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 S&P 500
• Have 25+ consecutive years of dividend increases
• Meet certain minimum size & liquidity requirements

You can see the full list of all 51 Dividend Aristocrats here.

Telephone & Data Systems, Inc. (TDS) 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.

This article will discuss why Telephone & Data has been excluded from the Dividend Aristocrats index and analyze the investment prospects of this company in detail.

Business Overview

Telephone & Data Systems, Inc. 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 dividend 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, Illinois. 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 & liquidity requirements’. These requirements are not specified, but it is possible that 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) and Federal Realty Investment Trust (FRT) – have market capitalizations of $7.0 billion and $9.1 billion, respectively. 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 FRT, these include Sherwin-Williams (SHW), Clorox (CLX), McCormick & Co. (MKC), Cincinnati Financial (CINF), and Cintas (CTAS).

With that data in mind, it is hard to tell whether Telephone & Data has been excluded because of its size & liquidity.There’s a possible argument to be made for size, but not for liquidity relative to other Dividend Aristocrats.

However, 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 of 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 & 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 & 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, and 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: $0.36
• 2008 adjusted earnings-per-share: $0.38
• 2009 adjusted earnings-per-share: $0.40
• 2010 adjusted earnings-per-share: $0.41

Telephone & Data’s adjusted earnings-per-share ground steadily upwards during the last recession, which demonstrates this company’s recession resiliency.

Valuation & 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 $0.1550 per share which yields 2.2% on the company’s current stock price of $27.97.

The following diagram compares Telephone & Data’s current dividend yield to its long-term historical dividend yield.

Source: YCharts

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 $0.39 in 2016, and is expected to report adjusted earnings-per-share of $0.50 in 2017. The company’s current quarterly dividend of $0.1550 (or $0.62 annually) exceeds both of these earnings numbers by a wide margin.

Given its unreasonable dividend payout, there are two future scenarios for Telephone & Data:

1. A dividend cut occurs
2. 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-to-earnings 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 price-to-earnings 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 price-to-earnings 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 price-to-earnings 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 very volatile and Value Line estimates that the company’s earnings will only grow to about $1/share over the next 5 years. Like it or not, Telephone & Data is grossly overvalued.

The 8 Rules of Dividend Investing tells investors to sell stocks with an adjusted price-to-earnings 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.

However, the company is not a member of the S&P 500 Index, 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 price-to-earnings ratio to more normalized levels – before investors should consider an investment in Telephone & Data.