Are big dividend yields in European telecoms safe?

Recent decreases might be sending investors fleeing for the exits.

By InvestorPlace Feb 28, 2012 10:38AM
Tetra Images/Getty ImagesBy Charles Sizemore

The highest dividends of any mainstream stock market sector in the world are being paid by European telecom firms, with many offering yields in excess of 10%. Unfortunately, as is generally the case with something that seems too good to be true, those dividends also are at risk.

Telefonica (TEF), Spain's largest telecom provider and a longtime recommendation of the Sizemore Investment Letter, is a case in point. In December, Telefonica opted to cut its dividend from a planned 1.75 euros per share to 1.50. Though the company had (and still has) the financial strength to continue paying the higher rate, the company had to accept the ugly reality that it was operating in a market that could at any moment descend into a 2008-style banking crisis.

In this kind of environment, conserving cash and reducing debt was the wiser course of action, even if it disappointed investors that had come to expect the fat dividend payout. (Investors should take to heart; even after the cut, Telefónica still yields nearly 9%.)

Alas, the Spanish giant was only the first of many. Just last week, France Telecom (FTE) warned of lower dividends in the next two years, followed by similar announcements by Telekom Austria and Telecom Italia (TI).

Normally, declining dividends are a sign for investors to run for the door. And to be fair, the sluggish performance of many European telecom stocks in recent years would seem to lend credence to that bit of wisdom. Still, there are a couple things investors should consider before abandoning the sector.

First, as I pointed out with Telefonica, lowering the dividend was part of a broader risk-reduction strategy. After watching perfectly viable companies experience financial destruction in 2008 thanks to short-term financing issues, no telecom CEO wants to follow in the footsteps of General Electric (GE) or Goldman Sachs (GS) and have to turn to someone like Warren Buffett for a lifeline in the event that a Greek default spirals into something far bigger.

As readers might recall, Buffett was pretty much the only person with both the available cash and the willingness to spend it when all hell broke loose in 2008. He also wasn't opposed to extracting the proverbial pound of flesh for his services, buying special preferred shares paying 10%. GE and Goldman got what they needed, but they paid dearly for it and lost a lot of credibility. Better to "self fund" by trimming the dividend a little than run the risk of turning to the capital markets under crisis conditions.

Secondly, the cash needs of Europe's telecoms are due less to declining fundamentals (though the old landline businesses certainly are in decline) than to the pains of growth. Both European and American telecom providers are in the process of upgrading their networks for 4G, also known as long-term evolution or "LTE," which is sorely needed to keep pace with surging demand for smartphone and tablet computers like Apple's (AAPL) iPad.

According to the Financial Times, nearly one out of seven people in the world already carries a smartphone, and that number grows daily. Furthermore, the most popular phones -- those featuring Google's (GOOG) Android operating system -- also happen to be the biggest data hogs.

The Financial Times estimates that the industry will need to spend $800 billion in just the next four years to meet demand. Yes, that's $800 billion, as in four-fifths of a trillion dollars.

There is good news and bad news here. The good news, obviously, is that the services provided by the world's telecom firms will be in greater demand than ever. The bad news is that meeting the demand will be expensive, even while margins are cramped by continued weak demand from business users.

Knowing this, firms are looking for new revenue streams. Many, including Telefonica, are partnering with the likes of Visa (V), also a longtime Sizemore Investment Letter holding and the winner of InvestorPlace's 10 stocks for 2011 contest, and rival MasterCard (MA). Expect to see more partnerships like these being formed in the coming quarters.

Still, dividend cuts, for whatever the reason, are a bitter pill to swallow. The issue, of course, is to what decree the possibility of future cuts are already factored into share prices.

It is the view of the Sizemore Investment Letter that prices are cheap enough and dividends (even taking into account future cuts) are high enough to make the sector worthy of consideration. As the threat of meltdown continues to fade, I expect credit conditions to loosen and that telecom boards of directors might be more inclined to maintain or even raise their dividend. One might even view the rash of dividend cuts as a contrarian signal of managements rushing to close the barn door after the horses have already bolted.

I continue to recommend Telefonica because I consider it an emerging-market growth story disguised as a stodgy European telecom. When you buy Telefonica, you do so with the understanding that its home market in Spain will not be recovering anytime soon. You're not buying Spain; you're buying Latin America, which makes up over 40% of sales (and growing).

But while I like telecom as a contrarian investment, I also believe that yield-focused investors should look to other sectors as well. Within Europe, I like consumer products giant Unilever (UL). The company already gets the majority of its sales from fast-growing emerging markets, and it pays a solid (and growing) 3.6% dividend.

And, if you're a dividend investor looking to branch out, you may find these 5 foreign dividend stocks worth your while.

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. TEF and UL are recommendations of the Sizemore Investment Letter. Sign up for a FREE copy of his new special report: "4 Dividend Stocks to Buy and Forget."

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