2023-06-20 00:26:51 ET
Summary
- The preferred stock of Telephone and Data Systems has plunged 54% over the last 12 months due to high interest rates and the company's high debt load.
- The company is currently struggling with poor business momentum, excessive debt, and operating losses, which raises concerns for investors.
- While the preferred dividend may be safer than the common dividend, investors are advised to avoid companies with high debt loads and a focus on EBITDA instead of earnings.
The preferred stock of Telephone and Data Systems ( TDS.PV ) has plunged 36% over the last 12 months. The decline has resulted from the surge of interest rates to multi-year highs as well as the high debt load of the company. Due to these two factors, the preferred stock is currently offering a 13.0% dividend yield and is trading at a 54% discount to its par value of $25. In other words, if interest rates revert to their 2008-2021 levels in the future and Telephone and Data Systems recovers from its ongoing downturn, the preferred stock is likely to approximately double off its depressed price. Nevertheless, there are some material risks in this investing thesis.
Risk Factor #1: High Interest Rates
Before purchasing a preferred stock, investors should always evaluate the prevailing environment of interest rates. High interest rates enable investors to identify attractive yields in many securities and thus they render preferred stocks less attractive. All the preferred stocks have felt the impact of the surge of interest rates since early last year.
Due to the sanctions imposed by the U.S. and Europe on Russia for its invasion in Ukraine and the excessive fiscal stimulus packages offered by the U.S. government in response to the coronavirus crisis, inflation soared to a 40-year high last year. Consequently, the Fed has been raising interest rates at an unprecedented rate since early 2022, in order to cool the economy and restore inflation to 2.0%-2.5%. The central bank has thus led interest rates to multi-year highs. The surge of interest rates has taken its toll on all the preferred stocks in the investing universe, including the preferred stock of Telephone and Data Systems.
On the bright side, the drastic response of the Fed has borne fruit. Since it peaked at 9.1% in June 2022, inflation has declined every single month and thus it is currently standing at 4.0%. As it takes about a year for the economy to feel the full impact of the interest rate hikes of the Fed, it is only natural to expect inflation to remain on its downtrend for the foreseeable future. Given also the stated determination of the Fed to drive inflation back to 2.0%-2.5%, investors should rest assured that the central bank will meet its goal sooner or later. Whenever that happens, the Fed is likely to begin lowering interest rates, towards normal levels. Such a development will provide a strong tailwind to all the preferred stocks, including the preferred stock of Telephone and Data Systems.
Overall, the current environment of interest rates is certainly adverse for the preferred stock of the telecommunications company but investors should be confident that the historical cyclicality of interest rates will turn out to be the norm once again. Therefore, investors should expect interest rates to revert towards their 2008-2021 levels at some point in the upcoming years, though patience may be required.
Risk Factor #2: A potential liquidity problem of Telephone and Data Systems
Telephone and Data Systems is a telecommunications company that provides its approximately 6 million customers with cellular and landline services, wireless products, cable, broadband, and voice services across the U.S. The cellular business comprises 75% of total operating revenue and hence it is critical for the entire company.
Telephone and Data Systems has exhibited an uninspiring performance record. During the last nine years, the company has grown its revenues and its gross profit at an average annual rate of only 1.0% and 0.6%, respectively. Even worse, its operating income plunged 47% in 2022, from $285 million in 2021 to $151 million, due to a steep increase in selling, general and administrative expenses amid a highly inflationary business environment.
On the one hand, management provided an ambitious 4-year strategic plan in its latest presentation.
Telephone and Data Systems Growth Plan (Investor Presentation)
Source: Investor Presentation
Telephone and Data Systems aims to essentially double its marketable fiber service addresses until the end of 2026 and grow the percent of service addresses served by fiber from the current level of 40% to 60%.
However, the company did not provide any guidance related to earnings. Even for the running year, the company has offered guidance only for its sales and its EBITDA, which are likely to remain essentially flat over the prior year. According to Warren Buffett and my personal experience, when a company focuses on EBITDA instead of earnings, it raises a red flag for investors.
It is also important to note that Telephone and Data Systems is experiencing poor business momentum right now amid somewhat intense competition. In the first quarter, it continued losing subscribers in its U.S. Cellular segment and posted a 1% decrease in its total revenues. Due to high cost inflation and increased interest expense, the company switched from earnings per share of $0.37 in the prior year’s quarter to a loss per share of -$0.08, thus missing the analyst’s consensus by $0.10 . It was the third consecutive quarter in which Telephone and Data Systems missed the analysts’ estimates. This is a testament to the poor business momentum of the company.
There is also another red flag for this stock, namely its high debt load. Due to poor business results and a steep increase in interest rates, the net interest expense plus the cost of preferred dividends has surged 59% , from $153 million in 2020 to $243 million in the last 12 months. This amount is much higher than the operating income of the company ($95 million in the last 12 months) and hence it results in material operating losses.
Moreover, the net debt of Telephone and Data Systems (as per Buffett, net debt = total liabilities – cash – receivables) is standing at $6.5 billion . As this amount is 770% the market capitalization of the stock, it is undoubtedly excessive. It is also important to note that the company will have to refinance a portion of its debt in the upcoming years, at much higher interest rates than it issued its debt, given the multi-year high interest rates prevailing right now.
Due to lackluster business momentum and a steep increase in its interest expense, the telecommunications company is far from becoming profitable again. Analysts seem to agree on this, as they expect Telephone and Data Systems to report losses in each of the next three years. Given also the unsustainable payout ratio of 195% of the common stock, the common dividend is likely to be drastically reduced sooner or later.
On the bright side for the preferred shareholders, the preferred dividend cannot be suspended unless the common dividend is completely eliminated. This means that the preferred dividend has a much lower risk level than the common dividend of Telephone and Data Systems. The company may continue struggling in its business but its preferred shareholders may keep receiving the 13.0% dividend.
On the other hand, I recommend avoiding stocks that incur operating losses, focus on EBITDA instead of earnings and carry an excessive amount of debt. The preferred stock of Telephone and Data Systems has good chances of maintaining its generous dividend for a few years but its aforementioned risks probably do not justify an investment in the stock, especially for risk-averse investors.
Final thoughts
The preferred stock of Telephone and Data Systems, which was issued less than two years ago, has plunged 54% during this period due to the surge of interest rates and the excessive debt load of the company, which results in operating losses. If interest rates revert to normal levels soon and the company greatly improves its business performance, the 13.0% preferred dividend is likely to remain safe. Even if the company keeps struggling, the preferred dividend is much safer than the common dividend. However, investors are advised to avoid companies that carry a high debt load and focus on EBITDA instead of earnings.
For further details see:
Telephone and Data Systems Preferred Is Offering A 13.0% Yield, But Beware Of Its Risks