Telcos - dial D for dividend?

TELECOM companies are generally viewed by investors as defensive shares. In other words, they can be in demand when economic growth is slow. That's because they could compensate for lower interest rates we earn from our savings accounts, thanks to their reliable dividends. But there's a downside. They can lag the market when economies are growing quickly. After all, who would want dividends when share prices are shooting the lights out?

So, are telecom shares worth the effort? From a total return perspective, they could be. The median annual total return over the last decade for a basket of global telecom companies is a not-at-all-disappointing 8.7 per cent. In other words, S$1,000 invested in those businesses would have been worth S$2,303 after 10 years.

But there are notable differences. Singtel has returned about 3.8 per cent annually, StarHub has returned 2.2 per cent, while Japan's NTT has delivered a total annual return of 10.6 per cent over the last decade.

What's interesting is that only a fraction of the returns has come from the rise in share prices. Put another way, it means that nearly all the returns have been due to reinvested dividends.

So, dividends are key. Consequently, investors should moderate, if not abandon, their expectations for rapid share-price growth. Instead we should focus on the ability of telecom companies to pay reliable and, more importantly, affordable dividends.

On that count, the future doesn't look too disappointing. The retention ratio, which is a proportion of the profits that telecom companies retain for investing in their own businesses has been around 40 per cent over the last decade. However, that money must be put to work prudently, if future dividend payouts are to be both sustainable and growing.

To help us arrive at a view about the future dividends of telecom operators, the return on equity can help. This is a measure of the profits that they make on the money that shareholders have invested in the business, which includes those retained profits. In general, the higher the return on equity, the brighter the outlook for future pay outs. And telecom companies don't disappoint.

The return on equity since 2006 has been in the high teens, with a median of 17 per cent. It means that telecom companies have, on average, delivered S$17 of bottom-line profit on every S$100 of investor funds. The upshot, given that telecom companies have retained around 40 per cent of profits, is that investors could expect dividends to grow around 6 per cent. That is not too different from the annual total returns that these companies have delivered to shareholder over the last decade.

But that still leaves unanswered the question as to whether it is worth buying telecom companies. This is where the free cash flow yield could point us in the right direction. This measures the amount of free cash flow the company is expected to earn compared to its market price. In other words, how much free cash is being generated for every dollar of shares that we might decide to buy.

The reason why we might want to look at cash flow rather than profit is because of the capital-intensive nature of these businesses. They can spend heavily on capital goods and licenses, which then need to be depreciated and amortised. That can distort bottom-line profits, which is why cash flow is more useful. In general, the higher the free cash flow yield, the better. It means two important things. Firstly, investors are paying less for the free cash flow. Secondly, it could mean that the company is better able to sustain its ongoing operations without having to resort to raising more working capital.

So, what about the dividends? How attractive are the yields? They range from a low of less than 1 per cent to a high of more than 7 per cent. The median dividend yield is a respectable 4.8 per cent. But it's important to bear in mind that the dividend yield is made up of two components, namely, the payout and the share price. So, a high yield could be the result of a pessimistic outlook, which could result in a low share price, or a very generous dividend.

One way to determine if the pessimism is justified could be to look at whether the dividends are adequately covered by cash flow. We know from the payout ratio that telecom companies have generated enough profits to pay dividends. But do they produce enough cash to do so?

There is a worrying trend that we should be aware of. In 2007, dividends were adequately covered by cash flow. But since then, they have slipped. That could help explain why some telecom companies have had to cut their dividends. So, from an investor's perspective, it is vital to look closely at the dividend cover. The yield only tells us one part of the story.