FOOL ON THE HILL
Dividends: Your Safe Haven?

If you're looking for a sign of hope in this market, look no farther than the dividend yield. For a growing list of high-quality companies, the yield has become quite attractive. Within the S&P 500, 79 companies recently yielded between 3% and 6%. One such company, Alltel, has a 3.4% yield and is growing sales modestly and maintaining profit margins. At only 12 times expected 2002 earnings (halfway fulfilled), Alltel looks cheap, indicating some bargains are emerging among large caps.

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By Matt Richey (TMF Matt)
August 6, 2002

In the story of Noah and the ark, after more than five months of flooding and being cooped up on his boat, Noah sent out a dove to see if it would return with any sign of newly grown vegetation. Sure enough, the dove returned with a freshly plucked olive leaf -- a sure sign of dry ground.

We investors today wonder, has the rain of this bear market stopped? Is there any dry, solid ground on which to rebuild wealth? After two years of being cooped up in this bear market, it's time to send out a dove in search of tangible value. I think the dove has, in fact, returned, and in its mouth� a dividend -- a fat, juicy one.

While market averages have plummeted, dividend yields have quietly increased. Look around now, and you'll find that those once small, almost negligible dividends among many industrial companies have grown to be quite attractive. Today, there's a growing list of S&P 500 companies paying yields in excess of 3%.

Stop yawning! A 3% yield is nothing to blow off in a low-inflation environment. Plus, with or without inflation, dividends make up a considerable portion of the stock market's total return. The S&P 500 has returned approximately 7.8% annualized since 1926, without dividends reinvested; with dividends reinvested, it has returned 10.8% annualized. That's a big difference, when compounded over many years. Given that long-term average equity returns are likely to fall somewhere between 6% and 8% going forward, a yield of 3% could represent nearly half of your average annual return. From another perspective, consider that a yield of 3% isn't bad compared to the current five-year Treasury yield of 3.2%, or the 10-year yield of 4.3%.

I recently ran a screen of the S&P 500 and found 79 companies with yields ranging from 3% to 6%. (There were a few with yields in excess of 6%, but those situations typically entail more risk.) Among the list of 79, I found 40 companies yielding in the 3% range, including such blue chips as Kellogg (NYSE: K), Merck (NYSE: MRK), Caterpillar (NYSE: CAT), Emerson (NYSE: EMR), Sara Lee (NYSE: SLE), and BellSouth (NYSE: BLS); 24 companies yielding in the 4% range, including U.S. Bancorp (NYSE: USB), ChevronTexaco (NYSE: CVX), General Motors (NYSE: GM), H.J. Heinz (NYSE: HNZ), and Duke Energy (NYSE: DUK); and finally, 15 companies yielding 5% and change, including the likes of Philip Morris (NYSE: MO), Bristol-Myers Squibb (NYSE: BMY), and Verizon (NYSE: VZ).

I would bet the list of high-yielders includes more than its fair share of market beaters over the next five years. But to further narrow down the list of 79, I applied a few additional screens in an attempt to find which of these has the strongest business. I looked for positive sales growth, positive free cash flow, and an improvement in net debt (debt minus cash) versus a year ago. That proved a pretty tight screen, as only four companies filtered through: May Department Stores (NYSE: MAY), The St. Paul Companies (NYSE: SPC), Exelon (NYSE: EXC), and Alltel (NYSE: AT).

I believe all four companies deserve a closer look, but for this article, I chose only one for deeper investigation: Alltel. One of the first things that caught my attention is that Alltel's executives and directors collectively have a material position in Alltel common stock -- 8.65% of total shares outstanding. That's a combined $1 billion stake motivating them to run this business successfully. I like that. None of the other three companies has anywhere close to that level of inside ownership.

Onto the business� Little Rock, Ark.-based telephone company Alltel provides wireless and wireline services to over 10 million customers in 24 states. (Check out its geographic footprint.) As a rural operator, Alltel is one of the lesser-known players in the telecom services industry. The company has quietly strung together 41 consecutive years of dividend increases. And for the previous five years through December 2001, Alltel stock returned 118%, galloping past both the S&P 500 and its peer group, which both returned around 65%.

So far this year, Alltel stock has dropped from around $62 to its current perch of around $39 -- a decline of 37%. The current price seems to reflect investors' verdict that Alltel is guilty by its association to an ugly, scandal-ridden telecom industry. But in reality, Alltel's business remains solid.

Total revenue in the June quarter increased 1% versus the year ago quarter. Business may not be booming, but it's not declining either. Of course, that begs the question: Is Alltel propping up revenues by reducing prices? Find the answer by examining gross margins, which show no sign of profit deterioration. Gross margin in the most recent quarter was 37.6%, only a very slight decline from last year's 38.3%. Also, margin pressures are even less of a concern when you consider the trailing 12 months, over which time Alltel's gross margin reached a record 40.0% high. That's a great sign of strength.

Moving down the income statement, reported net income for the most recent quarter declined 1%, but even with that, Alltel maintained a respectable 11.2% net margin. The trailing 12-month net margin is 11.7%.

The highlight of the June quarter report was the company's wireless operations, where revenue grew 4% on the strength of 80,197 net new customers. In an interview with Reuters, Alltel's Group President of Communications Kevin Bebee said, "Over 40% of Alltel's new wireless customers in the quarter signed up to higher-priced monthly plans."  In addition, wireless customer churn was only 2.19%, which marked the company's third sequential quarter of improvement. Given that the wireless segment represents over half of Alltel's business, these are positive signs.

Looking to the balance sheet, we find that Alltel has actually reduced its net debt over the past 12 months from $4 billion to $3.6 billion, as of June 30. Much of the cash on the balance sheet, however, was spent on Aug. 1 to purchase the assets of Verizon's local telephone business in Kentucky and CenturyTel's wireless operations. Through those two acquisitions, Alltel gained 1.3 million customers. Post this transaction, I estimate Alltel has $6.4 billion in net debt.

Telecom acquisitions and their resulting debt load have begun to wear on investors' nerves, but Fools shouldn't lose sight of the fact that consumer telecom service is an excellent business that generates handsome and consistent cash flow. Check out this graphic, which displays how Alltel's equity free cash flow (defined as net income plus depreciation and amortization minus capital expenditures) has increased at a 27% annual rate for the past five years.

The beauty of this business is that, come hell or high water, customers will almost never reduce their telephone usage. It's a stable, consistent business. As such, the debt load is not something to worry about. In the most recent quarter, Alltel's operating income was five times the amount of interest expense (this is a metric called "times interest earned"). That's a manageable level of debt to carry.

At the current price of around $39, Alltel stock is trading at a low 12 times estimated 2002 earnings of $3.18. That translates into an earnings yield (earnings divided by stock price) of over 8%, which isn't bad, in and of itself, even assuming no growth. Consider, too, that Alltel's seven-year average P/E is 20. A multiple of 20 is probably the high end of Alltel's fair value, but I think the company merits at least a P/E of 15, given the reliability of its earnings.

I'd say, then, that fair value falls somewhere between a P/E of 15 and 20, which means we're talking about $47.70 on the low end and $63.60 on the high end. With business holding steady, I see little risk on the downside and an upside of at least 22% (at a P/E of 15); plus, let's not forget the dividend yield of 3.4%.

If Alltel, with its stable business and solid yield, is what the dove brought back, we're at least beginning to see some dry ground in this market.

Matt Richey is a senior investment analyst for The Motley Fool. At the time of publication, he had no position in any of the companies mentioned in this article. Matt's personal portfolio is available for view. The Motley Fool is investors writing for investors.