Desperately Seeking Yield Through Equities: Part 4 - Telecom Stocks

Includes: BCE, CTL, FTR, T, VZ
by: Philip Mause

Most lists of stocks with high dividend yields which are not oriented to the flow-through entities discussed in Parts 1-3 (and which will be discussed in some future parts) include one or more telecom stocks. In this part, I will discuss companies which are primarily in the business of providing telecommunications services and whose dividend yields make them attractive to yield oriented investors.

First, here are the companies which seem to appear frequently on lists of high yielding stocks(in each case I will give the symbol, Friday's closing price and the current dividend yield).

  1. Frontier Communications (NYSE:FTR): (7.87), (9.6%)
  2. CenturyLink (NYSE:CTL): (39.45), (7.4%)
  3. AT&T (NYSE:T): (30.77),(5.7%)
  4. Verizon (NYSE:VZ): (35.51), (5.6%)
  5. BCE (NYSE:BCE): (37.86), (5.3%)

Some background information is important here. Until about 30 years ago, the telecom industry was essentially based on a regulated monopoly model. There was no internet, cable television coverage was limited and only a few wealthy people had "car phones." It was a very good business because costs were going down due to technological advances and rates did not necessarily go down as fast because of "regulatory lag." A high percentage of earnings could be paid out as dividends because of the stability of the business; this also justified relatively high levels of debt which had been assumed in order to fund the constant need for capex. There was the beginning of competition in the long distance market which was viewed as the really profitable part of telecom because traffic was growing so rapidly. Most customers had copper wire voice service.

There are probably few other industries that have experienced so much change over this period of time. Mobile phones have become ubiquitous, the internet and internet telephony have become dominant and cable systems have built out to cover a very high percentage of households. That copper wire voice service which dominated the industry in the past is becoming quaint and more and more customers are deciding that they don't really need it because (1) they can rely completely on their mobile phones, or (2) they can use internet telephony instead.

On top of this, regulation changed and encouraged competition throughout the industry. These changes have created both challenges and opportunities for telecom companies. On the one hand, some of these companies have been able to provide wireless service and expand into a growing and profitable business line. They have also been able to offer internet service and television service by enhancing the capacity of lines serving their customers. On the other hand, the abandonment of traditional voice service has eroded revenue and continues to do so.

Each of these companies faces this set of issues. Revenue from traditional voice service is declining inexorably on a sequential basis as customers abandon the service - usually at an annual rate of between 5 and 10% per year. In order to stay profitable, these companies must 1) expand wireless service and revenue, 2) expand services like FIOS which offer customers a combination of internet access, television service and internet telephone (the trifecta) and 3) cut costs.

Items 1 and 2 require capital expenditures although, as to the second item, there is a build-out point at which marginal capex declines because coverage has been extended to a large enough part of the service territory. Not all of these companies offer wireless service and, for the ones which do not, the challenges may be more daunting. Finally, there has been a pattern of consolidation in the industry which should make it easier to achieve objective 3 (reducing costs).

T and VZ are well known to most investors and are Dow 30 stocks. VZ has a territory including the old Bell Atlantic and GTE territories - basically the Eastern corridor and certain areas that were GTE legacy territories (notably in the LA, Dallas, and Tampa areas), T has most of the rest of the country except for the Qwest legacy territories (Pacific Northwest, Northern Rocky Mountain, Northern Great Plains) that have been taken over by CTL. FTR has a variety of mostly, but not exclusively, rural territories throughout the country. FTR receives some funds from the FCC Universal Service and High Cost Funds. These funds do not tap into taxpayer money and so should not be threatened by the budget debate. On the other hand, changes in how these funds are administered are always possible and apparently are under discussion.

T and VZ are the Big 2 in Wireless , CTL resells VZ wireless service and FTR is not a wireless carrier (although it provides WIFI and wireless data services). BCE does both wireline and wireless(and several other things in Canada).

Aside from wireless, which is a competitive industry but which is certainly characterized by important product differentiation, these companies are now in several different businesses. One business is the declining old copper wire voice telephone business. One might think that this business would decline a certain amount and then flatten out as everyone who wanted to shift to another service would have done so. However, demographics play a role here. Many of those who continue to use traditional voice service are senior citizens who will never switch to mobile or FIOS. Each quarter, there will iikely be some attrition due to the Grim Reaper, transfers to nursing homes or transitions to living with relatives. At this point, the decline seems steady and inexorable but each quarter there is a smaller base from which the decline is subtracted.

Most of these companies offer FIOS or some other service or services designed to provide the customer with the trifecta - in some cases, bundling other services with satellite television to get to the trifecta. In this regard, these companies are somewhat similar to their main competitors, the cable television companies. Both sets of companies sell pipes into households and businesses which provide the trifecta. The beauty of this business is that once a territory is "built out," capex is reduced and the business can be very attractive from a cash flow perspective.

Finally, these companies provide a variety of services to business customers,other telcos and retail customers - including access, WIFI, hosting, data services and directory services.

T and VZ should continue to grow as wireless revenue growth and FIOS and other enhanced service expansion outstrip losses of voice customers. They also serve certain growing markets and have valuable names and franchises in the market. They face a constant need for capex as wireless traffic grows and FIOS is built out. On the other hand as a higher and higher percentage of households are "passed" and in FIOS capable areas, capex should decline or at least flatten out.

BCE faces the same opportunities and challenges in Canada. The strength of the Canadian economy should provide it with a tail wind and appreciation of the loonie against the dollar could create a windfall for US investors.

CTL has just more than doubled its size by acquiring Qwest. We still do not have a financial report for a quarter of the combined entity. With a limited upside from wireless, CTL will face challenges. On the other hand, it should be able to achieve important synergies. And its service territory provides some attractive opportunities. Management is committed to improving cash flow and paying down debt. It will be hard to assess exactly how all of this will play out until we have at least a quarter or two of financial reports from the combined entity. On the other hand, at this price it appears attractive.

FTR has also had recent expansion - acquiring a big operation from VZ in 2010. I sense it is hunkering down and reducing costs aggressively. Like CTL, it is now digesting a big acquisition and wants to reduce debt levels. Management seems on top of the situation. Again, I think a couple of quarters of financial results will tell a lot. As with CTL, it is attractively priced and, if the company stays on target, there is potential for appreciation.

I think that the yields probably reflect the risks and growth prospects reasonably well with the lower yielding T, VZ, and BCE having the best shot at top line growth and the least danger of straying into the black hole of declining revenue. CTL and FTR have to digest the recent acquisitions and pay down some debt but appear to be on track to do so. It is likely that neither of these will increase dividends in the near term but will instead use cash to pay down debt. Debt pay down arguably justifies a higher stock price because it reduces interest expense; in addition, if enterprise price stays the same, market cap should go up.

If CTL and FTR stay on track and pay down debt successfully, there could be substantial appreciation in the share prices of these companies. Of course, all of these stocks have certain advantages over pass-through entities - dividends are taxed as dividends, not as ordinary income, and there is certainly potential for growth in the long run. I think that a selection of these stocks belong in the portfolio of any dividend oriented investor.

Disclosure: I am long T, VZ, FTR, BCE.