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AT&T (T) is one of the dogs of the Dow, which is a strategy designed to pick ten stocks offering the highest dividend yields from the Dow Jones Industrial Average. Under this strategy, an investor who purchases these stocks should outperform the market benchmark on a total return basis. The telecom industry in the US is characterized by companies that boast high dividend yields. AT&T recently announced that it will increase its quarterly dividend to 45 cents per share, which roughly translates into a dividend yield of 5.4%, based on the current share price of $33.20. In the rest of the report, we will discuss the company's cash flow position and the sustainability of its high payout.

AT&T recently posted its third quarter results. Revenue remained largely flat quarter over quarter. However, it managed to beat the earnings estimates. One of the major reasons behind the earnings beat, apart from the growth in its wireless segment, was that the company continued to repurchase its shares. In the recently ended quarter, the company repurchased 101.1 million of its shares for $3.8 billion. As of October end, the company had purchased a total of 270 million shares worth $10 billion. Also, in the third quarter, AT&T's board approved another 300 million share buyback plan. In a recent press release, the company expressed that it now expects its debt to EBITDA ratio to move from 1.42 to around 1.8. The reason provided was that it plans to take advantage of the debt market and the prevailing low interest rates to finance its capital spending and share repurchase program. However, the announcement has prompted Moody's, the credit rating agency, to place AT&T's debt under review for a downgrade.

In a recent press release, the company announced that it will boost its capital spending to $22 billion for each of the next three years to overhaul the infrastructure for its Wireline and Wireless segments. This represents a 16% hike in capital spending, which is a worrying sign for investors as it is a significant amount and it is not just for one year. Even though we believe the hike in capital spending will help the company in bringing top line growth in future years, it could dampen profitability and dividend payouts in the short term.

AT&T has been able to produce stable operating cash flows year over year. In 2011, T generated an operating cash flow of approximately $35 billion while it paid total dividends of $10 billion. Moreover, its free cash flows have shown an impressive growth over recent quarters. In the third quarter, the company generated a free cash flow of $6.5 billion, which led the company to raise its full year free cash flow guidance to $18 billion, representing an increase of $2 billion. This translates to a forward free cash flow yield of 9%, which compares well to its dividend yield of 5.4%. However, the company's recent decision to finance its capital spending and share repurchase program through debt implies that it is unlikely that the company will be able to sustain its high payout through its operating cash flows. If we analyze the results of the first three quarters of the current year, the cash flow deficit is visible. In the first nine months, the company generated an operating cash flow of $28.94 billion while it incurred $29.3 billion in capital expenditures, dividend payments and share repurchases, which indicates that the current high payout might not be sustainable.

Even though the company was able to finance its dividend payments in the past years, T has not been able to bring about the kind of growth in its dividends that investors would have wanted. The company has been increasing its payout by one cent every quarter, which translates into a modest five year growth rate of only 4%. Based on the historical dividend data for the company and the recent developments, we expect limited dividend growth going forward.

The latest quarter was a mixed bag for the company, characterized by growth in the Wireless segment alongside a consistent decline in its Wireline business. Compared to its rival, Verizon (VZ), T's Wireless segment showed signs of a slowdown, as the company reported net postpaid additions of only 150,000, which is a significant drop from third quarter additions. The results are even more surprising when we consider the fact that Verizon added 1.5 million postpaid subscribers in the third quarter. AT&T has historically sold more iPhones than any other telecom carrier in the region and the last quarter was no exception, with the company selling 4.7 million iPhones in the quarter. However, selling more iPhones had a dampening effect on the EBITDA margins for its wireless service, which shrank from 44% in Q3 2011 to 40.8% in Q3 2012. The company's Wireline business continues to decline quarter over quarter due to wireless substitution, as is the case with all major telecom operators. Total revenue from T's WireLine business declined by 2%.

The stock is up 10% on a YTD basis, however, we believe that much of this appreciation has been brought about by investors seeking a stable dividend. Based on its multiples, the stock is overvalued. T is trading at 13.5 times its forward earnings while historically it has traded at 11x. Moreover, on a price to sales basis, the stock looks expensive with a multiple of 1.5x, at a premium to Sprint's (S) 0.5x and Verizon's 1.1X. With shares trading at the current level, investors seeking growth should wait for a better entry point.

Source: AT&T: Limited Dividend Growth For This Dog Of The Dow