How an Overdue Phone Call Led Me to 11.1% Yields

I hadn’t spoken to my friend Harriet for almost a year. We were really close in university, but with her living several hundred miles from me, we drifted apart. So a few weeks ago, I picked up the phone, dialed, and awaited with pleasure her cheery “Hello.”

Instead, a tinny voice on the other end informed me, “This line is no longer in service.”

I grabbed my electronic address book. “Harriet has a cell phone,” I thought to myself. I never call her on that number because of the sky-high charges she incurs, but today was an exception.

I dialed and held my breath. Almost instantly, I heard her upbeat “Hello.” “Sorry, to phone you on your cell,” I said, “I know it’s expensive for you.”

“That’s fine,” she replied, “I’m just happy to hear your voice. But you know what, I just cut the cord.”

“Cut the cord?” I thought. “Come on Harriet; it’s awfully late in life for you to get pregnant.”

“Yeah,” she continued. “Phil and I dropped our land-line phone a month ago. We only have a cell phone now. But call me at this number anytime.”

The Fall of Fixed-Line Service
Unfortunately for telephone companies, my friend Harriet’s story is not unique. The National Center for Health Studies estimates that at the end of 2008 one out of every five homes relied exclusively on cell phones. This number grew by about +2.7% over the previous year.

The trend is reflected in the performance of the benchmark iShares Dow Jones U.S. Telecom Index (NYSE: IYZ), which has sharply underperformed the S&P 500 since the March lows.

Then why on earth would I want to turn your attention to the opportunity in a widely shunned group of income stocks — land-line phone firms?

I imagine you’re skeptical. After all, you’ve likely seen the headlines about land-line losses, or maybe like my friend Harriet, you’ve come to rely exclusively on your cell.

Telecom Alchemy: Turn Copper Into Gold
But for income investors, the land-line phone company story is undeniable. These companies throw off piles of predictable cash flow that power their high dividend yields. The group has had some bad press and is out of favor, but that just makes the shares more undervalued and their yields more robust.

In particular, one group of telecoms — Rural Local Telephone Exchange Carriers or RLECs — offer sky-high yields. The pun is all too easy to make: They are relics of an earlier age when cell phones were only for the very affluent and not in everyone’s pocket.

But relic or not, you can’t argue with their dividends. As of late November, the average yield of the six major RLECs is 11.1%!

What powers these strong yields are their services and geographical focus. RLECs provide traditional land-line service. They may offer wireless, but land-line traffic comprises the bulk of their revenues.

They normally operate in rural, small town, or suburban America, outside the big cities. Their rural roots are a great advantage in today’s intensely competitive telecom landscape. Aside from losses to wireless companies, traditional telecoms also have to compete with cable operators who provide bundled television, phone and Internet.

But because population is sparse in the areas that many RLECs operate, other providers are not particularly interested in much of their territory and competition is far less than in big cities. The result is that RLECs are somewhat shielded from the often intense price competition while having a near monopoly over their service areas.

The Secret Weapon Increasing Business
The most interesting feature of the regional telecoms is that they are still able to increase their revenues, thanks to broadband Internet. As fast as fixed-line customers like Harriet cut the cord, broadband customers are hooking it up.

Broadband is a source of rapid growth for RLECs. For one of my favorite companies, only about 35% of its customers are broadband consumers. Moreover, only 88% of the company’s access lines are currently broadband enabled, so there are still plenty of growth opportunities.

Investors should watch out for the debt of the rural telecoms The spending required to constantly upgrade technology and infrastructure tends to create high debt levels. If inflation were to rise sharply and interest rates skyrocket, these companies could need their cash flow to pay interest or reduce debt rather than reward investors with dividends.

But for at least the time being, investors can lock in some appetizing yields in this stable — yet out of favor — industry.

P.S. — How exciting is the opportunity in RLECs? So exciting that I covered the section in the “Feature Article” of my December High-Yield Investing issue. In my issue, I also covered my two favorite picks in-depth — diving into their mechanics behind their 7.9% and 13.0% yields. To subscribe today and read my analysis, follow this link.