Verizon's (NYSE:VZ) ample dividend yield is the main reason why most, if not all, investors who purchase and hold the shares do so. VZ has a robust dividend record that means the common shares are treated more as a bond issue than a stock held for capital gains. In a sense, VZ is a utility stock like a power producer or other components of the SPDR Utilities ETF (NYSEARCA:XLU), and as such, the dividend is the lifeblood of the value of the company. With the stock hitting highs not seen since the tech bubble of the late 90's, the yield has fallen to a still-robust 4.20%. However, this pales in comparison to the days of 2011 and 2012 when a yield of nearly 6% was enjoyed by shareholders. With VZ's dividend at the heart of the company's value, it is important for potential and current shareholders to understand the risks associated with keeping the dividend payments flowing. This article will examine VZ's cash flows in relation to dividend payments and attempt to assign a risk to the dividend payment streams.
First, the most basic measure that is cited in financial media for dividend safety is the payout ratio. Simply put, it is the amount of money a company pays in dividends divided by the company's net income; Verizon's is below.
We can see that while the ratio has been trending up, it is still in the 50% range. From this we can infer that VZ is earning roughly double its dividend payments in net income each year. This is well within the range of what dividend investors would consider "safe" and includes some cushion for dividend raises in the future. However, I would argue that the payout ratio is a virtually pointless metric as companies do not make dividend payments with "earnings" as defined by GAAP. Net income is simply an accounting metric that helps investors get a complete picture of its financial performance for the year and is also good for getting tax deductions. However, net income is not a cash flow and as such, comparing it to dividend payments is meaningless. Instead, we can compare dividend payments with the company's operating and investing cash flows.
Operating cash flows are those that the company's assets produce while conducting business. Investing cash flows are those that are produced (or used) in acquiring those assets. Therefore, it can be inferred that the operating cash flows of a company minus its investing cash flows would produce a pretty good estimate of how much cash a company produces from its assets and uses to acquire those assets during the normal course of business. It is with this cash that a company then can pay dividends.
In VZ's case, this graph of net income versus operating cash flows minus investing cash flows shows us the importance of ignoring net income in computing a dividend's safety. In 2008, VZ reported net income of over $12 billion while cash flows were less than negative $4 billion. On the flip side, in 2010, those cash flows were nearly double reported net income. The point is to remember that net income is not important for assessing a dividend's safety.
With this in mind, we now will turn our attention to some analysis for VZ.
This graph shows the amount of operating cash flows minus investing cash flows (blue columns) that VZ produced for each of the past six years in relation to the amount of dividends (red columns) the company paid. We can see a few interesting things. First, VZ's cash flows are generally much higher than the dividend payments it makes, which is great for dividend stability. In 2008, however, cash flows were negative as the financial crisis took its toll on VZ's business and heavy investments were made. So far, so good, as we can see that it appears VZ produces more than enough cash to continue to pay the dividend payment.
However, there is a startling trend that VZ has been engaging in for a very long time and that is excessive debt issuances. In this graph, we can see the amount of dividends paid each year for the past six years in relation to the amount of long term debt VZ has issued. Note, 2010 has no red bar because VZ did not issue any long term debt in that year.
It is obvious that there is a huge spike in 2008 in debt issuances and to a smaller extent in 2009 and 2011. The graph below can help us to understand why.
This graph shows the aggregate amount of operating cash flow minus investing cash flow versus the amount of long term debt proceeds for VZ each year. For instance, we saw that VZ issued well over $20 billion in new long term debt in 2008 and we can see from this graph that it was most likely in response to the massive negative cash flow that occurred for that year. We can infer from this graph that VZ appears to need roughly $18 billion annually of cash flow to run its business and pay its shareholders' dividends. I came to that conclusion because we know that in 2008, when cash flows were very negative, VZ borrowed more than ever, producing a net value of roughly $17.6 billion between the debt issuances and the negative cash flows. In 2010, VZ issued no debt as its cash flows totaled to $18.3 billion. I have to assume these numbers are not a coincidence and that VZ management is targeting a particular level of cash each year; thus the debt issuances when cash flows come up short.
The point of this graph is to illustrate that if VZ shows any signs of weakness in its business, it is forced to issue long term debt to make up the cash flow deficit. While this is fine for a company to do and can even be desirable if terms are favorable, there comes a point that the debt load is just too high to continue to issue more. The issue is this; once VZ issues this debt to make up for its cash flow shortfalls, it must then use its cash flows in subsequent years to pay off the prior years' debts. This is a vicious cycle in which, eventually, either the company needs to become more profitable or it will be forced to cut the dividend payments.
Verizon currently spends about $2.5 billion annually on interest expense and roughly double that amount on its common stock dividend payments. This is a red flag to me as it means VZ is paying half of what it pays shareholders to creditors just to keep the lights on, essentially. VZ is not at the breaking point yet, but I fear that if management doesn't find a way to make VZ more profitable, it will eventually get to a point where it can no longer afford its dividend payments. VZ is playing a dangerous game in which it must delicately balance its cash flow shortfalls with investor demands to make dividend payments.
With the stock trading at 10+ year highs, the idea of a dividend cut could send the stock plummeting back into the low $30s. Since VZ is a utility stock, it is not valued based upon standard metrics like PE ratios or other fundamental analysis. By these metrics, VZ is very, very expensive but it keeps its lofty valuation due to its ample dividend rate. If the dividend were ever called into question, it would be a case of a rapid, violent revaluation of the shares as just another stock instead of the utility giant it has become. I'm not suggesting this will happen this quarter or this year but at some point, VZ will need to figure out how to finance its business without accumulating debt. If the company is unsuccessful, I believe we will see a massive downward move in the share price to compensate for the extra risk.