European telecom stocks have declined more than 10 percent over the past year, while the benchmark Stoxx Europe 600 index is up more than 7 percent. That sell-off has pushed yields on many large-cap names to between 6 and 10 percent. Yet dividend fund managers who would normally snap up such high yielding stocks are steering clear, worried about the sector's health and the prospect of dividend cuts.
"I wouldn't interpret [the high dividend yield] as a buying signal, but a worrying signal," said Alexander Wisch, equity analyst at S&P Capital IQ Research. "The high dividend yields we see today are not a reflection of the mid-term dividend paying capability. The dividend outlook for European telecoms is mostly negative, due to pressures on free cash flow generation."
There has been a wave of dividend cuts in the European telecoms sector recently. Deutsche Telekom, the biggest player in the sector, cut its dividend in December to 50 euro cents from 70 euro cents previously, while France Telecom cut its dividend by nearly half to 80 euro cents from 1.40 euros.
Still, based on the new payouts the two stocks pay a dividend yield of 6 and 10.5 percent respectively.
In the opinion of S&P Capital analysts, the wave of cuts in telecoms dividends has not stopped yet. "I wouldn't be surprised if France Telecom cut it again," said Wisch.
Last week, Telecom Italia halved its dividend to maintain its credit rating and fund infrastructure spending.
After winning the 4G wireless licenses in the Dutch auction, KPN decided not to pay a final dividend for 2012 at all, and cut its forecasted dividend for 2013.
Sectoral Struggles
Will James,fund manager of the European Equity Income Fund at Standard Life Investments told CNBC, European telecom companies have too much debt on their balance sheets.
The average ratio between net debt and earnings before interest tax depreciation and amortization (EBITDA) in the sector is around 2, according to S&P Capital's Wisch. "Given the strong cash-flow generating capacity over the past few years, it has been relatively easy for them to raise debt to fund capex and acquisitions to build their empires," he said.
But the industry is now facing recession-hit domestic markets, which are impacting their revenues.
"Telecoms and utilities have a larger dependency on their states. We call them 'the national victims of the euro crisis'," Wouter Sturkenboom, EMEA investment strategist at Russell Investments, told CNBC.
Another factor weighing on these companies is their inability to cut costs through mergers, as the regulatory structure does not allow consolidation, said Standard Life's Will James.
The pricing pressure from new competitors is further deteriorating the industry's cash flows.
Dividend Investors
European equity income managers said yields above 8 percent should concern dividend investors,as they are unlikely to be sustainable in the long run.
According to James, investors should instead focus on yields of 5 to 6 percent.
"We cannot afford a single company with the risk of dividend cut in our portfolio. We sell the risky stocks immediately," said Andreas Zoellinger,co-fund manager of BlackRock's Continental European Income Fund.
"Historical studies show that above 6 percent, there is an increased probability of a dividend cut… Above 6 percent, the risk increases exponentially."
Norway's Telenor is however an exception, according to Wisch. The company's debt-to-EBIDTA ratio of 1 is significantly lower than its peers, he points out.
It is also among the top ten holdings of Standard Life Investments'European Equity Income Fund.