It has now been four full quarters since telecommunications giant AT&T (NYSE:T) last increased its dividend. That means that it's time for another increase. Dividend growth investors clearly appreciate AT&T for its long track record of raising its dividend each and every year. In fact, AT&T is a member of the Dividend Aristocrats list that includes companies that have increased its dividend for at least 25 years. AT&T has actually managed 30 years of consecutive dividend increases. Since most companies would go to great lengths to keep their dividend streaks alive, it's extremely likely AT&T will increase its dividend. The key question, though, is by how much.
Growth slowing down
AT&T is a strong income stock that offers a 5.4% dividend yield, which gives it obvious appeal to dividend investors. However, AT&T's earnings growth is slowing down, which makes it difficult for the company to increase its dividend at high rates. Revenue is up just 2.5% over the first three quarters of the year, and diluted earnings per are down 6% in this period. AT&T's results lag those of its closest rival, Verizon Communications (NYSE:VZ), which explains the divergence in their respective dividend growth over the past several years. Verizon's earnings per share rose 14% last quarter, thanks to its fantastic wireless business. By comparison, AT&T's earnings fell 4.5% last quarter even after adjusting for one-time items. Verizon's growth is truly impressive; it has come through with double-digit earnings growth in 10 out of the last 11 quarters.
Verizon owes its success to Verizon Wireless, which it now owns entirely after purchasing the remaining stake from Vodafone (NASDAQ:VOD). Verizon Wireless is far more profitable than AT&T's wireless segment, and thanks to the ongoing smartphone boom, wireless is the business providing the most growth for telecom companies nowadays. Consider that Verizon's earnings before interest, taxes, depreciation, and amortization (EBITDA) margin in its wireless segment was 49% last quarter, a full six percentage points higher than AT&T's 43% EBITDA margin. This explains Verizon's and AT&T's contrasting earnings growth, and as a consequence, their respective dividend growth as well.
Verizon's dividend growth over the past five years has been roughly double AT&T's. That's because Verizon has much more room for higher dividend growth because of its superior assets and cash flow generation. Verizon's free cash flow totaled $10.5 billion in the first three quarters of the year. Its dividend cost $5.6 billion, which amounts to only 53% of its free cash flow. As a result, Verizon increased its dividend by nearly 4% in September, and I expect AT&T's dividend increase to once again come in below Verizon's because of its slower growth.
Bank on one penny
The inconvenient truth is that AT&T doesn't have a lot of financial flexibility. It's loaded up on debt to help finance its $67 billion (including debt) acquisition of DIRECTV (DTV). At the end of its most recent quarter, AT&T held $70.5 billion in long-term debt. AT&T's interest expense is up 11% over the first three quarters, and this much debt will continue to weigh on future earnings. In addition, AT&T distributes the vast majority of its free cash flow already. Through the first three quarters of the year, AT&T generated $8.7 billion of free cash flow, and paid $7.1 billion worth of dividends in this time. This equates to an 82% free cash flow payout ratio.
And, unfortunately, there likely won't be enough growth this year to provide the necessary room for a strong dividend increase. AT&T management expects 3%-4% revenue growth for the full year, which puts a lid on how much it can provide its investors as a dividend raise. With this in mind, investors should temper their enthusiasm for what's possible when AT&T declares its dividend increase. The fact that AT&T has a lot of debt on the balance sheet and a high free cash flow payout ratio explains its small dividend increases in recent years. Over the past five years, AT&T has increased its dividend by just 2% compounded annually. AT&T's last six dividend increases were in the amount of one penny per share. For all the reasons discussed, I predict AT&T will stick to that model and increase its quarterly dividend by one penny per share, to $0.47 per share.
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