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Long-term horizon, dividend investing
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I’ve been dumpster diving through the wreckage of large-cap European stocks recently, paying particular attention to the companies that have been hit so hard that they now pay an annual dividend of over 10%. Personally, I think the notion that diversification is a necessary component of asset allocation might be a bit overstated—after all, companies like Coca-Cola (KO), Johnson & Johnson (JNJ), and General Electric (GE) generate at least half their revenue overseas. And since I plan on converting all my money to US dollars anyway, I’ve never felt the need to own ADRs just for the sake of owning ADRs.

But with the recent market decline among many large-cap European companies, their dividend yields have increased substantially, which has caught my attention. Most shareholders of Altria (MO) will point out that the relentlessly increasing dividend has been the source of serious long-term outperformance, and the research of Wharton professor Jeremy Siegel has pointed out that dividends (and in particular, growing dividends) has accounted for a very large percentage of a stock’s total return over the past century.

Which brings us to Spanish telecommunications giant Telefonica, S.A. (TEF). Telefonica is a large mobile, internet, and telephone company that is headquartered in Madrid and employs over 250,000 people. Their business is largely divided into three separate business units—Telefonica Spain, Telefonica Europe, and Telefonica Latin America. Going into 2011, the Spain unit accounted for 31% of sales, the Europe unit 26%, and the Latin America unit 43%.

Over the past five years, Telefonica has managed to grow revenue at a 17.5% clip, from $14.19 per share in 2006 to an estimated $20.00 per share in 2011 (Note: These numbers are for Telefonica’s ADRs, and the estimates used for 2011 are based on the consensus of analysts covering the company itself). The earnings per share have grown 24.5% over the same time frame, from $1.28 in 2006 to an estimated $2.40 in 2011. And most impressively, Telefonica’s dividend has grown 29.5% over this stretch, from $0.70 per share in 2006 to an estimated $2.20 per share in 2011. The caveat is that the dividends are paid out on a semi-annual basis, with the December dividend usually being sizably higher than the June dividend. For instance, in June 2009, Telefonica paid out $0.544 per share, and in December, paid out $0.726 per share. In June 2010, they paid out $0.82 per share, and in December, they paid out $0.90 per share.

The CEO of the company, Cesar Alierta Izuel, recently indicated his intention to raise the dividend by 15% next year. That is all well and good, but it would be nice to see the earnings growth match the dividend appreciation. In 2010, Telefonica paid out $1.72 per share in dividends on $2.37 per share in earnings. That’s a payout of 72.5%. Personally, I get a little concerned when the payout ratio exceeds 60-65%, because I would like to see reinvestment in the company and a sizable buffer so that the dividend does not become threatened if earnings decline or remain stagnant during a difficult 2-4 year stretch.

To be sure, Telefonica has taken several steps to navigate this difficult stretch. They have recently hired 2,500 people to start a division called Telefonica Digital. The concept is to have four main locations—Silicon Valley, Sao Paulo, Madrid, and London which will help Telefonica achieve technological innovation, unlock economies of scale, and look for cost-cutting opportunities. I’d conservatively estimate increased profitability of 3-5% over the next three years, and if they can internally cut costs by that much (as they plan to do), then we’re looking at 6-10% growth over the medium term, which ought to give the dividend some room to grow.

So far this year, Telefonica paid out $1.073 per share dividend in June. Last year, their December dividend was $0.90. Although I expect their December dividend to be materially higher, let’s conservatively base our calculations on a $1.97 annual payout.

Right now, the shares of Telefonica trade at around $18. Let’s say you make a $3,600 investment in the company in your Roth IRA, purchasing 200 shares. That gives you $394 in annual dividends, which is all the more impressive considering that it is most likely a conservative estimate. Your December dividend will allow you to reinvest in about 11 additional shares of Telefonica at today’s prices, which will throw off roughly $21.67 in annual income. The compounding accelerates pretty quickly when you start off with a dividend yield over 10%. If you buy in at today’s yield of around 11-12%, and reinvest the dividends for ten years (calculations based on current prices and a constant dividend), that annual dividend payout will be around $1,020 in 2021, or 28% of your initial investment. And if the dividend increases at all over the next ten years (and it has at a twenty-percent plus pace for the past five), your dividend returns will amplify quite considerably.

Of course, investors should be aware that 10% yields don't show up without reason. A small minority of analysts are predicting that Telefonica's second half earnings will decline 10-20%, and therefore, the company will either have to borrow to pay its dividend or cut it significantly altogether. Management strongly disagrees with these assertions, and are planning on a substantial dividend raise in 2012. Obviously, time will reveal who is right. But I think that for many investors, Telefonica offers an interesting risk/reward potential. The realistic worst case scenario for this company is that earnings fall and the company has to cut the dividend in half. At today's rate, that's about the same yield that you would get with AT&T (T).

Most investors who are bearish on this stock look at Spain's 20% unemployment rate in some major cities and the economic malaise hanging over the nation and the continent, and conclude that hard times must lie ahead. But the free cash flow coming from Telefonica's Latin American operation is substantial (it accounts for 43% of Telefonica's operations), and Spain only accounts for 31% of sales. To me, the risk reward is worth it. The realistic good case scenario is that you lock in at an 11% or so yield, and watch it rise over the coming years. The worst case scenario is that the dividend gets cut in half, the stock price stagnates for a couple years, and you have to deal with share price appreciation through a 6% semi-annually compounding dividend. A 10% yield does not come without risk, and to me, this might be worth throwing a small percentage of your available funds at.

At today’s prices, putting aside 3-4% of your tax-deferred portfolio into shares of Telefonica seems compelling. At $18 per share, Telefonica is slightly above its 52 week-low of $17.31, and is trading in the vicinity of 6-7x forward earnings. With a sky-high dividend covered so far by earnings, income-oriented investors might want to give this deep value play a look.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Telefonica: Deep Value Play Worth Considering For Retirement Portfolios