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Monday, December 16, 2013 - 08:30
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Monday, December 16, 2013 - 08:30

This International Stock Offers An 11% Yield And 45% Upside

Monday, December 16, 2013 8:30 AM

I've always loved telco stocks.

As investors, we're told to train ourselves to look at stocks rationally and to remove emotion from the process. Warren Buffett warns that your stock won't tell you it loves you when you come home at night.

But dividend investing is also about finding great yield -- and, with a tip of the hat to Willie Sutton, telco stocks are where the money is.

Investors have almost always done well with domestic heavyweights AT&T (NYSE: T) and Verizon (NYSE: VZ). But I've always found more yield and value in international telco stocks. Vodafone Group (NYSE: VOD) has always been a good holding thanks to the British company's investment in Verizon (a 41% stake before its recent sale) and its focus on emerging and frontier markets.

Telefonica Brasil (NYSE: VIV) has the yield and value characteristics I look for in an international telco stock. The Sao Paulo-based telecom provides fixed-line and mobile communications, broadband Internet and pay TV services, among other offerings. A subsidiary of global telecom conglomerate Telefonica (NYSE: TEF), Telefonica Brasil serves nearly 28% of Brazil's wireless market under the Vivo brand.

Yet VIV is off by more than 30% from its 52-week high. What gives?

The main factor is external. Brazil has been struggling with economic weakness and social unrest. According to research firm IHS, Brazil's GDP growth cooled from a red-hot 10% in 2011 to virtually zero by mid-2012. No surprise that the Brazilian stock market sustained a correction of 19%.

Flickr/Roger Schultz
Brasil Telefonia provides fixed-line and mobile communications, broadband Internet and pay TV services, among other offerings.

A broad economic turndown and subsequent weak stock market spares no one. Overall, wireless communications demand in Brazil has weakened, punishing Telefonica Brasil's stock price as well as some of the company's numbers. But the news isn't all bad.

Telefonica Brasil saw a significant decline in pre-paid wireless subscribers, more than 1 million. While that is a concern (telecom companies can pre-book pre-paid wireless subscriber revenue), Telefonica Brasil added 1.5 million postpaid customers for a net gain of half a million subscribers. Even better, postpaid customers are much more profitable, as they tend to purchase higher value devices such as smartphones and pricier data services. Over the long term, I see this as a major positive for the stock.

Overall, revenues are growing in Telefonica Brasil's core voice and data transmission business. For the third quarter this year, voice services contributed $6.72 in revenue per share versus the estimate which called for $6.58. Results were the same in the higher margin data transmission segment with $3.23 over the estimate which called for $3.12 per share. And the total revenue picture is even more encouraging.

Telefonica Brasil is forecast to deliver $14.6 billion in net operating revenue this year and $15.2 billion in 2014 -- but it's the company's EBITDA (earnings before interest, taxes, depreciation and amortization) that really has me excited. EBITDA is expected to come in at $4.6 billion this year before rising a healthy 17% next year, to $5.4 billion. EBITDA margins should expand as well, growing from 31.5% this year to 35.4% in 2014.

Telefonica Brasil's balance sheet is also quite healthy. Free cash flow before dividends grew by 8% this year, to $1.7 billion. Next year looks even better with 21% free cash-flow growth, to $2.1 billion.

Why am I harping on the free cash flow number? Well, the amount of free cash a company has to work with is important to shareholders who enjoy steady, generous dividends. If the company can achieve average free cash-flow growth for three years running, shareholders should be pleased.

The company's long-term debt-to-capital ratio is also extremely low at just 11%. Telecoms usually rely on a lot of debt to operate, so this figure shows Telefonica Brasil is capable of managing and growing using the cash it generates. Return on equity is also strong, with a five-year average of 21.7%.

Risks to consider: The Brazilian economy has decelerated dramatically, and most businesses have a tough time growing in that kind of environment. Brazil is also experiencing noticeable social unrest due to the sour economy. Unfortunately, this is not isolated to just Brazil but is prevalent throughout the region. Expect more volatility in Latin American markets.

Action to Take --> Despite the obvious challenges, Telefonica Brasil's prospects remain bright. VIV is trading at under $19 a share, with a forward price-to-earnings (P/E) ratio of 12.2 and a dividend yield of 11.1%. Based on Telefonica Brasil's growing cash flow and higher-margin product sales, a 12-month price target of $25 looks attainable. Combined with the dividend, the potential total return would be over 45%.

P.S. Stocks like VIV are perfect for what we call a "Dividend Trifecta" strategy. Simply put, it's a three-part approach to dividends that multiplies the effectiveness of every dollar you invest. Click here to learn more...

Adam Fischbaum 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.