My last article on AT&T (NYSE:NYSE:T) generated a lot of buzz, as I discussed its performance and where I felt the company, and subsequently, the share price were heading. Prior to this piece, I had demonstrated that the company's strength was in its dividend. I illustrated, in very simple mathematical terms, the power of the dividend over time to generate significant, yet stable, investment returns. I like safe. I like boring. I need more of it in my life. I digress. One of the key discussion points after my last article was what would happen to the dividend. I said very plainly in the article the payout ratio was 57%. This was down from 67% last quarter. Just today, an article was published speculating on a dividend increase, and I have been hit with many questions regarding this piece.
First, I want to thank Mr. Ruben for his article. He correctly points out that dividend increases tend to be announced in December. I agree, as history has shown this. Take a look at Figure 1 below. As you can see, the raises have occurred like clockwork each year, and begin with a higher payout in Q1 of every calendar year. I want to be clear. I fully believe a dividend hike is on the way. However, I have to respectfully disagree with the amount.
Figure 1. Five-Year Trading History of AT&T Stock Price, With Dividend Amounts Shown
Source: Google Finance
Why do I say I disagree, respectfully? Well, as pointed out for the past seven years, the company has announced a single penny increase in its quarterly dividend. Mr. Ruben believes AT&T is trying to redefine itself, and will surprise investors by increasing the quarterly dividend by $0.015 or $0.02. I think the full range is $0.01-0.03, but the company is conservative. I see think the $0.01 payout will not continue. Why is that?
For several reasons. First, the company has spent a fortune acquiring DirectTV, and has also spent a bundle trying to support increased data usage of customers. But here's the thing. It comes down to the payout ratio. That where I think my colleague believes there is room for a greater-than-a-penny increase. That said, we need to consider other factors. But I noted in my article that the company saw its free cash flow payout ratio fall to 57% from 67%. One could argue that AT&T can afford to up what it is paying. And while that may be true, there is one priority the company has after paying its dividend.
What is this second priority? Paying down debt! In the latest conference call, debt was discussed in one key moment. But the payout ratio is also a key. John J. Stephens said this:
"Our focus is on maintaining a strong balance sheet. We paid down more than $5 billion in debt early, and we still have more than $6 billion of cash on hand. These strong cash flows are a fundamental part of our business. This gives us the financial strength to invest in our business, reduce debt, and return substantial value to our shareholders... Secondly, with regard to future years, we would stand by what we've said earlier. That is that we expect free cash flow to provide us with a dividend payout ratio that's in the 70%. We're not moving away from that. We're not shying away from that at all, and expect that to continue to be the case."
So that is pretty clear to me. The company wants to pay down debt and keep its payout ratio at about 70%. But it's 70% of cash flows. Let's run some numbers. The company has paid $7.311 billion in dividends over the first three quarters, and has had $12.8 billion in free cash flow in that time. So that's the 57% (7.311/12.8). For the year, it sees $15 billion or more. Well, the company will pay another $0.47 this quarter, bringing the payouts to around $9.75 billion. At $15 billion free cash flow, we see the payout ratio will be about 65%. That's great. It's under the 70% goal.
But the 2016 free cash flow number is anyone's guess, even if the company is going to cut capex. If free cash flow comes in at this same number, $15 billion in 2016 (we don't have guidance to work from), and the company raises the dividend by a penny to $0.48, we can expect dividend payouts to be approximately $10 billion. This is a 67% payout. But if free cash flow is only say $14 billion, this becomes a 71.4% payout. Alternatively, if the payout is raised to $0.50 as some call for, then we are looking at around $10.38 billion. This changes things. From $14 billion to $16 billion in free cash flows, the payout ratio would be 74%, 69%, or 65%.
The thing is, we just don't have guidance on this number yet. I happen to think that the raise will be a penny, and the company will save cash to pay down its significant debt burden (which comes out of either existing cash or free cash flow). Long-term debt is $119 billion. That's hefty. The company also needs money for Latin American expansion. And this year, it has taken on over $30 billion in new debts. It needs to use caution. Thus, I think a penny is more likely for the dividend hike, but of course, this will ultimately depend on final 2016 guidance for free cash flow.
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