Standard and good advice for a balanced portfolio includes having some solid dividend payers. The value of either a steady income stream or compounding over time is clear. The challenge comes in finding companies that you can count on to deliver those dividends over time. In this review, let's look at the very popular telecom stocks. They all have nice yields and can be attractive to dividend investments - however, as the recent dividend cuts at CenturyLink (CTL) show, they may not be certain.
CenturyLink made an interesting move by cutting the dividend and then announcing a $2 billion share buyback program. In the CenturyLink statement about the change, it said: "The share repurchase program, which will be accretive to free cash flow per share, along with our very competitive cash dividend, will enable us to significantly increase the total cash returned to our shareholders in 2013 and 2014. Additionally, we are positioning the company to maintain a dividend payout ratio of less than 60 percent of free cash flow after we have fully utilized our federal income tax net operating loss carryforwards." Why would it be doing this and could other dividend-paying telecoms do the same?
All these stocks are slow movers as shown by their beta of less than one. Verizon and AT&T move the slowest while Sprint and Windstream tend to move the fastest, relatively speaking.
Price does not tell the whole story, to compare relative value, we also need to look at the Price / Earnings multiple and the Price Earnings Growth ratio. For the P/E ratio I prefer to look at the trailing twelve months because this is based on actual results, not analyst expectations. In the below table, also included is the industry P/E and PEG for comparison
Sprint jumps out with no P/E ratio and a negative PEG driven by its earnings losses. On the remaining, all but Verizon are right around the industry average. Only Verizon is way below the average - by this measure, Verizon is currently undervalued. The PEG ratio shows both Sprint and Windstream with negatives. At the far extreme, CenturyLink is 10 times the industry average suggesting by this measure it is significantly overvalued.
Now, let us look at the dividends. Of the six, only Sprint does not pay a dividend. This makes sense given they are not making a profit. At the top end, Windstream is paying almost 12% with Frontier at nearly 10%. Based on the recent cuts and what we will see a bit later, these were clearly unsustainable. CenturyLink is next at about 6% with AT&T and Verizon in the four range.
What is most striking about this table is that all are paying dividends beyond their earnings. Wait a minute, how can that be - they are paying shareholders more than they are earning? Yes they are. As the next table shows, all five payers are distributing cash at a much higher rate than they are earning it.
OK, how can that be? Let us try to follow the money trail through the financial statements to see where these payments are coming from. Dividends are partly a function of earnings and partly a function of cash flow. With payout ratio above 100%, it means these companies are pulling value off their balance sheets to pay shareholders.
Our first stop is at the cash on hand according to the balance sheet. Sprint has the highest cash position per share with almost half their share price in cash. Frontier is next with 33% and the balance are running 3% or less. With the majority with very little cash on hand per share and Sprint not paying a dividend, this is clearly not where the funds are coming from.
Are they borrowing the money to pay? There are two types of debt - short term (due in the next 12 months) and long term.
Short-term debt and assets are helpful to study because they show a company's ability to pay its immediate bills. This ability is often expressed by the Quick Ratio. A QR above 1 indicates that short-term assets (minus inventory) are large enough to cover short-term liabilities. A QR of less than one indicates a shortage and the firm is relying on future earnings and cash flow to pay their bills.
In the telecoms, Sprint and Frontier are the only two with QRs above zero. The remaining four are counting on future earnings and cash flow to pay their bills.
Looking at long-term debt, we need to examine the trends. The table below shows the trends over the last three fiscal years of each firm's long-term debt. All except Verizon have increased their long-term debt. Verizon has significantly reduced their long-term debt.
Is this a bad thing? Not necessarily because firms sometimes need to borrow to reinvest and with the structural shift from legacy copper wires to fiber optics and wireless, some significant investment is needed. What this chart shows is that, possibly, part of the dividends are being funded through borrowing.
Now, let us look at Retained Earnings. RE is the percentage of net earnings not paid out as dividends. These earnings are held by the company to be reinvested in its core business or to pay debt. The calculation is: RE = Beginning RE + Net Income - Dividends Paid.
To see what is happening here with our telecoms, we also need to look at a 3-year trend. The table below shows the retained earnings from 3 years ago to the most recently completed fiscal year.
What jumps off the table is that every company has declining RE. Sprint was negative three years ago and has continued to get worse. The rest have all reduced their RE significantly over the last three years.
OK, so now we see that the companies are increasing their borrowings and reducing their retained earnings. If this money is being reinvested in the business, presumably we will see it in increasing assets.
Looking at the following table, also showing the data over the most recent three years, all the companies are increasing their asset base.
But, this asset increase is far less than the increase in debt combined with the reduction of retained earnings. As the following shows, only Verizon has not increased its financial position. It has used the increase in debt and cash flow from earnings to pay down debt somewhat at the expense of retained earnings. All the other firms have not put their funds to as good use. An argument could be made that they have actually destroyed shareholder value over the last three years.
Before drawing any conclusions, let us take a quick look at the trends on margins - gross and operating. Another sign that the investments being made are having a positive result is if the margins are increasing.
Each of the telecoms is growing their revenue. Sometimes growth requires funding, which would be another drain on cash. However, the growth rates over the last three years, with the exception of CenturyLink, do not appear to be significant enough to consume significant cash.
And, this growth is happening while, the margins are shrinking, except for Verizon and CenturyLink. (Note: Frontier does not report gross margins in its financial statements). At the Operating Income line, Frontier has held steady while the remaining five all have declining Op Income. So they are growing but with declining margins.
We have seen that these companies are paying dividends in excess of their income. These payments appear to be funded, at the broadest level, by increasing debt levels. Overall, Verizon appears to be managing their balance sheet well for the long term, but their 650% payout ratio is a concern.
Summarizing all the trends we have examined…..
We saw CenturyLink change its capital allocation strategy under the financial strain. The others in this group might be in slightly better relative financial health, but they should be watched closely for changes in their debt management, cash flow, continued reduction of retained earnings and further erosion of margins. Any more deterioration in any of these areas could be a trigger for reducing dividends. And when this happens the stock price will take a hit hurting both your income and portfolio value.
So bottom line, the telecoms are offering very attractive yields, but they are not risk free. If you have a portion of your portfolio here, these must be watched as closely as any other stock you own.
Additional disclosure: I am long T puts. I have no business relationship with any company whose stock is mentioned in this article. I am not a registered investment advisor and do not provide specific investment advice. The information contained herein is only my opinion based on personal research and offered for informational purposes. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling any equity, do your own research and reach your own conclusion. Investing includes risks, including loss of principal.