Why dividend cuts can spell opportunity for investors
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Associate Editor
David Stevenson Dec 16, 2011
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Investors in Spain have just had a nasty shock.
Telefonica, the country’s biggest telecoms firm, has been one of the highest-yielding stocks in Europe. But yesterday the company announced that next year’s dividend payment would be cut.
It’s the first time the pay-out has been cut in a decade. And it’s a big change from what the Spanish giant said just a few months ago. Analysts are now getting jittery that more dividend cuts could be on the way across the sector.
So should you avoid these stocks?
Not at all. In fact, this could be the perfect buying opportunity…
The telecoms sector is no longer ‘exciting’
Telecom companies in the UK and Europe used to be seen by the markets as growth stocks. But they aren’t in that category any more.
That’s quite understandable. Firms that supply your landline, your internet package and run the mobile phone networks, are no longer ‘exciting’. The days of rapid growth are largely behind them.
Worse, managements in the industry have been variable at best. Several big telecom companies destroyed lots of shareholder value by overpaying for acquisitions at the peak of the dotcom boom, and many have racked up big debts in the process of building their businesses.
The industry also faces the double whammy of stricter regulation and rising capital expenditure (capex) needs. The latter means the sector might have to raise fresh cash from shareholders via rights issues. In turn, that would create an extra supply of shares, which could depress share prices.
Given all that, you can see why many stocks in the sector have fallen right out of favour. However, that’s one of the reasons why telecom stocks are so attractive – falling share prices mean they now offer some of the highest dividend yields on the market. And with Britain’s inflation rate still running at 4.8%, a nice big yield is just what many investors are looking for.
But now of course, a snag has just appeared: that news from Telefonica. The Spanish telecoms giant is standing on a yield for 2011 of over 12%. However, next year’s cash dividend will be cut by more than 25% from the firm’s original forecast.
That’s despite an earlier series of assurances from management that the 2012 payment ought to be safe from harm. And the lower payout level could be repeated in 2013.
All this, say Miles Johnson and Daniel Thomas in the FT, “will call into question the sustainability of shareholder payouts by its competitors”. In other words, investors will now be keeping a very close eye on other high-yielding European telecoms stocks, to see if Telefonica’s move is repeated elsewhere.
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Why you should stick with the telecoms sector
So does this mean you should sell or avoid telecom stocks like Telefonica? No it doesn’t. Here’s why.
Firstly, the cut isn’t as bad as it sounds. You see, Telefonica had originally planned to raise its 2012 dividend compared with this year by almost 10%. So the actual cut in the cash payment for next year compared with 2011 will be around 19%. Remember that Telefonica currently stands on a yield of more than 12%. So a 19% payout cut would still leave it on a near-10% yield.
Sure, we may not have seen the last of Telefonica’s dividend-cutting yet. The group is one of the most indebted European telecom firms. So it needs to try to pay down its borrowings. Sales in Spain are suffering as an already weak economy gets even worse.
But even if the dividend were to be cut by a third in total, shareholders would still be getting an 8% yield. That would still be a healthy annual return to be going on with.
And Telefonica has been keen to stress its future commitment to its shareholders. “Paying dividends is in our DNA”, as chief financial officer Ángel Vilá said. With the firm’s Latin American operations, which already account for almost half overall sales, growing well, there’s hope for the future, too.
The same applies to other major European telecoms stocks on very high yields. These firms have their problems. And now that Telefonica has cut its dividend, the others may feel they have the green light to follow suit.
But these businesses are still big cash generators. That enables them to pay most of their profits out to their shareholders. So a future pick-up in business, even if it’s some way off, should be reflected in higher dividends again.
Is now the time to buy?
So should you buy European telecom stocks now? The more cautious among you might want to wait for the dust to settle after Telefonica’s move.
But it’s often a good idea to snap up stocks after dividend cuts: they clear the air by bringing the bad news into the open. And when I see doom and gloom everywhere in the sector – as was flying around yesterday – I can’t help but think that a good buying opportunity is on the way.
Alternatively, if you like the idea of the telecom sector’s high yield, but prefer something a bit safer than Telefonica, why not look at our long-term favourite Vodafone (LSE: VOD)? Even after its recent ‘special dividend’ payout, it’s on a p/e of just 11 and a 5.5% yield. That’s still better than the UK inflation rate.
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