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<< Back to Part XVI - The Near Monopoly In Railroads

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

There are really three industries directly involved in the telecommunications industry: telecom equipment, telecom services (wireless providers), and telecom utilities. There are, of course, companies that overlap more than one of these industries but each is classified based upon the emphasis of it operations. I am explaining this difference because readers will undoubtedly notice that the industry averages differ between some of the companies presented here.

With a continued adoption and convergence of communications (voice, video and data) onto mobile platforms and devices around the globe, the future growth of some of the more globally positioned companies is relatively assured. Some companies have a veritable moat in the form of barriers to entry, be they technology patents, global manufacturing and distribution networks, brand recognition, cost advantages or other sustainable advantages that provide each with a dominant competitive position. Telecom utility companies that once had geographic monopolies for their services now find competition making advances from every side. One could easily argue that cable television companies belong in the telecommunications industry or that those companies and the telecom utilities are converging through service offerings that compete against each other. Both of these industries have huge capital investments in land lines that are also being leveraged by Internet service providers and other Internet-based businesses. All are trying to leverage assets to provide more services and collect more tolls from the data and commerce that travels through those land lines, at least for the final mile to households and businesses. Then again, other companies are trying to provide wireless access to all in an attempt to relegate those same, huge capital investments obsolete. But for the foreseeable future, the sheer volume of data, voice and video that is being transferred requires all forms of transport and that volume continues to grow.

What is most interesting to me is that much of the world's developing economies are skipping right over the investment in land lines and going straight to wireless for everything right up to the house. There are, of course, land-based data centers that are involved in the switching and directing of all those bits and bytes, but the need for wires is lessening in many geographies. That is not to say that there are no land lines for telephones or cables for television in these areas, but that there are competing alternatives available and choices that we in the developed countries did not have when we were at the same stage of economic development. It makes for a very different and interesting world with many more competing forces grappling for a piece of an ever-expanding pie.

I will start out by first looking at the dominant companies in the telecom equipment industry. The first is Qualcomm (QCOM) which is the dominant company in the mobile communications infrastructure technology arena. The company nearly owns the global standard upon which most of the world's mobile communication depends. It owns the patents on technology that is used in nearly all mobile devices around the globe. If QCOM doesn't manufacture the patented components it is paid a royalty by those companies that do so using its technology. For more detailed analysis of QCOM please refer to "A New Effort Will Support Rising Dividends At Qualcomm" or for a different perspective consider "Qualcomm: The Long View," by John Helzer. Now, let's take a look at the metrics for QCOM.

Metric

QCOM

Industry Average

Grade

Dividend Yield

1.7%

1.5%

Pass

Debt-to-Capital Ratio

0.0%

11.1%

Pass

Payout Ratio

28.0%

20.0%

Neutral

5-Yr Average Annual Dividend Increase

14.1%

N/A

Pass

Free Cash Flow

$2.13

N/A

Pass

Net Profit Margin

32.0%

8.9%

Pass

5-Yr Average Annual Growth in EPS

14.5%

-3.3%

Pass

Return on Total Capital

17.7%

10.0%

Pass

5-Yr Average Annual Growth in Revenue

14.3%

5.6%

Pass

S&P Credit Rating

NR

N/A

Neutral

Two neutral rankings and eight passes is hard to beat, especially when you consider that one of the neutrals is due to not being rated by S&P because it has not debt to be rated. QCOM continues to have a bright future with market leading products in a growing marketplace. My five-year target price for QCOM is $97 which, when combined with the growing dividend, should provide an average annual total return of over 15 percent.

Broadcom (BRCM) enables commercial broadband digital transmissions over analog communications infrastructures. Broadcom is into a lot of spaces that need its expertise and it growth potential overseas looks promising. Last quarter and the current quarter should be exceptions for the company in that business has fallen slightly. Growth in some areas has not been able to offset delays in previously expected purchases by Nokia that have been put off until 2013. But increases in capital spending announced by T and VZ have begun to show up in orders for Broadcom. Third quarter results should show improvement and September may provide a good buying opportunity. Let's look at the metrics.

Metric

QCOM

Industry Average

Grade

Dividend Yield

1.3%

1.5%

Neutral

Debt-to-Capital Ratio

15.0%

11.1%

Neutral

Payout Ratio

19.0%

20.0%

Pass

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$1.06

N/A

Pass

Net Profit Margin

13.8%

8.9%

Pass

5-Yr Average Annual Growth in EPS

23.1%

-3.3%

Pass

Return on Total Capital

13.4%

10.0%

Pass

5-Yr Average Annual Growth in Revenue

15.2%

5.6%

Pass

S&P Credit Rating

A-

N/A

Pass

The company rates three neutrals and seven passes. Two of the neutral rankings deal with the dividend; the company has not paid a dividend long enough to assess the growth yet and the yield is slightly below the industry average. The debt-to-capital ratio is slightly higher than the industry average, but still very manageable at 15.0 percent. My five-year price target for BRCM is $45 which translates into an average annual total return of approximately ten percent.

My next list entry is Cisco (CSCO), the beneficiary of the ever-expanding reach of the Internet and all the growing demand for data that requires a supporting infrastructure. A good portion of that infrastructure comes from Cisco. A growing portion of revenues (over 46 percent in 2011) is derived from outside the U.S. Cisco may be one of the few companies that are being realistic about their guidance. That guidance has disappointed investors and the share price has dropped in response providing what I believe to be a great opportunity. Cisco has proven its ability to navigate challenging market conditions in the past and I believe the company will come through the current global economic slowdown in great shape with excellent prospects. Let's take a look at how the company fares against the metrics.

Metric

CSCO

Industry Average

Grade

Dividend Yield

2.0%

1.5%

Pass

Debt-to-Capital Ratio

26.0%

11.1%

Fail

Payout Ratio

17.0%

20.0%

Pass

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$0.88

N/A

Pass

Net Profit Margin

15.0%

8.9%

Pass

5-Yr Average Annual Growth in EPS

7.9%

-3.3%

Pass

Return on Total Capital

10.7%

10.0%

Pass

5-Yr Average Annual Growth in Revenue

11.1%

5.6%

Pass

S&P Credit Rating

A+

N/A

Pass

One fail, one neutral and eight pass rankings is a good showing. The neutral ranking stems from not having offered a dividend long enough to assess; the second year of dividends has given holders a 12.5 percent increased. The fail comes from the debt being 26 percent, which is high for a technology-based company. But I believe that the debt level is manageable for Cisco because of the free cash flow levels. My five-year price target for CSCO is $28.50 which should provide an average annual total return of about 15 percent.

The telecom services industry has some 800-pound gorillas in AT&T (T), Vodafone (VOD) and Verizon (VZ), but my favorite from a long-term investment perspective is America Movil (AMX) based primarily upon its growth prospects in Latin America. The company has doubled subscribers just since 2007 and there is still significant potential growth left in the future. I don't necessarily like the dividend yield but the company has made special dividend payments in 2007 and 2009. While I don't necessarily expect more special dividends in the future, I do expect the dividends to rise more in sync with earnings going forward. Let's look at the metrics.

Metric

AMX

Industry Average

Grade

Dividend Yield

1.1%

4.6%

Fail

Debt-to-Capital Ratio

49.0%

40.1%

Neutral

Payout Ratio

18.0%

60.0%

Pass

5-Yr Average Annual Dividend Increase

6.4%

N/A

Neutral

Free Cash Flow

$0.36

N/A

Pass

Net Profit Margin

12.9%

9.5%

Pass

5-Yr Average Annual Growth in EPS

6.8%

5.2%

Pass

Return on Total Capital

13.4%

8.5%

Pass

5-Yr Average Annual Growth in Revenue

15.3%

6.2%

Pass

S&P Credit Rating

NR

N/A

Neutral

On fail, three neutrals, and six passes is just barely good enough to make the cut. The company's debt is slightly higher than I would like it to be, the dividend could be higher and increases could be more consistent. As penetration of its markets increases and growth begins to slow somewhat (likely to be several years away), I do believe that more emphasis will be placed upon returning value to shareholders through dividend increases. Of course, this is more speculation than fact at this point. My five-year price target for AMX is $44 which works out to an average annual total return of over 17 percent.

I also like AT&T as a long-term holding, but do not expect the total return to be nearly as high. This is one of those companies that pays the nice dividend and increases it every year. I have owned stock in this company for several years. However, when I tightened the metric measurement methodology for free cash flow, both T and my other telecom services holding, VOD, fell off the list. I am including the metrics for both T and VZ because I think that both are fine to hold and will be able to adjust cash flows without reducing dividends. But neither is on the list.

Metric

AT&T

Industry Average

Grade

Dividend Yield

5.3%

4.6%

Pass

Debt-to-Capital Ratio

36.7%

40.1%

Pass

Payout Ratio

78.0%

60.0%

Fail

5-Yr Average Annual Dividend Increase

5.3%

N/A

Neutral

Free Cash Flow

-$1.14

N/A

Fail

Net Profit Margin

10.3%

9.5%

Pass

5-Yr Average Annual Growth in EPS

-1.2%

5.2%

Fail

Return on Total Capital

8.9%

8.5%

Pass

5-Yr Average Annual Growth in Revenue

5.6%

6.2%

Neutral

S&P Credit Rating

A-

N/A

Pass

Three fails, two neutrals and five passes. On that basis I could not include T on the list. The fail for EPS growth has to do with its failed bid for T-Mobil last year. I expect the company to be back on the list in 2013 or 2014 as its operating earnings continue the gradual climb. My five-year target for T is $47 which would provide an average annual total return of about 12 percent. There is nothing wrong with that.

Verizon is in a similar boat with negative free cash flow based upon my worst case methodology which includes 20 percent of the debt maturing over the next five years. Again, for those readers who are new and unfamiliar with my estimate of free cash flow, I am eliminating companies that would need to reduce either dividends or capital spending (or both) if credit markets were to freeze up again and refinancing debt were to become impossible. I realize that it is a very stringent rule, but it really filters out a lot of companies with a lot of debt maturing soon. My purpose for using this method is to be prepared for the worst if things go very badly in the European sovereign debt crisis and the collateral damage affects U.S. financial institutions more than expected. I really don't believe that the banks here or in Europe are in good shape, especially in Europe.

Metric

VZ

Industry Average

Grade

Dividend Yield

4.8%

4.6%

Pass

Debt-to-Capital Ratio

33.5%

40.1%

Pass

Payout Ratio

91.0%

60.0%

Fail

5-Yr Average Annual Dividend Increase

3.9%

N/A

Neutral

Free Cash Flow

-$2.13

N/A

Fail

Net Profit Margin

5.5%

9.5%

Fail

5-Yr Average Annual Growth in EPS

-3.2%

5.2%

Fail

Return on Total Capital

8.0%

8.5%

Neutral

5-Yr Average Annual Growth in Revenue

5.3%

6.2%

Neutral

S&P Credit Rating

A-

N/A

Pass

VZ has four fails, three neutrals and only three passes. This doesn't seem to make sense when thinking about the history of the company and its position in the market, but it is not a top performer and the metrics don't lie. About half of the total return I expect from VZ is likely to come from the dividends. Again, it is not a bad company. It just isn't a great company by these metrics and I have to draw the line somewhere.

As for the rest of the telecom industry participants, I don't include companies that do not pay dividends or companies that are not listed on U.S. exchanges. If the company has negative free cash flow it does not make my list, either. If the company fails in three or more categories it also does not make the list. If a company has a credit rating below BBB- from S&P it does not make the list. Finally, if a company has reported negative EPS growth over the last five years while the industry has been positive, it does not make the list. I prefer not to provide an explanation for every company in each of these three industries, but I will spend a little time on a few notable companies that are missing.

VOD would have made the list with two fails and three neutral rankings if it had reported positive EPS growth over the 2006 - 2011 period. Telecom New Zealand (NZT), Shenandoah Telecom (SHEN) and Telephone and Data Systems (TDS) all have negative free cash flow while NZT and SHEN also had negative EPS growth. Sprint (S) is still reporting losses.

Adtran (ADTN) has a flat dividend which hasn't been increased since 2005. Nokia (NOK) and Ericsson Telephone (ERIC) pay very nice dividends, but the companies have posted inconsistent EPS. The company has also cut its dividend more than once. Motorola Solutions may belong on the list, but I am hesitant because the company has a relative short history since its spinoff.

BCE (BCE) and Telefonica (TEF) have negative cash flows as do Deutsche Telecom (OTCQX:DTEGY), Windstream (WIN), and Frontier Communications (FTR).

That concludes my assessment of the telecommunications industry. I hope you have found it interesting and informative. If you would like to read my assessments on other industries, a complete list of all articles in this series is available with the articles listed both chronologically by date of publication and by industry in my blog titled, "The Dividend Investors' Guide to Successful Investing Index Blog." As always I welcome comments and will attempt to answer any questions. The exchange of information is always welcome and it is how we all become better informed investors.

Source: The Dividend Investors' Guide: Part XVII - Talking About Communications