Sometimes it's difficult to entertain a variant perspective on a tried-and-true investment. But that's what we think investors should do when they think about AT&T's (NYSE:T) dividend growth potential. AT&T's Valuentum Dividend Cushion score is below 1 (meaning that the sum of our expectations of the company's future dividend payments and existing debt balance overwhelms the sum of its future expected free cash flow and existing cash balance). We don't expect this telecom bellwether to cut its dividend anytime soon (especially given its shareholder base, which comprises mostly of investors holding shares for the dividend payment), but we think there are many other more attractive places for long-term dividend growth than AT&T's equity.
The historical track record of a company's dividend payments reveals management's willingness to keep raising the dividend each year, while the strength of a company's balance sheet (net cash position and borrowing capability) and future free cash flow (operating cash flow less capital expenditures) reveals its capacity to continue raising the dividend going forward. AT&T's historical dividend track record is second-to-none, but its fourth-quarter results (and in particular its balance sheet, see here) reminded us that the firm's future dividend growth capacity ("cushion") is not that great. We think assessing the health of a company's financial position (balance sheet) is a key component of any dividend growth analysis and probably one of the most overlooked by the individual investor. Because a firm can keep paying dividends from cash on its balance sheet should its free cash flow come up short in any given year, assessing a firm's net cash position on its balance sheet is extremely valuable; the income statement (earnings-per-share) is only part of the story.
Let's first say this loud and clear: AT&T boasts a solid balance sheet (it garners a single A credit rating from the agencies) and its pension plan poses little risk to the equity or debt holders at the moment. When we talk about AT&T's financial flexibility in the context of future dividend growth, we're not talking about default/credit risk specifically, though we note they are related concepts. In assessing the balance sheet with respect to the potential for future dividend growth, we like to look at the relationship between a firm's cash balance and its debt load. AT&T ended 2013 with only $3.3 billion in cash and cash equivalents and a massive $69.3 billion long-term debt load, which doesn't include another $5.5 billion of current debt that is maturing within one year and not included in the long-term debt number. Dividend growth investors should prefer companies that have AT&T's cash and debt positions reversed (all else equal), companies such as Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) that have massive cash positions and negligible debt (as excess debt restricts financial flexibility).
Looking forward, AT&T expects consolidated revenue to expand at a 2-3% clip in 2014 and adjusted earnings per share to advance at a mid-single-digit pace. Many investors remain concerned about the firm's pace of net subscriber add growth in the fourth quarter and intensifying competition from T-Mobile (NASDAQ:TMUS), which could provide top-line and/or margin pressure relative to expectations. The competitive environment is certainly not easing at all. For the year, AT&T expects free cash flow (cash from operations less capital expenditures) to be weighed down by $21 billion in capital spending, resulting in free cash flow in the $11 billion range in 2014, down from $13.6 billion in 2013 (see page 18 of its slide deck here). The expected free cash flow of about $11 billion in 2014 compares to an expected dividend cash outflow of about $9.5-$10 billion for the year (it paid out $9.7 billion in dividends in 2013), leaving very little room for share buybacks on an organic basis, excluding unsustainable proceeds from asset monetization initiatives (which helped tremendously in 2013). The comparison of free cash flow to expected dividend payments in 2014 reveals a tight situation at AT&T, especially considering its net balance sheet position. If the company is unable to monetize assets in 2014, AT&T may have to use its healthy credit rating to float more debt (why not hide new debt in an acquisition?).
AT&T is a bellwether with a strong balance sheet that has an enviable track record of paying consecutive dividends. Most of the company's shareholder base is holding the firm for its current dividend (income) stream, not its potential for future dividend growth, which in our view, remains muted. We do not believe AT&T will cut its dividend in the near-term as a result of competitive pressure and free cash flow declines, but we do think there are better dividend growth ideas out there. Still, we don't think investors should overreact in any fashion-the company's operating cash flow remains remarkable and capex can always be cut, even if it hurts the company's long-term competitive position. We're waiting to see how performance evolves relative to 2014 expectations. Shares are fairly valued at present.
Disclosure: AAPL and MSFT are included in the portfolios of our newsletters. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.