Misleading Payout Ratios In International Telecommunications Stocks

Includes: ORAN, TEF, VOD
by: Analytical Chemist

Domestic telecommunications stocks are frequently owned for their large, safe dividends. International telecommunications stocks vary from large, safe, slow-growing companies in Europe to rapidly expanding and significantly more volatile firms in emerging markets. International telecommunications stocks, like domestic ones, tend to pay high dividends as well.

With high-yielding stocks, a natural concern is how well companies are able to pay and grow their dividends. One of the measures of the sustainability of a company's dividend is its payout ratio, defined as the ratio of a company's dividend payments to net earnings. Lower ratios are seen as healthier because they allow more cash to be used for operating activities and corporate expansion, as well as providing a margin of safety if earnings decrease. Higher ratios, of course, allow for higher dividends sought by income investors. Very high dividend payout ratios, particularly those over 100%, are viewed as danger signs that the company's business prospects are fading, earnings are decreasing, dividends are in danger of being cut, etc.

In some industries, however, net earnings are a poor measure of the ability to pay dividends. A better measure is "owner earnings," which can be calculated as net income plus non cash charges such as depreciation and amortization, less the capital expenditures necessary to maintain the business. Owner earnings can be thought of as the cash generated by a company that is available for distribution to the company's owners. I have previously written about domestic telecommunications companies with payout ratios based on net earnings over 100% but actually have quite safe dividends when considering owner earnings. In this article, I'll discuss a few international telecommunications companies with large dividends, and show that when analyzed as a percentage of owner earnings these dividends are actually quite safe.

Telefonica (NYSE:TEF) has both mature and fast-growing businesses. Telefonica is based in Spain and has large land-line and mobile networks there. The market in Spain is mature, however, and there are 129 wireless devices per 100 people in the country. Fortunately, Telefonica receives only about 35% of its revenues in Spain. 25% of its revenues come from other areas of Europe, with a mixture of mature and growing markets. In 2010, Telefonica Europe revenues grew 13%, while revenues in 2011 have been relatively unchanged. The last 40% of its revenues from Latin America, and is another growth engine of the company, with revenues increasing 13% in 2010 and 18% through the first nine months of 2011. Telefonica paid dividends (converted from Euros to dollars) of $2.05 over the last 12 months against reported earnings of $2.26 per share in the last four quarters, for a 91% payout ratio. Adding depletion, depreciation, and amortization to reported net income, and subtracting an estimate for maintenance capital expenditures gives owner earnings of $3.82 per share, and dividends are just 54% of that. Owner earnings for Telefonica are particularly useful in evaluating its 2012 dividend; since Telefonica has indicated it will pay a reduced full-year dividend of about 1.30 Euros, corresponding to about $1.70. Zack's reports that analysts estimate 2012 earnings of $1.98, giving a reported payout ratio of 86%. Its dividend payout based on owner earnings, however, should be more like 2011's 54%.

One challenge in calculating owner earnings is determining the capital expenditures needed to maintain, as opposed to expand, the business. For Telefonica, for example, 2010 capital expenditures were 10.8 billion Euro, compared to depreciation and amortization costs of 9.3 billion Euro. The most conservative calculation of owner earnings would be to say that all of the capital expenditures were necessary to maintain the business. This would result in an owner earnings figure below that of net income, which seems absurd since overall Telefonica's revenues are growing. The most aggressive way to calculate owner earnings would be not deducting any capital expenditures at all, but this is just as unrealistic. With Telefonica, we can make a rough approximation using its different business segments. We know its businesses in Spain are mature, so let's assume that all of its capital expenditures in Spain are maintenance expenses. And we know it's businesses in the rest of Europe and in Latin America are expanding, so we'll say that all of the capital expenditures there are designed to grow the business. Of course neither of these are completely accurate, since Telefonica is of course trying to grow its business in Spain and there are some required maintenance capital expenditures in its growing markets. But if we guess that these offset each other, we come up with a workable estimate. In this case, our estimate for maintenance capital expenditures is 2.0 billion Euros. Perhaps most importantly, we arrive at a number for owner earnings for which we know the limitations, but that we believe to be more useful than net income in understanding a company's ability to pay dividends. As Warren Buffet often quotes Keynes, I'd rather be vaguely right than precisely wrong.

Vodafone (NASDAQ:VOD), based in the United Kingdom, is the world's second-largest wireless carrier by number of customers and serves more countries than any other wireless carrier. Between its regular dividend and special dividend from its Verizon Wireless joint venture, Vodafone has a 7.5% yield this year. Its regular dividend, however, is $1.46 per share, for a payout ratio based on net 2011 earnings of 67%. Adding depreciation and amortization costs of £7.9 billion to net income gives £15.7 billion, or about $4.40 per ADR. Total capital expenditures were £6.2 billion in fiscal 2011, and allocation of this amount between maintenance and growth capital expenditures is difficult. Assuming all of the capital expenditures were maintenance would give owner earnings of $2.67, our range of owner earnings is from $2.67 to $4.40 per share. Since Vodafone revenues have grown over the last few years, some of the capital expenditures are aimed at growth. My estimate of owner earnings for Vodafone is about $3.50. The dividend payout ratio on this amount is 42%.

France Telecom (FTE) paid dividends (converted to dollars) of $2.02 in the last twelve months, and had earnings from continuing operations of about $1.51. This would be an indicated payout ratio of about 134%, which is normally an extremely alarming rate. Adding back depreciation and amortization (6.8 billion Euro) and subtracting out an estimate of maintenance capital expenditures give a figure of owner earnings of $3.40 per share. The dividend payout on owner earnings is 59%, which is a much healthier figure than that based on net earnings.

Telecommunications stocks are a great example for illustrating the importance of looking beyond net income in evaluating a company's prospects for paying and expanding a dividend, primarily because of the large non-cash depreciation and amortization costs. This is true of both domestic and international telecommunications companies. While some analysts prefer EBITDA (earnings before interest, taxes, depreciation, and amortization) and others prefer free cash flow, owner earnings is a superior metric to evaluate a company's ability to pay out a dividend while continuing to fund expansion and while paying interest to bond holders. Each of these metrics examines a company's non-cash expenditures, and is a good starting place but is not a substitute for studying the company's income statement.

Disclosure: I am long TEF.