Income investors can't count on their traditional go-to investments anymore to provide the kind of payouts they've grown to rely on. With bonds and other fixed-income investments having had their yields plunge, investors have had to look elsewhere to meet their income needs.
Today, we're concluding the Fool's week-long look at innovative investments to provide much-needed income for cash-strapped investors. Earlier this week, you had the opportunity to read about the double-digit yields that mortgage REITs offer, as well as the unique tax advantages of master limited partnerships and the diversified exposure that dividend ETFs provide. In the final article of this series, let's take a closer look at a specific sector of the stock market that has traditionally provided some of the richest payouts available: telecom stocks.
The foundations of telecoms
It may be hard for many younger investors to believe, but telecom stocks started out looking a lot like utilities. The telephone industry was heavily regulated for decades, with AT&T (NYSE:T) essentially having a monopoly on domestic landline service and therefore generating reliable yet government-limited income for shareholders year after year.
Even after the breakup of AT&T, regional Baby Bells still enjoyed dominance over their respective parts of the country. It took still more time for deregulation to take hold, for the long-distance business to fully separate from local landline service, and finally for the rise of mobile technology to gain ascendance and transform the industry from a staid and stable bastion of industry to a rapidly evolving growth powerhouse.
Still churning out cash
The pace of innovation among telecom companies has created a huge divide within the industry. AT&T and surviving former-regional Verizon are the top two telecom stocks in the U.S., both with rapidly growing wireless networks that the companies are using to support sales of mobile devices and lucrative data contracts. Yet despite huge capital expenditures for network expansion, the two companies maintain the two highest dividend yields in the Dow Jones Industrials. By contrast, former long-distance specialist Sprint Nextel (NYSE:S) has gained attention due to its recent capital infusion from Japan's Softbank, but it's been on shaky-enough financial ground that it hasn't paid a dividend recently.
On the other side of the spectrum are the companies that have taken on the leftovers of the legacy businesses of those high-growth telecom giants. Frontier Communications (NASDAQ:FTR), Windstream (NASDAQ:WIN), and CenturyLink (NYSE:CTL) all have even higher dividend yields than AT&T and Verizon, because their focus isn't on rapid expansion of cutting-edge wireless networks. Rather, these rural telecom companies still serve customers who've held on to traditional landlines and other lower-margin services.
Because maintaining these old-tech solutions is relatively inexpensive, the revenue these companies produce largely goes out to investors in the form of free cash flow. Yet as the number of people willing to pay for obsolescent technology declines, these companies face a dwindling customer base. Despite seeking new avenues for growth such as higher-margin services like broadband and cloud computing products, Frontier has had to cut its dividend twice, and neither CenturyLink nor Windstream has been able to match the dividend growth that AT&T and Verizon have given their shareholders.
Understanding telecom dividends
One common issue that confuses investors in telecom stocks is reconciling earnings with cash flow. On the face of it, many telecoms pay dividends that greatly exceed earnings, which is traditionally a red flag that indicates a dividend isn't sustainable.
Telecoms, however, have huge sunk costs invested in their existing networks. Because they have to depreciate those assets over time, the full cost of those capital expenditures isn't reflected immediately in earnings, instead being spread out over years or even decades. Yet depreciation isn't a cash expense, which means that the companies have more cash on hand than their earnings would suggest. That's why looking at how dividends compare with free cash flow is a far more useful metric for gauging whether dividends are sustainable.
Get the income you need
In evaluating telecom stocks, you need to be comfortable with the different income characteristics of each player in the industry. Only by understanding both current dividend yields and prospects for future growth will you find the right balance for your particular portfolio.
Thanks for reading our week-long series on income solutions for investors. I hope that by using some of the information from these articles, you'll find sources of income that are consistent with your investment objectives and financial needs.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.