A Giant Cash Machine with a Fat Yield

10/09/2009 1:39 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Why? That’s always the first question to ask when you see a common stock like Verizon Communications (NYSE: VZ) trading with a dividend yield of 6.52%.

That’s so much higher than the yield on the Standard & Poor’s 500 index (2.1% as of last week) that any reasonable investor wants to know what the market thinks is wrong with this company.

In this case, I think it’s easy to figure out why enough investors hate this stock to drive the yield up so far—and to conclude that the market is wrong in the degree of its worry.

That makes Verizon a buy for the investor in search of reasonably safe, but high yields.

Here’s what’s wrong with Verizon: 

The company’s land line business is slowly shrinking. In the second quarter, phone lines to homes and businesses declined by almost 10% from the second quarter of 2008.

The US wireless market, which is supposed to grow fast enough to make up for the drop in land line phones, is nearing saturation. There are now nine mobile devices in circulation for every ten people in the United States.

Verizon’s solution is to invest in its network so that it can add more, very profitable Internet and video users through its FIOS system. That’s enormously expensive. The company plans to spend $23 billion in 2009 and 2010 to build out its fiber optic network.

Verizon already carries a huge amount of long-term debt. The company finished the second quarter of 2009 with $59 billion in debt.

That’s a long list of worries, and most of them are reasonable—which is why the price is low enough for the stock to pay a 6.52% yield.

But while these worries are reasonable, they are overblown. (For more on Verizon’s business, see my August 14th post.)

Yes, Verizon is losing land line customers. (Hey, it is a recession, remember?) But the company is losing them in a controlled fashion, and its strategy of replacing the revenue from departing customers by getting remaining customers to upgrade to higher-margin data, high-speed Internet, and video services is working.

The crucial metric here is cash flow. The company’s cash flow from operations was a huge $23.6 billion in 2008. That was more than enough to cover the $1.90 per share annual dividend and the company’s capital spending.

The board of directors signaled its confidence that this cash flow would continue by raising the dividend payout in the third quarter of 2009.

Yes, the wireless market in the United States is reaching saturation in numbers, but there’s still room to take market share from Sprint Nextel (NYSE: S), a fading number two, and to upgrade customers to new smart phones.

Smart phone customers should be more profitable than regular cell phone users. Here, the number to watch is AMPU, or average margin per user. (Hats off to Morningstar for this insight and number crunching.)

This ratio divides a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA) by the number of customers to figure out how profitable the average customer is.

For Verizon, the AMPU in the second quarter came out to a very healthy $24. That’s the highest in the industry.

Yes, Verizon’s build out of its fiber optic network is very expensive, but as an investment, it appears to be worth it so far. In the second quarter, Verizon added 303,000 net FIOS Internet customers and 300,000 FIOS television customers. On average, FIOS customers pay $135 a month, about twice the bill for the average Verizon customer.

And yes, Verizon carries a huge debt load, but the company has the cash flow and earnings to pay the tab.

In conclusion, I think the worries are overstated, the price is overly depressed, and the yield is a bargain.

Today, I’m adding Verizon to my ten-stock dividend income portfolio to replace US Bancorp (NYSE: USB). I’ll start tracking the whole portfolio next week.

Look for a new portfolio tab at the top of the page on JubakPicks.com.

Full disclosure: I don’t own or control shares of any company mentioned in this post.

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