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Telecom Stocks : The "Ka-Ching" Ring Tone

 May 10, 2012 11:04 AM

(By Kevin Donovan) In a skittish U.S. stock market scared that the deepening shadows of Europe will lengthen to darken these shores, investors in two big telecommunications names have been enjoying extended sunshine.

We think it's still midday for Verizon Communications (VZ) and AT&T (T) and that it's not too late to buy, whether you believe the bull market is in its dotage or not.

Trading near 52-week highs, the U.S. phone service giants have delivered healthy stock price appreciation this year along with hefty dividends.  Verizon's share price is up 6.9% and AT&T's up 10.1% in the last three months.  On a 12-months' basis, the shares are up 8.9% and 5.4%, respectively.  That compares with industry share price returns of 2.3% and -1.0% for the same time periods.

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Verizon sports a dividend yield of about 4.93%, while AT&T's dividend is at 5.33%.

Coverage is impressive, too.  In the latest quarter, Verizon reported free cash flow of $2.4 billion, covering the $0.50 quarterly dividend about 1.7 times.  Meanwhile, AT&T reported first quarter free cash flow of $3.5 billion, which covered the $0.44 dividend 1.33 times.

Compared with the industry and the market, these big boy companies trade at premiums we think are justified, given clear growth prospects and histories of steady dividend increases. On estimated 12-months earnings, Verizon is valued at 43.1 times earnings and AT&T at 47.6 times, versus an industry average of 28.0 and the S&P 500 at 15.93.

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On a forward basis, the multiples are more reasonable, with Verizon at 14.48 times 2012 estimates and AT&T at 12.77.  The S&P 500 PE for forward estimates is 13.25.

Growth in earnings and free cash flow is key to sustaining returns, so we looked at recent results and prospects for these two companies and are confident they can deliver.

At Verizon, first quarter EPS were $0.59, up 15.7% over first quarter last year. Revenue was up 4.6% year over year to $28.2 billion. Adoption of Verizon's high-speed optic cable service, FiOS, continued with room for further gains. And smart phone penetration remained brisk.  Verizon said its broadband net additions were the highest in three years.

AT&T reported $0.60 diluted EPS compared to $0.57 in the first quarter of 2011.  Revenues of $31.8 billion were up1.8% vs a year earlier.

The companies had similar operating margins in the latest quarter – Verizon at 17.5% and AT&T at 18.0% vs the industry's 15.9%. Risks include smart phone subsidies eating into margins and cutbacks to data growth if consumers are pinched by another economic downturn.  We don't see that, despite the risk of European contagion and recent anemic jobs data.  We think equities that pay safe dividends significantly higher than returns on Treasury notes will continue to be valued by investors.  Verizon and AT&T, the dominant carriers in the telecommunications sector, fit that bill.

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