Telecom Companies: 3 Safe, 4 Dangerous Dividends

Includes: BCE, CNSL, CTL, FTR, T, VZ, WIN
by: Efsinvestment

While many investors consider telecommunication stocks as old school, this industry is highly dynamic in its nature. Traditionally, the companies in this sector used to derive their revenues from network services such as voice communication. However, with the invention of high-speed data networks, the data services provided by telecommunication companies became an integral part of our society. There is an ever increasing demand for data services, which, I believe, will replace the traditional services as the primary source of revenues.

Telecommunication companies are the cash cows of the market. The profits and regular cash flows are appetizing. However, becoming a telecommunication provider requires significant amount of initial capital. Given the dominant market position of incumbent companies, it is almost impossible for new companies to enter this sector. Consequently, we observe an oligopolistic structure, where few companies dominate the industry.

While the telecom stocks were deeply affected from the financial crises, the recovery was strong. Income-inelastic telecom services like internet, GSM, home telephone services saved the telecom companies during the recession. Most companies in this sector share their profits with the shareholders by means of nifty dividends. However, a higher yield does not necessarily imply a good deal. High dividend is good, but sustainability of the dividends should also be considered. It is always a good idea to find out whether the stock can keep paying this dividend or not.

Therefore, I have analyzed the highest yielders that operate in the U.S and Canada. Based on my analysis, I rate 3 of them as safe dividends, but 4 of them as risky. Here is a brief analysis of 3 safe and 4 dangerous dividends:

Safe Dividends

AT &T (T) offers a yield of 5.92% with a payout ratio of 87%. It has a market cap of $172 billion. At the beginning of the year, AT&T announced its intention to acquire T-Mobile USA from Deutsche Telecom (OTCQX:DTEGY) for $39 billion. However, there has been a strong opposition from the regulators. Soon after the Federal Communications Commission reported its negative opinion on the merger, AT&T fired back, stating that the report was biased. However, in the mean time, AT &T withdrew its FCC application on the T-Mobile deal, suggesting that the company's priority will be Department of Justice's approval. However, overcoming the DoJ barrier would be a really hard issue to tackle with. The law suit regarding the merger is due in the federal court. I think, sooner or later, this issue will become a political subject. In a recent press release, AT&T stated that the FCC blockage to the deal will cost $4 billion in potential breakup fees to Deutsche Telekom. Apparently, if the deal is not approved, the AT&T shareholders (and customers) will pay their fees to contribute in the Euro zone bailout.

Looking at AT&T's aggressive merger and acquisition record, I believe the telecom giant will be able to finalize the deal. However, it is obvious that such a large entity will restrict the competition in an already concentrated industry. Therefore, It is very likely that the finished merger deal will significantly differ from the original intention. Nevertheless, AT&T is trading at a low forward P/E ratio of 11.7. The company would still have enough profits - even after the $4 billion break-up fees- to keep its yield. Therefore, I think AT&T is a safe dividend stock.

Verizon Communications (VZ) offers a yield of 5.2% with a payout ratio of 78.5%. It has a market cap of $108 billion. Verizon Communications has very similar ratios to that of AT&T, but the forward P/E ratio 15 suggests not-so-bullish earnings estimates for the next year. Vodafone (VOD) has a 45% stake in the company. Verizon Communications also owns 55% of Verizon Wireless company. The rest is owned by Vodafone.

The stock has been an outperformer, returning 14% in this year. I think the company has sustainable quarterly dividends, which has been raised to 50 cents in the last quarter. Dividends have been very stable throughout the last 5 years. In fact, dividends increased by near 30% in the last 5 years with a sustainable payout ratio. I think Verizon offers safe dividends. But, I would rather wait for a pullback to buy more, since the stock is trading near 52-week highs.

Bell Canada Enterprises (BCE) offers a yield of 5.7% with a payout ratio of 89%. It has a market cap of $32.4 billion. Founded in 1880, BCE is one of the oldest companies in Canada. The company increased its dividends by 7.7% in the beginning of the year. The stock has been a nifty dividend payer, consistently increasing its dividends. In the last 5 years, dividends increased by almost 50%. This year, the company also increased its dividends. In the next year, EPS increased is expected to reach $3.23. Surely, that is more than enough to pay the current dividends.

Similar to Verizon, BCE has been an outperformer, returning 18% in this year. It is also trading near its 52-week high. While I think BCE is a cheap stock with safe dividends, I would rather wait to buy its shares.

Dividends in Danger

Century Link (CTL) offers a yield of 8.12% with a payout ratio of 223%. It has a market cap of $22 billion. Century Link operates as an integrated telecommunications company. The company has acquired Embarq and Qwest in 2009 and 2010, becoming the third largest telecommunication company in the U.S.

The stock has been loser so far in 2011, returning -17%. That is one of the reasons why the yield is high. Another reason for the high yield is the high payout ratio. Obviously, the company would not be able to support 223% payout ratio. Forward P/E ratio falls to 14. Assuming a 100% payout ratio for the next year, that will result at an approximate yield of 7% for the next year. Still a great number, but it all depends on whether the company can support analyst estimations or not.

Windstream (WIN) offers a yield of 8.53% with a payout ratio of 198%. It has a market cap of $6 billion. Windstream has been a great dividend payer, offering a stable $1/year dividend since 2007.

It is great to have consistency in the dividend payments, but Windstream's payout ratio is obviously beyond its limits. The balance sheet shows an alarming debt/equity ratio of 9, and P/B ratio of 7.37. The stock has a book value of only $1.59. It might still offer its nifty dividend of 25 cents per quarter, but investors should note the downside risks of investing in the company.

Frontier (FTR) offers a yield of 14.5% with a payout ratio of 500%. It has a market cap of $5.1 billion. Frontier has the best yield in the industry, but the payout ratio is obviously unsustainable. In a recent article, Jim Pyke, pointed out a possibility of dividend reduction. Using a simple Capital Asset Pricing Model, he suggests that either the price is not justified or the yield is not sustainable. The discount rate used in the process was 12%, which is similar to my standard discount rate of 11%.

Looking at the stock, it still looks expensive with a trailing P/E ratio of 34.4, even after losing 40% in 2011. While the yield is appetizing, the future of the yield is uncertain. The management can insist on offering the $0.75 dividend payment, but they need to generate enough cash to sustain this dividend. Cramer is also bearish on the stock, pointing out a possible dividend cut.

Consolidated Communications (CNSL) offers a yield of 8.35% with a payout ratio of 186.5%. It has a market cap of $555 million. The company operates as a telecommunication services provider in the states of Illinois, Texas, and Pennsylvania.

The company generates enough cash-flow to support the dividends, but the debts are at alarming rates. The debt-to-equity ratio of 15 is the highest among its peers. At some point, sooner or later, the debts need to be paid. However, instead of reducing the debt load, it is the management's policy to pay the standard dividend of $1.55. They paid this dividend since the last 5 years. At the same time, insiders are literally dumping their stocks. I think investors should be very careful with this company. The current price offers a compelling exit point.

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