Volumes have been written on Dow Theory, "Dogs of the Dow," as well as sector investing, and I have also written in the past about these topics. However, I thought it useful to review the Dow stocks that are in each S&P 500 sector, one sector at a time.  AT&T, Inc. (NYSE: T) and Verizon Communications Inc. (NYSE: VZ) are two Dow Jones Industrial Average (NYSE: ^DJIA) component stocks, and the only two Dow stocks in the S&P 500 Telecommunications Sector. 

Company Year To Date G/L Dividend Yield Total Return YTD Price/Earnings Ratio Earnings Quality Score
AT&T 23.70% 4.68% 28.38% 50.17

C
Verizon 11.91% 4.46% 18.37% 44.43

C

Source: S&P Capital IQ

The table uses recent prices for AT&T and Verizon to derive year-to-date stock price gains and total returns, including dividend yields.  Each stock also has a "C" rating for earnings quality, but both were "A" stocks at the start of 2012. The Motley Fool Earnings Quality Score database ranks stocks "A" through "F" weekly, based on price, cash flow, revenue, and relative strength, among other things. Stocks with poor earnings quality tend to underperform, so we look for trends that might predict future outcomes. 

You may not have known before reading this, but these two Telecommunications Sector stocks are among Dow leaders for returns to date, with 23.38% average return between them.  Other interesting facts: These two stocks have the highest dividend yields and, also, the second (AT&T) and third (VZ) highest price/earnings ratios in the Dow. This is subject to change, of course, but affects fundamental analysis and earnings quality.

Putting aside fundamental trend data for a moment, the real battle between these two telecom giants is for market share of Apple Inc.'s (Nasdaq: AAPL) iPhone and iPad device sales, and data and voice subscriptions of the seemingly ever growing population of Apple fans.  But this "tower of babble" could come crashing down if current users wait to upgrade to the latest models of these devices, or purchase them at lower price points. These are just two examples of things that could go awry.  Google Inc.'s (Nasdaq: GOOG) Android operating system also remains a fierce competitor to Apple's OS. From the fundamental data, however, AT&T clearly wins the battle as far as its 2012 year-to-date return over Verizon.  AT&T beat earnings estimates, whereas Verizon's earnings were in line with analysts' estimates for the most recent quarter.  Big deal, however, as Verizon's growth rates are slightly higher than those of AT&T, and Verizon actually may be the better buy among the two stocks.

AT&T
AT&T's reported quarterly earnings per share of $0.66 showed a 10% growth rate from a year ago, based on reported net income of $3.9 billion. AT&T's quarterly revenue of $31.575 billion was slightly ahead of last year's $31.495 billion, same quarter.  The last 12 months' revenue showed a gain of only 1.35% year over year.

AT&T reported operating cash of $9.663 billion, and free cash flow (operating cash minus capital expenditures) of $5.352 billion for the quarter.  However, debt increased year over year from $58.663 billion to $61.132 billion.  Despite AT&T's robust operating cash flow, some of this debt may have been used to buy back approximately 121 million shares during the last 12 months, thereby artificially boosting earnings per share.  This is the likely reason why EPS advanced 10% versus revenue growth of only 1.35%.

Verizon
Verizon's reported quarterly earnings per share of $0.64 showed a 12.28% growth rate from a year ago, based on reported net income of $1.825 billion. Verizon's quarterly revenue of $28.552 billion was better than last year's $27.536 billion, same quarter, and a modest gain of 3.69% year over year.

Verizon reported operating cash of $9.314 billion, and free cash flow of $4.662 billion for the quarter.  Verizon decreased its debt year over year by $1,448 billion to $46.479 billion, and shares actually increased by 18 million shares to 2.849 billion shares.   Even with these added shares outstanding, earnings were in line with estimates.

Foolish Bottom Line
Casual stock pickers might be concerned about the PE ratios, or that the high dividend yields may be in jeopardy. But notice that I focus on trend data, and I'm also not big on traditional earnings analysis, because other metrics like cash flow are as, or more, important, in my opinion.  To this point, if you look at each company's cash flow per share (cash from operations minus preferred dividends divided by shares outstanding), you'll get a more accurate idea of a company's financial situation, and the strength and sustainability of their business models.

AT&T has quarterly cash flow per share of $1.63, whereas Verizon has $3.27 per share.  Their operating cash flow to price ratios are 5.9x and 3.9x, respectively.  Verizon is growing revenue and earnings slightly faster than AT&T, and has better cash flow per share. But the point of this commentary is to reveal your results if you had purchased both stocks as a sector play.  Foolish readers should base investment decisions on earnings quality.

Time for action
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