There is a classic conundrum facing dividend-focused investors: Income or capital appreciation?

 

The iShares Select Dividend ETF (NYSE: DVY) is a classic example. It delivers a 3% yield and relatively low volatility, but has underperformed the iShares S&P 500 Growth Fund (NYSE: IVW) by roughly 40 percentage points  over the past ten years on  a total return basis.

 

 

 A decent yield is always nice, but a 40% gap is too large to ignore.

 

There is one way to get the best of both worlds. The secret is what type of income stocks you focus on.

 

Many  dividend-paying companies operate in mature industries with slower sales growth and competitive environments. Such dynamics often generate solid cash flow, but high payout ratios and saturated markets mean little in the way of stock price appreciation.

 

Find one of these cash machines with new growth engines and you’ve got yourself a stock that could be the best of both worlds.

 

A Cash Machine With Nowhere To Go

For years, the U.S. telecom sector has been the model of slow-growth dividend stocks. Despite fairly reliable cash yields, the iShares U.S. Telecommunications ETF (NYSE: IYZ), for example, is up just 50% over the past five years, badly lagging the major indexes.

 

As of this year, there are more wireless subscribers in the United States (336 million) than there are people (including those in Puerto Rico, Guam and the Virgin Islands). But subscriber connections increased by just 2.8% last year, against a 21% gain the year before. Wireless revenue increased 2.3% to $189.2 billion last year, well off the 25% pace the year before. The slowdown in subscriber growth and revenue has increased price competition between the major carriers.

 

Near-term prospects promise more of the same. Sprint Corp.’s (NYSE: S) recent promise to sharply undercut the prices of AT&T, Inc. (NYSE: T) and Verizon Communications, Inc. (NYSE: VZ) threatens to keep a lid on industry revenues.

 

In some respects, Sprint had no choice. Sales have recently risen at a 1% annual pace, thanks to market share losses and expensive promotional spending. Despite that, Sprint  still generated $11.3 billion in free cash over the past year.

 

AT&T has had to cut expenses dramatically to protect earnings growth. Sales rose just 1% in 2013 to $128.7 billion, though the company was able to shave $12.4 billion off of operating expenses. Despite the cost cuts, earnings only rose around 7% last year to  $2.50 per share.

 

Add it up and the outlook for dividend growth and/or share price appreciation for these stocks seems dim — except for one carrier that may have just found two significant growth engines.

 

Geographic And Domestic Opportunities Could Send AT&T Shares Higher

AT&T announced plans to acquire DirecTV (Nasdaq: DTV) for $48.5 billion in May 2014, which could set the stage for strong growth in pay-television, thanks to the satellite provider’s 20 million U.S. customers.

 

Sales at DirecTV grew 6.8% in 2013 to $31.7 billion and have increased at a compound rate of 8% over the last five years. Not only does AT&T get a segment with faster sales growth, but the deal also opens up the opportunity for cost advantages on service bundling.

 

Better still,  DirecTV has a strong footprint in Latin America, with 18 million customers. AT&T has been positioning for faster growth in the region, with its plan (announced last month) to acquire  Grupo Iusacell SA, the third-largest wireless operator in Mexico, for $2.5 billion.

 

In 2013, Mexico’s mobile phone user penetration was 86%, meaning the market is not yet fully saturated. The country recently signed a telecom reform bill intended to diminish America Movil’s (NYSE: AMX) monopoly-like grip on the market. AMX is controlled by billionaire  Carlos Slim.

 

Iusacell has struggled to compete with the larger rival, but AT&T’s acquisition may be coming at just the right time as America Movil is weakened by legislation.

 

Shares of AT&T trade for 13.5 times projected 2015 and 2016 earnings per share, which is expected to remain flat at around $2.60. It may take a year or two to fully digest the DirecTV acquisition, but I expect a slowdown in capital spending, which will help support dividend growth. Sales could pick up quickly as the company integrates and bundles services across new markets.

 

As growth is renewed, I expect shares to trade up to around $40, thanks to an expansion of the price-to-earnings multiple to around 15. That potential gain comes  on top of the 5.2% yield. Investors may want to stick around even if shares beat that target, as growth could accelerate over the next several years. Rising cash flow could  support an even higher dividend payment in coming years.

 

Risks To Consider: AT&T still needs regulatory approval for its DirecTV bid, but has promised to expand broadband services to 15 million homes if approved. Without the DirecTV acquisition, the company is left struggling for growth, as are others in the domestic telecom industry.

 

Action To Take –> Two acquisitions open up multiple avenues for growth and profitability at AT&T. An expansion of services and geographic reach could break the low-growth curse at the U.S. telecom carrier, giving shares a badly needed boost.

 

Now that you have a dividend-payer with strong catalysts, you need a strategy to make the most of your investment. Amy Calistri’s The Daily Paycheck specializes in putting dividend-payers to work for you… and your retirement. She recently gave a live presentation detailing how she got a dividend paycheck for every day of the year — totaling $1,382 a month. To get all the details, click here.