Calling All Yield Hunters!

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Dividends have become more popular over the last few years, as investors have realized that these payouts give them protection even if the market goes down. For those who reinvest their dividends they also get the benefit of a higher effective yield over time. There are certain areas of the market where dividends are more prominent, and the telecom industry has been a mainstay for income investors for a long time. On the surface, many telecoms seem to offer very attractive payouts, with some yields in the double digits. However, investors have learned with the blowup of Telefonica's dividend that these payouts are not all created equal. That being said, there are still some very attractive dividends within the sector, particularly in the international marketplace.

To try and determine the most attractive company in telecom, I recently used The Motley Fool's CAPS Screener to find highly rated telecom companies. I know that most telecoms pay good dividends, but I wanted only the highest rated (4 – 5 star) stocks on CAPS. This screen returned several companies, but I chose four of the highest yielding telecoms. With dividend yields starting at 5%, each company offers a yield much higher than most bonds or other investments. The four companies we will be looking at are BCE, Inc. (NYSE: BCE), France Telecom (NYSE: ORAN), Portugal Telecom (NYSE: PT), and Vodafone (NASDAQ: VOD).

These companies give investors exposure across the globe, from Canada to Portugal, with different growth and income characteristics. Let’s begin by comparing each according to relative valuation. 

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>P/E on '12 Earnings</strong></p> </td> <td> <p><strong>Growth Expected</strong></p> </td> <td> <p><strong>PEG</strong></p> </td> </tr> <tr> <td> <p>BCE, Inc.</p> </td> <td> <p>13.68</p> </td> <td> <p>3.75%</p> </td> <td> <p>3.65</p> </td> </tr> <tr> <td> <p>France Telecom</p> </td> <td> <p>7.1</p> </td> <td> <p>-0.95%</p> </td> <td> <p>negative</p> </td> </tr> <tr> <td> <p>Portugal Telecom</p> </td> <td> <p>7.08</p> </td> <td> <p>14.30%</p> </td> <td> <p>0.5</p> </td> </tr> <tr> <td> <p>Vodafone</p> </td> <td> <p>10.75</p> </td> <td> <p>8.20%</p> </td> <td> <p>1.31 </p> </td> </tr> </tbody> </table>

As you can tell, the growth rates vary widely between companies. Normally the highest PEG ratio could indicate a stock that is the most overvalued. Generally speaking, a low growth rate and high P/E ratio would be a big deterrent for investing in any company…but it’s even worse with France Telecom. The company is selling for a very cheap P/E ratio, but analysts expect negative earnings growth. This puts France Telecom at the bottom of the ladder. On the opposite end of the spectrum is Portugal Telecom, which is selling for half of its growth rate and has the fastest growth of the four. (Portugal Telecom – 4, Vodafone – 3, BCE – 2, France Telecom – 1)

Each of these companies sells mobile and broadband services, as well as local line access. One of the most basic ways to measure a company's efficiency is by looking at its gross margin. In theory, the company that keeps the most out of each $1 of sales could produce the most cash flow for investors. Portugal Telecom sells for the lowest relative valuation, and also has the highest gross margin at 59.44%. France Telecom shows a gross margin of 56.63%, Vodafone comes in at 48.97%, and BCE is the lowest at 42.38%. (Portugal Telecom – 4, France Telecom – 3, Vodafone – 2, BCE - 1)

However, gross margin doesn't always determine who generates the most free cash flow. Free cash flow shows what a company can do for its shareholders. It makes sense to know how well a company generates free cash flow, particularly if you are looking at dividend paying stocks. BCE clearly wins this category, with $0.27 of free cash flow per $1 of sales in the most recent quarter. In second place is France Telecom, which shows $0.14 of free cash flow. Vodafone comes in third, reporting $0.11 of free cash flow per $1 of sales. Last is Portugal Telecom, which shows negative free cash flow. This also gives us a clue to why Portugal Telecom's stock is selling at a discount: as long as the company is free cash flow negative, that's a big problem for dividend investors. (BCE – 4, France Telecom – 3, Vodafone – 2, Portugal Telecom – 1)

Since each company's dividend is the primary attraction for many investors, both dividend yields and payout ratios must be considered. When it comes to dividends, I personally always prefer a sustainable payout ratio over a higher yield. Portugal Telecom pays the highest yield at nearly 14%, but the company is currently reporting negative cash flow. Last year, the company's free cash flow payout ratio was over 200%. While France Telecom has the second highest yield at nearly 13%, its free cash flow payout ratio is much more reasonable at 71%. Vodafone has an over 100% payout ratio, but its yield of 6.8%. BCE has the lowest yield of the group at 5.29%, and its payout ratio is somewhat reasonable at just less than 80%. With the highest yield and best payout ratio, France Telecom wins this category by a landslide. (France Telecom – 4, BCE – 3, Vodafone – 2, Portugal Telecom – 1)

The end result is BCE – 10, France Telecom – 11, Portugal Telecom – 10, Vodafone – 9. Given the fact that France Telecom pays a nearly 13% yield that appears to be covered, even its negative expected growth rate isn't enough of a deterrent for the company to take the overall win. Portugal Telecom pays the highest yield and has the highest growth rate. However, this has to be taken with a grain of salt because of the company's negative free cash flow. If Portugal Telecom cannot reverse its negative free cash flow, its dividend is likely to be cut or eliminated, which eliminates the primary reason to consider the stock.

BCE pays the smallest yield, has the second lowest growth rate, and the lowest margin, thus leaving it as a less attractive option. Vodafone falls somewhere in the middle, and its high free cash flow payout ratio is somewhat offset by its partnership with Verizon under the Verizon Wireless brand. Considering the huge dividend payment Verizon made to Vodafone not long ago, the company's free cash flow payout ratio may not accurately reflect the cash flow the company could expect in the future.

Bottom line, it appears either French Telecom or Vodafone could be attractive options for investors looking to capitalize on the high dividend yields offered in this sector. Investors hungry for income should consider dialing up their gains with one of these high yielding stocks.

MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of France Telecom (ADR). Motley Fool newsletter services recommend France Telecom (ADR), Vodafone Group Plc (ADR), and Vodafone Group Plc (ADR). 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.If you have questions about this post or the Fool’s blog network, click here for information.

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