verizon wireless network, which is generally rated better than AT&T’s, could make 2011 a banner year for Verizon. Verdict: The dividend is safe, and the expected arrival of the iPhone could reignite subscriber growth, pushing up Verizon’s shares. Buy Verizon.

On the defensive. The new AT&T, a former Baby Bell that was once called SBC Communications and is not to be confused with the original Ma Bell, is performing well. Third-quarter revenue rose 2.8% as wireless revenues grew 10.5% and data sales climbed 7.4%. AT&T added 2.6 million wireless subscribers -- an all-time high for third-quarter additions -- for a total of 92.8 million.

Of course, what would be a blessing for Verizon -- obtaining rights to sell the iPhone -- would be problematic for AT&T. Such a development would certainly lower subscriber growth and might even lead customers to defect and cause a net reduction. Presumably, investors are aware of this risk, and the likely development is baked into AT&T’s shares, which closed at $29.25.

With free cash flow of $4.0 billion in the third quarter of 2010 and dividends of $2.5 billion, the payout ratio is 64%. The dividend is safe, but uncertainty surrounding the likely loss of iPhone exclusivity is great.

For a truly fat yield, consider Windstream (WIN). At $14.23, its shares yield 7.0%.

When Alltel jettisoned its land lines in 2006, the spinoff merged with Valor Communications to become Windstream. In 2009, the Little Rock, Ark., company bought four companies for a total of $2.2 billion and now has operations in 23 states. While shedding land lines, Windstream is moving into business services, as represented by its $310-million purchase of Hosted Solutions, a provider of Web hosting services, in November. Donna Jaegers, a research analyst at investment bank D.A. Davidson, says business services now account for 57% of the company’s revenues, which jumped 32% in the third quarter, to $966 million. When it released its third-quarter results, Windstream boosted its estimate of free cash flow in 2010 by about 6%, to between $814 million and $859 million. With the company now paying dividends at an annual rate of $465 million, the payout ratio is 54% to 57%. The dividend appears to be safe.

Fund options. The problem with telecom funds is that they don’t focus on the high yielders. Consider Fidelity Select Telecommunications Portfolio (FSTCX). Verizon and AT&T are its two biggest holdings and account for 23% of the portfolio. After that, the fund holds a bunch of low yielders, as well as stocks that pay no dividends. Although the fund returned 17.8% in 2010 through December 27), its current yield is just 1.3%.

If you want an unmanaged approach, Vanguard offers its Telecom Services fund in both mutual fund (VTCAX) and exchange-traded (VOX) formats. Although the ten biggest holdings of both funds include Verizon, AT&T, Frontier and Windstream -- and Verizon and AT&T account for 44% of assets of both – the funds also own many low-paying stocks. As a result, although each fund returned 19.4 % in 2010 through December 27, each yields a modest 2.4% (note that the minimum investment for the mutual fund is $100,000).