News Analysis date published New: 
Monday, February 4, 2013 - 10:00
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Monday, February 4, 2013 - 11:07
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Monday, February 4, 2013 - 10:00

Are These 2 High-Yield Small Caps Worth The Risk?

Monday, February 4, 2013 - 10:00am

The goal for many income investors is to find high-yielding stocks selling for bargain prices. After all, not only is it possible to buy more shares with lower-priced stocks, but they have the potential to provide greater capital gains than higher-priced ones.

In this light, small-cap stocks are perfect. Known for sporting nice yields of 3% or more and for their greater upside potential, dividend-paying small caps can really supercharge any portfolio.

But small caps can also be risky. They are often too volatile and have a greater chance of dividend cuts.

I'm not really worried, though.

In the past five years, small caps have produced better gains than the overall market, with the S&P 600 SmallCap Index returning almost double than the S&P 500's 4%.

After looking at the chart above, it's easy to see why small-cap dividend payers can play a vital role in a well-diversified portfolio.

With this in mind, here are two small dividend-paying telecom companies investors should consider, despite their intrinsic risk:

1. Cellcom Israel Ltd. (NYSE: CEL)
Trailing yield: 12%

This member of the Russell 3000 Index provides one third of all cellphone services in Israel.

The company has paid a stellar trailing dividend yield of more than 12% in the past, attracting many investors seeking super high yields. It also has a trailing price-to-earnings (P/E) ratio of almost 6 and a PEG ratio of 0.67 (A PEG ratio is also known as the P/E-to-growth ratio. It determines a stock's value while considering earnings growth. So if the PEG ratio is one, then the company is considered fairly valued. If it's below one, then the company is considered undervalued. A PEG ratio above one shows the company is overvalued.)

Total cash on hand of $4.29 per share and an expected profit of nearly $4 per share this year just show how the company's metrics are positive .

But before I continue, I need to share some bad news: The company's 12% dividend has been shrinking at an annual rate of 7% during the past five years. In addition, the board of directors announced in the third quarter of 2012, it had decided not to distribute a dividend in order to get the balance sheet back on track.

The company's existing infrastructure limits it to 3G service, while the competition has upgraded to much faster 4G service. This caused Cellcom's earnings to plunge 38% in the third quarter of 2012 to 32 cents a share, while revenue also fell 13% to a little more than $370 million during the same period.

To add to the weakness, Cellcom acquired competitor NetVision in 2011, taking on $421 million of debt in the process. Since then, the company's entire free cash flow has been used to pay this debt. The board will decide when to resume dividends on a quarter-by-quarter basis, effectively turning this once high payer into yielding zero.

But despite these recent hurdles, Cellcom has launched efficiency measures to match its reduced revenue. Free cash flow has actually ramped up by 58% to $106 million in the third quarter of 2012 compared with a year earlier.

It's important to note that it's not just Cellcom that has been struggling in Israel: Three other telecom companies that had led this sector for more than 12 years are having to face a few challenges, just like Cellcom. Federal changes in Israel in 2011 forced them to cut the fees they charged one another to connect calls. The changes also required them to eliminate exit fines for customers, which caused their revenue and earnings to slide across the board.

That's not to mention a price war that started in 2012, when six new telecoms entered the market offering ultra-low rate plans.

But I think there are some bright spots on the horizon.

Cellcom recently won a military contract and it's making plans to enter the Internet TV business. Still, it may be a rough few quarters before this major Israeli telecom starts paying dividends again.

Taking a look technically, Cellcom's price has dropped well below its 200-day simple moving average, eliminating the company from my value zone pullback criteria (To ensure the uptrend is still intact, the pullback must remain above the 200-day moving average.)

Despite its super high-yield, I only feel comfortable watching Cellcom for now, before waiting for signs of an upward momentum to really appear.

2. USA Mobility (Nasdaq: USMO)
Trailing Yield: 5%

This little telecom provides wireless messaging as well as mobile voice and data services to U.S. health care, government and business markets. It has a market cap of a little more than $240 million, a payout ratio of nearly 49% and net margin of almost 20%.

The dividend yield is just under 5%. In the third quarter of 2012, USA Mobility reported revenue of a little more than $55 million, but GAAP reported sales were 10% lower than the same quarter a year earlier. USA Mobility is estimating revenue of just under $54 million and earnings of 37 cents per share in the fourth quarter of 2012.

What I like about the company is that nearly 80% of the shares are institutionally-owned. In addition, the price has just bounced off of the 50-day moving average -- indicating upward momentum. I expect shares to be trading at $13 within the next year.

Risks to Consider: As stated earlier, small-cap dividend-paying stocks have more risks than higher-cap stocks. When investing in small-caps always be prepared for substantial volatility and only use money you can afford to lose.

Action to Take -- > Along with the risk comes high potential reward. Cellcom Israel has historically paid high dividends but it is currently suffering from a lower share price due to the dividend cut. I think this company may soon get back on the winning side, but I would wait for signs of upward momentum prior to entering long. USA Mobility, on the other hand, is exhibiting strength and is showing upward momentum, so it's a compelling pick right now.

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David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.