One thing that draws many investors to telecom stocks is the great dividend yields that many companies in the sector offer. Subscription revenue and long-term contracts are a great recipe for predictable free cash flow. And many of the industry’s largest companies are happy to return that money to shareholders.
Verizon Communications (NYSE: VZ)For example, $11.2 billion was returned to shareholders in the past twelve months. The share currently has an attractive dividend yield of 6.6%. AT&T (NYSE:T) has downsized in recent years and now focuses exclusively on its telecom activities. It has a dividend yield of 5% and returned $8.2 billion to shareholders last year.
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But one of its biggest competitors has returned even more money to shareholders. T-Mobile (NASDAQ:TMUS) returned a total of $11.8 billion last year. The only caveat is that this telecom giant primarily uses stock buybacks in its capital return program, something that has been virtually non-existent at Verizon and AT&T lately.
Over time, however, T-Mobile could shift that focus to dividends. Management just announced a 35% dividend payout increase, bringing the yield to a healthy 1.6%. T-Mobile’s massive capital return program could actually prove better for shareholders than big cash dividends from the competition.
There are really only two ways management can return excess cash to shareholders: stock buybacks and dividends.
Dividends are simple: the company pays owners a fixed amount of cash per share, usually at a regular cadence, such as every quarter. Although management is not required to pay out the same amount each period, dividends are generally very fixed. Once a company starts paying a certain amount, it tries to continue paying at least that amount. Often a company will increase its dividend over time. Verizon has increased its dividend annually for eighteen years in a row.
Share buybacks, on the other hand, are an indirect way of returning money to shareholders. Instead of handing out cash, management uses it to buy shares of the stock in private deals or on the open market. The shareholders ultimately get a larger share of the company.
Another way to think about it is that shareholders receive shares in the company instead of cash. It is almost the same as a shareholder automatically reinvesting his dividends in the stock. However, there is much less tax burden on the transaction. Share repurchases are subject to a 1% tax (paid by the company); qualified dividends are taxed at the long-term capital gains tax rate (paid by the shareholder).
Returning capital to shareholders through share buybacks can therefore be a much more effective way to create shareholder value than a dividend. So investors shouldn’t write off T-Mobile’s huge capital returns over the past year just because the company focuses on buybacks instead of dividends. For long-term investors, T-Mobile’s ability to reduce its share count today will increase the potential dividend the company pays in the future.
It’s one thing for a company to reduce cash on its balance sheet during a one-time spike in capital returns, but it’s another thing entirely if it consistently returns more and more cash to shareholders.
Management expects to generate approximately $80 billion in additional capital capacity and shareholder returns through 2027 by maintaining current leverage ratios and increasing earnings before interest, taxes, depreciation and amortization (EBITDA). The company has already set aside $10 billion for existing transactions, but expects to return $50 billion of that to shareholders. That’s an average of more than $15 billion annually at the time management made the announcement on investor day at the end of the third quarter. There also remains $20 billion for additional investments or acquisitions, but some of that could also end up in the capital return program.
The vast majority of these capital returns will come in the form of share buybacks, but investors can also expect steady dividend growth. As mentioned, management already announced a 35% dividend increase in September. Yet that will only total about $4 billion over the next year.
Management aims for a share of the free cash flow of mid 20% for its dividend. The 2027 outlook calls for free cash flow of $18.5 billion, meaning investors can expect a total of about $4.6 billion in dividend payments that year. Combined with the aggressive share buybacks, investors can reasonably expect annual increases of around 10% over the next two years, based on management’s comments.
T-Mobile has two advantages over AT&T and Verizon in its ability to generate cash and return it to shareholders. Firstly, it is not as user-friendly as both competitors. Both AT&T and Verizon have made debt-financed acquisitions over the past decade that added no value to shareholders but left them with a lot of debt. They are still paying off debt, which is eating up a lot of cash flow.
In addition, T-Mobile has an advantageous spectrum portfolio, allowing it to be more selective and cost-conscious when it comes to new auctions of spectrum licenses. It has also followed a different strategy when it comes to fiber, opting for leasing fixed assets. That saves money in terms of capital expenditure, but incurs ongoing costs. T-Mobile could change its strategy in the future, which could erode the $20 billion cushion from its long-term prospects.
There’s no denying that investors will have to pay a premium for T-Mobile stock versus AT&T or Verizon. The stock trades for an enterprise value/EBITDA ratio of 11. That’s well above AT&T (7.3) and Verizon (8.2).
That said, T-Mobile expects EBITDA to grow 7% annually from 2023 to 2027, more than three times faster than AT&T or Verizon. That’s driven by market share gains as T-Mobile remains the fastest-growing wireless carrier in the country. T-Mobile also expects to improve the margin on service revenue, with an emphasis on free cash flow conversion. It targets a conversion of 25% free cash flow in 2027, compared to 21% in 2023.
Faster growth and expanding margins should support a much higher multiple than its peers. With the massive share buyback program increasing the value of future earnings for each remaining share, the stock appears fairly valued.
Investors interested in a company focused on returning stable and growing cash flows to shareholders in the most effective manner should take a closer look at T-Mobile.
Consider the following before buying shares in T-Mobile US:
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool recommends T-Mobile US and Verizon Communications. The Motley Fool has a disclosure policy.
This unstoppable telecom giant has returned more capital to shareholders in the past year than both AT&T and Verizon, and just increased its dividend by 35%. originally published by The Motley Fool
