This Income Investor's Dream is Cheap Again

Friday, April 2, 2010 - 2:43pm

by Tom Hutchinson

Large telecom providers have become some of the market's strongest dividend-paying companies.

Although they pay strong yields, most of the big U.S. telecoms don't offer much in the way of growth. The problem is that fixed-line usage is slowly dying as more customers drop their wired phones for wireless ones. Wireless, for its part, is a highly saturated market with stiff competition.

However, investors can find a place that offers solid growth in wireless -- the developing world. One emerging-market telecom company in particular gets the best of both worlds and serves up the steady telecom cash flow found in developed market economies combined with the growth of emerging markets.

The combination of steady cash flow and earnings growth enables the company to pay a high yield while offering appreciation potential.

The company has one more advantage. It's cheap.

Telefonica (NYSE: TEF) is the world's third-largest telecom company, as measured by the number of customers. It's the largest telecom in Spain and Latin America. Telefonica's reach also extends to Europe, where it's the largest wireless operator in the United Kingdom and the Czech Republic. It's also a major provider in Germany.

The company operates in three primary regions: Spain, Europe and Latin America. About 65% of revenue come from outside Spain. The mature and slower growth Spanish and European markets offer steady cash flow. But the company's growth engine is Latin America, as the number of customers who use wireless and broadband is just a small fraction of those in the developed world.

A huge benefit of Telefonica is that it pays an already solid dividend -- and one that's growing.

The company pays dividends twice a year. These payouts have increased every year since 2003. A total of EUR1.00 per ordinary share was paid in 2009. Each of the NYSE-traded depositary receipts represents four common shares, so investors here received a dividend of EUR4.00. At today's price and currency conversion, the trailing yield is approximately 7.5%.

The dividend is well covered. Telefonica earned EUR 1.71 per share in 2009 and paid out EUR 1.00 per share in dividends. That's a modest and manageable payout ratio of just 58%.

The best part about Telfonica for income investors is that the company has announced its intention to steadily raise the dividend. Its target payout is EUR 1.75 per share by 2012, a +75% increase from 2009.

Telefonica reported a consistent performance in a brutal, recession-riddled 2009. For the full year, revenue grew +0.2% to EUR 56.7 million. A key measure of telecom performance -- operating income before depreciation and amortization -- increased +0.9%, to EUR 22.6 million. Net income increased to EUR 1.71 per share from EUR 1.63 per share the previous year.

The company seems to be gaining momentum. In the fourth quarter, net profit jumped +22%, to EUR 2.44 billion. The surge in performance was driven by adding 6.8 million customers, mostly in Latin America.

Telefonica has recently taken a beating as investors worried about recession in Europe and particularly Greece's financial woes. These concerns seem overblown -- most of the company's revenue comes from outside Spain, after all -- though the shares have shed -20% of their value, falling to about $72 from $90 in December.

With a rich yield of 7.5% and strong price appreciation potential, these shares warrant serious consideration by income investors. The recent sell-off has created a golden opportunity to enter one of the most well diversified and best-run telecom companies in the world.

Tom Hutchinson 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.