Published: August 19, 2010

This is a tricky market for income investors.

Bonds are selling at historically low yields and high prices. The 10-year Treasury bond currently pays a miniscule 2.6% and a three-year CD pays about 1.8% on average.

Meanwhile the S&P 500 had a huge run of about +80% from the lows of March 2009 to April of this year. But the rally has since sputtered. From here, the market looks questionable. The Federal Reserve has more recently categorized the current economy as "unusually uncertain."

With the future direction of the market especially hard to predict and bonds selling at terrible valuations, where should investors be looking?

How about dividends?

Historically, dividends have contributed nearly one-third of the equity return of the S&P 500 since 1926. That percentage return can be even higher in a flat or down market. And unlike bond interest, dividends can stand up to inflation. This is because stocks can grow earnings in an inflationary environment and raise dividends. Bonds, however, pay a fixed rate of interest that doesn't increase with inflation. In fact, average dividend income from the S&P increased about +5% per year on average since 1957, one percentage point ahead of inflation.

One of the best dividend sectors of the market has become telecom stocks. While growth in the sector has slowed as a result of wireless saturation and fierce competition, the steady stream of dependable revenue generated by these companies make for great dividends.

In addition, the telecom business is relatively defensive. People tend to cut back on other items before they reduce phone and Internet usage. And a defensive, high paying industry is just what the doctor ordered in this environment. Not all telecom operators are the same, however. Companies need a strong market niche and a dependable cash flow.

Alaska Communications Systems Group (Nasdaq: ALSK), also known as ACS, is the largest diversified telecom provider based in Alaska. The company offers local telephone, wireless, long distance, data and Internet services to business and residential customers throughout the state. It is also has the largest next-generation (3G) wireless network in the state.

What's so great about Alaska?

Alaska may be cold, but its population is wealthy and growing. According to ACS, Alaska has a median income +32% higher than the national average, and people spend about +33% more on communications services than other Americans. Population growth already far exceeds the national average and could grow much more in the next five or 10 years if proposed oil and gas development in the state comes to fruition. As a further compliment to these demographics, Alaska has a wireless penetration rate of just 67%, compared to 84% for the United States.

ACS has grown its revenue +25% from 2004 to $346 million in 2009 and grown EBITDA +19% during the same period to $122 million. This has resulted in a five-year average annual dividend growth rate of +17%. Quarterly dividends have been $0.215 per share since the first payment of 2006 and the annual $0.86 dividend translates to a fantastic 9.6% yield at current prices.

This high dividend looks solid going forward. ACS has maintained a long term payout average of 70% to 75% of cash available for distributions and guidance for 2010 forecast a below-average 67% payout ratio.

While Alaska is a great niche, ACS doesn't have the market all to itself. Wireless competition greatly increased in 2007 when AT&T (NYSE: T) bought Dobson Communications , ACS' only other wireless competitor. ACS also has competition in the land line business, as General Communication (Nasdaq: GNCMA) has grabbed a sizable chunk of the Internet access business and hastened ACS' land line losses.

As a result of increased competition, as well as a recessionary economy, total revenue slipped -11% in 2009 from 2008. AT&T has been luring away wireless customers with its exclusive offering of the iPhone from Apple (Nasdaq: AAPL), and ACS has also been forced to offer higher discounts to compete.

That said, the future looks bright for ACS. As traditional wire line business continues to shrink throughout the telecom industry as more customers opt for wireless, ACS has transformed its business. The wire line segment accounted for 75% of revenue in 2004, but accounted for just 26% in the second quarter of 2010, while the growing wireless and enterprise segments increased from 25% of revenue in 2004 to 54% in the second quarter.

ACS has been leveraging its state-of-the-art 3G network to lure new users and increase revenue per user with data services. Postpaid wireless data per user increased by +15% in the second quarter over the previous quarter to $10.77, as data revenue soared +52% from the year ago quarter. ACS has also laid a new cable to the lower 48 states offering more bandwidth than the existing cables and enabling the company to offer cutting-edge technology to businesses.

In the second quarter, overall company revenue fell just -1.6% from the year ago period and operating cash flow increased +15% as a result of cost costs. Going forward, ACS should grow cash flow in the quarters and years ahead. The company had the best quarter in its history for enterprise contracts sold and secured business that will add $5 million in annual revenue. The company also purchased a 49% stake in TekMate Inc., the largest publically held IT firm in the state .

ACS forecasts modestly higher profits in 2010 and above-average dividend coverage. The company also said it is likely to upgrade revenue projections, given the recent contracts and acquisition.

Action to Take --> ACS pays a secure 9.6% yield in an uncertain market. The company also has solid growth prospects going forward. Income-seekers should consider buying the stock now, as its high dividend yield is likely to attract yield-hungry investors.

-- Tom Hutchinson
Staff Writer
StreetAuthority