(Published by Nick McCullum on July 7)
The Dividend Aristocrats list is a great place to begin looking for high-quality dividend growth stocks.
These stocks represent some of the "best of the best" when it comes to dividend longevity.
The requirements to be a Dividend Aristocrat are:
- Be in the Standard & Poor's 500.
- Have 25-plus consecutive years of dividend increases.
- Meet certain minimum size and liquidity requirements.
You can see the full list of all 51 Dividend Aristocrats here.
Telephone & Data Systems Inc. (TDS, Financial) is an interesting omission from the Dividend Aristocrats index.
The company has increased its annual dividend payment since 1975 – a period spanning 42 years. Telephone & Data certainly satisfies the dividend history requirement to be a Dividend Aristocrat.
So why has the company been excluded from this prestigious group of dividend stocks?
It must have something to do with the S&P 500 inclusion requirement or the liquidity requirement.
Business overview
Telephone & Data Systems is a telecommunications services company with a market capitalization of $3.1 billion.
The company provides cellular and landline services to more than 6 million customers across 34 states.
Telephone & Data’s business is divided into two operating segments:
- Cellular Operations (77% of 2016 revenue).
- Telephone Operations (23% of 2016 revenue).
Telephone & Data was founded in 1969 and is headquartered in Chicago. The company provides services through its two operating subsidiaries, TDS Telecom and U.S. Cellular.
Why the exclusion?
There are two potential reasons why Telephone & Data has been excluded from the Dividend Aristocrats list.
The first is the failure to "meet certain minimum size and liquidity requirements." These requirements are not specified, but it is possible this is the reason why Telephone & Data has been excluded from the index.
Consider the following:
- Telephone & Data has a market capitalization of $3.1 billion while the two smallest Dividend Aristocrats – Leggett & Platt (LEG, Financial) and Federal Realty Investment Trust (FRT, Financial) – have market capitalizations of $7.0 billion and $9.1 billion. Telephone & Data’s market capitalization is noticeably smaller than the smallest Dividend Aristocrats.
- There are six Dividend Aristocrats who have had smaller average daily trading volumes over the past 30 days than Telephone & Data. Along with Federal Realty Investment Trust, these include Sherwin-Williams (SHW, Financial), Clorox (CLX, Financial), McCormick & Co. (MKC, Financial), Cincinnati Financial (CINF, Financial) and Cintas (CTAS, Financial).
With that data in mind, it is hard to tell whether Telephone & Data has been excluded because of its size and liquidity. There’s a possible argument to be made for size but not for liquidity relative to other Dividend Aristocrats.
Some research reveals that the company is not a member of the S&P 500 index.
While assessing the company’s size and liquidity is subjective, the company’s exclusion from the S&P 500 Index can be identified as a concrete reason why this stock is not a Dividend Aristocrat.
Growth prospects
Telephone & Data’s growth will be driven by rising subscriber numbers in its landline and wireless segments.
The company’s 2017 strategic priorities include increasing penetration in its existing markets along with continuing to be active in the mergers and acquisitions front.
Source: Telephone & Data First Quarter Earnings Presentation, slide 15
The importance of future acquisitions to Telephone & Data’s growth cannot be understated.
Management has stated that it intends to devote 75% of its cash flow to the acquisition of cable or broadband services companies as well as hosting services companies.
Competitive advantage and recession performance
Telephone & Data’s largest competitive advantage comes from its network quality.
Recently, U.S. Cellular (an operating subsidiary of Telephone & Data) received the JD Power award for the Highest Wireless Network Quality Performance in the North Central Region.
Source: Telephone & Data First Quarter Earnings Presentation, slide 6
The company’s high-quality network is noted by its customers; financially this results in a reasonable churn rate for Telephone & Data.
The company’s churn rate over recent financial periods can be seen below.
Source: Telephone & Data First Quarter Earnings Presentation, slide 6
As a telecommunications company, Telephone & Data should be reasonably recession resistant.
In today’s connected world, consumers are unlikely to cancel their cell phone plans due to a broad economic recession.
We can assess Telephone & Data’s ability to endure through economic downturns by looking at the company’s performance during the last recession of 2007-2009, shown below.
- 2007 adjusted earnings per share: 36 cents.
- 2008 adjusted earnings per share: 38 cents.
- 2009 adjusted earnings per share: 40 cents.
- 2010 adjusted earnings per share: 41 cents.
Telephone & Data’s adjusted earnings per share ground steadily upward during the last recession, which demonstrates this company’s recession resiliency.
Valuation and expected total returns
Telephone & Data’s expected total returns will be composed of its dividend yield, valuation changes and growth in the company’s adjusted earnings per share.
Telephone & Data currently pays a quarterly dividend of 15.5 cents per share which yields 2.2% on the company’s current stock price of $27.97.
While Telephone & Data’s dividend yield is above its historical levels as well as the average dividend yield in the S&P 500, it is not supported by the company’s current earnings.
Telephone & Data reported adjusted earnings per share of 39 cents in 2016 and is expected to report adjusted earnings per share of 50 cents in 2017. The company’s current quarterly dividend of 15.5 cents (or 62 cents annually) exceeds both of these earnings numbers by a wide margin.
Given its unreasonable dividend payout, there are two future scenarios for Telephone & Data:
- A dividend cut occurs.
- Earnings rebound rapidly to support its dividend payment.
Regardless of which future scenario occurs, Telephone & Data’s lack of dividend coverage means that dividend growth investors should avoid this stock.
The company also appears to be severely overvalued.
Based on the earnings numbers mentioned earlier, the company’s current stock price of $27.97 is trading at a price-earnings (P/E) ratio of 71.7 (using 2016’s earnings) or 55.9 (using 2017’s expected earnings).
These valuation multiples are extremely high. The following diagram compares Telephone & Data’s current valuation to its long-term historical P/E ratio.
Source: Value Line; data unavailable for 2004, 2014 and 2016
Telephone & Data’s current valuation is high on an absolute basis, and it is also very high when compared to its long-term average.
One might think that the company’s sky-high valuation is due to robust earnings growth. Investors could be willing to pay more for a dollar of today’s earnings based on the expectations that earnings will rapidly accelerate in the future.
Sadly, this is not the case.
Telephone & Data does not have a track record of compounding its bottom line over long periods of time.
The company’s adjusted earnings per share were lower in 2016 than they were in 2001.
Source: Value Line
One of the reasons why Telephone & Data’s P/E ratio is so elevated right now is because its adjusted earnings per share dropped off a cliff in 2016, and its stock price did not decrease as much.
Computing a P/E ratio using 2015’s adjusted earnings per share of $1.98 gives 14.1, much more in-line with what one would expect from a telecommunications company.
With that said, the company’s earnings have been volatile, and Value Line estimates that the company’s earnings will only grow to about $1 per share over the next five years. Like it or not, Telephone & Data is grossly overvalued.
The 8 Rules of Dividend Investing tells investors to sell stocks with an adjusted P/E ratio exceeding 40. Telephone & Data is currently trading above that level.
Accordingly, investors should look elsewhere for a more reasonably valued source of telecommunications exposure. The company’s future shareholder returns will be significantly impaired by its current valuation multiple.
Final thoughts
Telephone & Data’s dividend history suggests that it should be a member of the Dividend Aristocrats list.
The company is not a member of the S&P 500 Index, though, which means it fails one of the three requirements to join this exclusive list of dividend stocks.
Not all great investments are Dividend Aristocrats. Stocks outside of this universe still merit some fundamental research.
Telephone & Data is grossly overvalued at current prices. Using 2017’s earnings estimates, the company’s stock should retrace by at least 50% – returning its P/E ratio to more normalized levels – before investors should consider an investment in Telephone & Data.
Disclosure: I am not long any of the stocks mentioned in this article.
