High-yielding stocks are often a favorite among investors looking for income. While high yields are attractive, investors need to be sure that company providing this income is able to cover its dividend. A dividend cut would likely cause the share price of the stock to collapse as well as reduce the investor’s income.
A dividend cut can occur because a company’s earnings or free cash flow have significantly deteriorated for a variety of reasons. For example, a company burdened with high levels of debt on its balance sheet could make the decision to cut its dividend in order to pay back its obligations.
One company that has an immense amount of debt on its balance sheet and a high dividend yield is AT&T (T, Financial). Normally, it would be a worry that the company’s debt level could have an impact on its ability to continue to fund its 6% and higher dividend yield. Due to free cash flow, we believe that AT&T’s dividend is well covered, making AT&T stock a strong buy.
Company background
AT&T can trace its beginnings to the 1870s, when Alexander Graham Bell invented the first version of the telephone. The current makeup of the company is a result of many mergers and spinoffs that have taken place since 1984. The company trades with a market capitalization of $236 billion, and annual revenues of $170 billion.
In an attempt to diversify away from phone service, the company purchased DirecTV in 2015. AT&T also added AppNexus and Time Warner Inc. in 2018. Today, AT&T is composed for four business segments: Communications, Entertainment, WarnerMedia and AT&T Latin America.
Debt levels
The effort to diversify away from just phone service has not been cheap. Using a combination of cash and stock, AT&T paid $48.5 billion for DirecTV. This included nearly $19 billion in assumed debt. While the acquisition of Time Warner was valued at $81 billion, this didn’t take into account the $23 billion in debt that AT&T is now responsible for paying back.
These two deals, completed just a few years apart, added more than $40 billion in debt to AT&T’s already bloated balance sheet. At the end of the first quarter of 2019, AT&T had more than $193 billion in short- and long-term debt. Many companies could not afford to make these moves.
Fortunately for shareholders of AT&T, the company produces a massive amount of free cash flow that has allowed it to pay back debt while funding a generous dividend.
The telecommunications industry requires that companies spend large amounts of capital to maintain and build out their infrastructure. The costs of doing so can cripple a company that doesn’t generate enough cash to cover expenses.
Even after accounting for $21 billion in capital expenditures in 2018, AT&T still produced more than $22 billion in free cash flow. This was more than enough to cover the approximately $13 billion that the company paid out in dividends to shareholders. The remainder of free cash flow was applied to AT&T’s debt.
To help speed up the repayment of debt, AT&T has divested non-core assets, such as its stake in Hulu and office space in the Hudson Yards development. These two divestitures alone gave the company $3.6 billion with which to use to help pay down debt.
These actions are already paying off for AT&T as the company believes that it will be able to pay off nearly $30 billion of the $40 billion of debt issued to buy Time Warner Inc. by the conclusion of 2019. The company targets an end-of-year net-debt-to-adjusted-Ebitda ratio of 2.5x, down from a ratio of 2.8x produced by the end of the first quarter of this year.
Only a company with AT&T’s free cash flow could pull off such a feat. For this reason, it looks likely that the company’s debt level will not impact its dividend. The dividend is likely to continue to grow for many years to come.
Dividend analysis
AT&T has increased its dividend for 35 consecutive years. This qualifies the company as a Dividend Aristocrat. Dividend Aristocrats are a select group of companies within the S&P 500 that have increased their dividends for at least 25 consecutive years. There are only 57 such companies.
The company has increased its dividend:
- By a CAGR of 1.4% over the past three years.
- By a CAGR of 1.7% over the past five years.
- By a CAGR of 2.0% over the past 10 years.
AT&T’s dividend growth over the last decade has been in the low single digits. In fact, the company has increased its dividend by just 1 cent per quarter per year over the last 10 years. This trend continued when AT&T announced a 1-cent increase in the quarterly dividend for the Feb. 1, 2019, payment. Given the company’s track record with its dividend, its dividends look set to continue to grow at this pace.
Even with muted dividend growth, shares of AT&T offer a yield of 6.7%. For context, this is more than 3x the average dividend yield of the S&P 500. At the same time, this is higher than the stock’s 5.6% average yield that covered the 2009 to 2018 time period.
AT&T should pay out $2.04 in dividends per share this year. Using the company’s expected earnings-per-share total of $3.60 for 2019, the payout ratio is 57%. This is well below the decade-long average payout ratio of 71%. Using earnings per share, AT&T dividend appears well covered for this year.
Many investors prefer to measure the safety of a company’s dividend using free cash flow.
AT&T generated $11.1 billion of cash flow from operating activities in the first quarter of fiscal 2019 and spent $5.2 billion on capital expenditures during the same time period for free cash flow of $5.9 billion. The company distributed $3.7 billion of common share dividends during the same time period for a free cash flow dividend payout ratio of 63%.
One quarter isn’t enough to properly gauge the safety of the company’s dividend. AT&T generated $45.7 billion of cash flow from operating activities over the last 12 months and spent $20.3 billion on capital expenditures for free cash flow of $25.4 billion. The company distributed $14.1 billion of common share dividends during the same time period for a free cash flow dividend payout ratio of 56%.
Using either earnings or free cash flow, AT&T’s dividend appears to be well covered, and we see no risk of a dividend cut in the near term.
Conclusion
AT&T’s dividend and debt level are well known to investors. While many companies would not be able to operate under the company’s debt, AT&T’s free cash flow has allowed it to pay down debt used to fund acquisitions in recent years.
Just as important to income investors, free cash flow has more than covered AT&T’s dividend payment. Dividends are expected to consume a decade-low percentage of earnings per share in 2019. The payout ratio drops even more when free cash flow for the last year is used. A lower payout ratio will allow AT&T to pay off debt at a much faster pace as well.
As such, we rate shares of AT&T as a strong buy and encourage income investors to consider purchasing the stock for a safe, high yield.
Disclosure: I am long AT&T.Â
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WestRock: Why This High-Yield Dividend Stock Is a Buy Right NowÂ
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