This 7.5% Yield just got a LOT Safer

In most cases, a stock with a high dividend yield is of great appeal to income investors. However, a stock with an above-average dividend payout could also mean investors have knocked the share price down because they don’t see the payout as lasting for much longer. When this happens, the stated dividend yield rises, but it is only a mirage.

I recently came across a company that is in a completely different situation. Not only does the stock have an above-average dividend yield, but it also pays out only half of its profits in dividends. Even better — it’s still growing its business at an impressive clip.

#-ad_banner-#In order to understand how uncommon it is to find a stock with a high dividend and a stable underlying business, consider two recent examples of what I call “mirage dividends.” World Wrestling Entertainment (NYSE: WWE) and apparel clothing maker Cherokee Inc. (Nasdaq: CHKE) recently cut their dividends because the underlying business lost steam and no longer generated enough cash to support the previous payouts. In World Wrestling’s case, the company cut its annual dividend payout from $1.44 per share to $0.48 per share. Cherokee’s payout varied based on annual profits, but was as high as $3 per share back in 2007 and was recently cut to $0.80 per share. At their highs, the dividend yields for these stocks were about 12% and 14%, respectively.   

The key way to tell if your dividend is safe is to see how much of the profit a firm generates is being paid out as dividends. In World Wrestling’s case, it was paying out more than it generated in profits. The same happened for Cherokee, so it was obvious to see both faced eventual cuts to their dividends. The dividend yields for both of these stocks are still above-average at 4.9% and 4.7%, respectively, but still represent big drops from previous highs. In addition, they won’t likely increase much unless these firms start growing their businesses again.

Now contrast this with a stock like U.K.-based Vodafone (NYSE: VOD), the second largest mobile phone provider in the world based on market capitalization, with about 341 million customers. Most of its operations are in Europe, with Germany, Spain and Italy representing the largest markets. These markets are stable, but slow growing. Fortunately, the company is also a big player in rapidly-growing emerging markets, including India and Africa, which together accounted for close to 20% of sales last year.

Vodafone is also handsomely profitable. Last year, it reported nearly $74 billion in sales and net income in excess of $14 billion, or $2.68 per share. Just less than half of this amount, $1.30 per share, was paid out to shareholders as dividends. This means the dividend is very well-covered from the profit Vodafone generates.

Based on historical trends, the dividend should continue to increase. In the past decade, Vodafone has grown its dividend at a 20% annual clip. Total company sales are up 16.5% each year in the past 10 years. In the past five years, the dividend has been raised close to 30% each year. Going forward, the company should continue to grow along with profits and growth in emerging markets.

But the story gets even better. Vodafone expects to start seeing a payout from its 45% ownership stake it has in Verizon Wireless, the mobile telephone business that is 55% owned by U.S. telecom giant Verizon (NYSE: VZ). Verizon Wireless is the largest mobile phone firm in the United States. Vodafone management recently estimated this could bring in an additional $5.5 billion in 2012.
Action to Take –> Based on the current payout of close to $2 per share, Vodafone’s current dividend yield is about 7.5%. This is an impressive yield for income-minded investors, considering the average stock yields 1.83%. And with billions more available due to the coming Verizon Wireless payout, Vodafone’s dividend has become even safer. I also see stronger potential for increased payouts over time, as the company continues to grow in emerging markets and either uses the payout money to further boost the sales and profits of its global wireless operations or return the money to shareholders.

P.S. — If you’re looking for quality stocks with high yields, you should take a look at this one. It pays a 19.2% dividend yield. It borrows cheap, gets paid handsomely and then pockets the spread. You’ll get the full story on this cash machine and others like it in this video.