Why I’m avoiding large cap telco’s for dividends

Stocks like AT&T and Verizon tend to be mainstays in a dividend investors portfolio. Not surprising given their large, inviting yields. I’m happy to give the large cap telecom stocks a wide birth at present.  

 

Dividend Sloths have the habit of being able to attract many of us to invest. It’s like a nice slow ball thrown right into the strike zone, begging to be smacked out of the park. AT&T and Verizon are two of the more popular Dividend Sloths, both are very widely held are offer yields of around 5%.

There are a number of things in favor of looking at the large cap telecom stocks as a potential source of dividends.

Stability of stock price

Verizon and AT&T pay out hefty dividends in the range of 5% and also experience less volatility than the broader S&P 500. In other words, higher-yielding stocks give you an incentive to stick around and give the dividend growth strategy time to work. You get paid to wait, even if there isn’t any immediate capital appreciation for some time.

In fact, not only do you get paid to wait, but more importantly, higher-yielding stocks help provide a buffer against considerable market fluctuations. They help make it less likely that downturns in the market will result in younger investors getting scared by volatility and selling out.

This is because these higher-yielding stocks can still generate considerable total return purely from the contribution of a high dividend, in spite of the general turmoil that may be happening in the stock market.

Verizon, for example, has a beta of only 0.45, meaning it moves approximately half as much in price as a general move in the market. Thus when the market takes a precipitous dip Verizon doesn’t dip as much, in general.

For a younger investor, reducing the amount of tension and stomach churning when establishing a portfolio can be very important in the early years to provide confidence to develop and stick to a strategy.

In 2008 for example, as the S&P 500 went into a nosedive and dropped 37%, Verizon stock not only outperformed the S&P 500 in terms of stock price performance, but in addition still managed to pay out a 5.4% yield, which may have provided a strong enough reason for a young investor to hold onto a stock.

Drives dividend income & reinvestment

Cultivating a large pool of dividend income for selective reinvestment allows an investor to diversify a portfolio into higher dividend growth stocks. By using the large dividends from dividend sloths as the fuel to power the reinvestment, you not only start building a material dividend income early, but you are also positioning your dividend portfolio for higher dividend growth going forward by directing more of your investment into classic dividend payers.

Manual dividend reinvestment allows an investor to take advantage of market downturns, even when you don’t have any money to reinvest. The mood of Mr. Market can create valuation opportunities at any point in time, which an investor can take advantage of with a more strategic, optimized dividend reinvestment strategy.

Mr. Market’s moments of panic can turn low yielding, high growth dividend stocks into high yielding, high growth dividend stocks. Investing in Verizon or AT&T helps grow your dividend pie and gets you in a position to respond to market downturns and shift resources towards potential opportunities as they arise.

There are a few factors against looking for dividend income from the telecommunications giants.

Paltry dividend growth 

Just look at the dividend growth over the last few years for the big US telecoms. It’s nothing to really write home about, at just 2-3% per year over the last 5 years.

And that’s scary. Not just because the level of dividend growth is so low, but the US telecoms have been in a purple patch for the last 5 years that’s unlikely to be repeated in the next 10 years. I think profitability and revenue growth is as good as it will be for a while.

Competitive dynamics will be  fierce going forward 

There are a few things happening that will put a cap on the growth of the wireless businesses of the large telco’s.

The feature to smart phone conversion is almost up

The last 5 years were a period of golden growth for US telco’s as subscribers essentially doubled down on their data plans. The results were significant growth in revenues and profits that AT&T & Verizon lapped up. With smart phone penetration rates now approaching 60% in the US, the data plan tail wind is slowing down. There’s probably a couple of years still left to milk what’s left, but not much

Defections from smaller carriers will dry up soon

Verizon and AT&T were able to feast on the woes of Sprint and to a lesser extent TMobile as subscribers fled the smaller carriers in droves and moved over to the larger carriers. Sprint’s acquisition by Softbank, and the upgrades that will be made to the Sprint network will reduce loss of subscribers and dry up carrier subscriber defections.

The connected devices bonanza hasn’t yet happened

There was a hope that subscribers would connect 2 or 3 devices each onto the wireless network. That hasn’t panned out at this point, with tablets, watches and other connected devices all going over wifi.

Likely shift from postpaid to prepaid

Most of you reading this likely are on contract with your carrier for a 2 year period, making you a postpaid customer. There are a bunch of folks who are setting and paying wireless budgets upfront, making them prepaid subscribers. These folks generally pay less, have a more limited range of devices but by and large have the same quality of network service.

While still a smaller % of the US wireless market, the prepaid market is where the growth will be over the next few years. Unfortunately for the wireless carriers, prepaid subs bring in less revenue, lower margin and lower profits. All of this translates to less to pay out for the carriers in dividends.

It’s not doom and gloom for AT&T and Verizon, far from it, but profit growth and therefore dividend growth is unlikely to rise significantly more than how it’s been trending to date.

AT&T and Verizon will still be significantly profitable, but they won’t be blitzing revenue and profit growth expectations anytime soon. Fortunately, dividend payments as a % of cash flow are still very comfortable, and there is scope for the payout ratio to still be increased from here.

Where I’d rather have my money

I like several aspects of the logic behind investing in the large cap telecom stocks.

Having a nice upfront,  solid dividend yield to power the rest of my dividend portfolio is appealing.

Being able to reinvest that yield across a number of faster growing dividend companies is also appealing.

Finally having some price stability and a strong, less volatile core is particularly appealing given the bevvy of small cap satelite dividend payers that I have in the outer rings of my dividend galaxy.

I feel like my recent purchase of BP ticks most of these boxes.

The yield is solid, beyond a 5% initial yield. Dividend growth, in recent years has been above average, with the most recent dividend increase at close to 10%. Price growth will probably be subdued until the overhang of the litigation arising from the Gulf Of Mexico spill several years ago is finally settled, but the yield strikes me as safe, with promising growth.

Of course, if AT&T or Verizon ever offer me the same opportunity, as Telstra (an Australian telco) , to have a starting yield of close to 10%, with the prospect of even 2-3% annual dividend increases over time, I’ll be there with my bat raised, ready to knock that juicy pitch out of the park!

Comments

  1. Jon says:

    Hi TI,
    I recently purchased a chunk of AT & T as part of my diversification into US listed stocks. Offered a 5.3% yield and hovering around 52 week low. I also own Vodafone. Interestingly there are rumours that AT&T want to enter European market and may acquire Vodafone once the Verizon deal is sealed. I will have option of also purchasing Verizon once the deal is concluded.

    I agree with your analysis on this industry. AT & T and Vodafone represent about 4 % of my portfolio and I have no plans to add additional Telco’s or sell these two. Its always a case of what would I buy if I do sell them. I don’t want to own just Coke, P &G, JNJ, EXXON etc. I try to diversify as much as possible across industries.

    Regards, Jon

    • Integrator says:

      Hi Jon,
      I do agree that the diversification point is a potentially relevant consideration in holding the telco’s. Nothing wrong in having the higher yield as well. I think provided they aren’t the mainstay of the portfolio and one is diversifying their income across other faster dividend growers, it’s fine. Interestingly, there are derivative plays in the telecom space without looking at the telco’s themselves. Qualcomm is an intriguing one that I’m following. The yield is a little low ~2%, but the company and dividend is growing rapidly.

  2. One reason I stay away from U.S. telcos is they are limited to the U.S. They do not expand overseas. I was in Telfonica (TEF) for awhile (sold couple years ago) as they were big across South America and Europe. Americans are pretty saturated by cellphones now and I am not seeing innovations coming to make me think there will be any growth.
    US telcos have a high payout ratio and as you mentioned… they don’t give big dividend raises.

    • Integrator says:

      The payout ratio for the telcos is a little misleading. They are actually comfortably on a cashflow basis, earnings are artificially depressed because they are writing off pension costs. I’d estimate payout is probably closer to 30-40% on an operating cash flow basis, so they are pretty comfortably servicing the dividend.
      Expansion in Asia Pacific markets is potentially interesting, I’m happy to avoid European exposure for the moment, more because the markets there are prepaid in nature and ultra competitive.

  3. I’m in the same boat as you on the Telecos, Integrator. Not a big fan of the limited growth, high payout and debt (I know it is common for the industry). There just isn’t too much domestic growth to be had and unless they can start acquiring/moving strongly internationally, the growth just won’t be there. And that assumes that international growth would be successful. Just as the US market is very competitive, so are the international markets. The biggest question in that arena: would the cost of developing any international market share through acquisition or organic growth be worth the return and be accretive to earnings?

    • Integrator says:

      Acquisitions are a bit of a poisoned chalice. The post merger integration risks are huge, you potentially get massive churn from subscribers who defect and you can squander millions of dollars…. just ask Sprint how their Nextel acquisition worked out for them.
      International telco acquisitions tend to have fewer synergies then most. There are relatively few fixed costs that you could leverage. It would just be a punt that on buying growth in an overseas market to provide a hedge for when US growth eventually gets saturated. That would probably mean that it’s fairly earnings dilutive from the beginning. Their was some talk of US telco’s looking at Canada to start with….maybe that’s the start of a wave of international growth ambitions.

  4. Dave says:

    Love all the negative talk. Added a nice chunk to T last Friday.

    • Integrator says:

      Dave, nothing wrong with the US telco’s. They’ll continue to churn out the profits and pay the dividend. Nothing wrong with collecting 4-5% annually that increases with inflation!

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  1. […] and Verizon are the only game in town as a play on telecom dividends. I’ve made clear my lack of interest in the big carriers  given where their share prices currently are and the factors that may hamper dividend […]

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