By The Valuentum Team
AT&T boasts a hefty dividend yield, but its best dividend growth years are likely behind it.
--> AT&T (NYSE:T) is one of the leading worldwide providers of IP-based communications services to businesses. The firm has the nation's largest 4G LTE network, and the largest international coverage of any US wireless carrier. The company recently acquired DirecTV and two Mexican wireless companies (lusacell and Nextel Mexico). It is based in Dallas, Texas.
--> Absent a massive debt load, it's hard not to like AT&T. The company has over 120 million wireless customers, 12+ million U-verse high-speed Internet customers, 6+ million U-verse TV customers, and ~5 million U-verse Voice customers. 240,000+ employees work for the company.
--> AT&T continues to execute across key growth areas including mobile internet, consumer IP and strategic business services. Its merger with DirecTV will create a content distribution leader across several platforms. Deal synergies are expected to exceed $2.5+ billion on an annual basis, a number that keeps being revised upward.
--> The company's wireless acquisitions in Mexico should help bolster AT&T's geographic footprint, but increased investment means the deals won't be EBITDA positive and EPS positive until 2017 and 2018, respectively. Its deal with DirecTV means that it will have more than $120+ billion in net debt after closing.
--> AT&T is shareholder-friendly. The firm has increased its quarterly dividend for 30+ consecutive years and frequently returns $20+ billion to shareholders annually through dividends and share repurchases.
Note: AT&T's dividend yield is above average, offering a ~5.7% yield at recent price levels. Though its yield is impressive, other factors keep us from truly considering AT&T for addition to our dividend growth portfolio. This article explains why.
AT&T has paid an increasing dividend for ~30 years thanks in part to its strong free cash flow generation. The company continues to integrate newly-acquired assets--DIRECTV, lusacell, and Nextel Mexico. The DIRECTV deal, for one, gives the company a more diversified list of products/services, while transactions in Mexico will help to bolster its international reach. With a well-known brand name and a long history, AT&T continues to make strategic moves to continue to grow its business, not resting on legacy positions. Such a strategy should help it remain competitive, though investments in Mexico and a staggering $120+ billion net debt position are cause for some concern. Debt-averse investors should look elsewhere.
A weak Dividend Cushion ratio shows that even the best companies aren't immune to the objective nature of the methodology. Even with strong free cash flow generation year after year, we expect the pace of dividend growth to eventually slow as investments and refinancing risks come back home to roost. Our biggest concern rests in the company's massive net debt position (~$120 billion) post DIRECTV closing, and with every year that passes with the company increasing the dividend, it means the hurdle to increase it the following year gets ever-more difficult to jump over. Deleveraging will eventually become a focal point, in our view, and in this light, we doubt AT&T will maintain a free cash flow dividend payout ratio in the 70% range over the long haul.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of AT&T's dividend is very poor. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For AT&T, this ratio is 0.5, revealing that on its current path the firm may have trouble covering its future dividends and growth in them with net cash on hand and future free cash flow.
The Dividend Cushion ratio is an objective measure, and while we'd like for AT&T's measure to be higher, a huge debt load and lofty dividend obligations are difficult pay prove difficult to overcome. The next recession could really challenge the pace of AT&T's dividend growth. We think the probability is very high.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. AT&T's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is less than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk
of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less
durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, AT&T's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of AT&T's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent, which is not the case for AT&T. We think the best dividend growth years are behind AT&T, and we rate its dividend growth as very poor.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In AT&T's case, we currently think shares are fairly valued, meaning the share price falls within our estimate of the fair value range, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low.
Wrapping Things Up
There is plenty to like about AT&T. The firm continues to execute across key growth areas including mobile internet, consumer IP, and strategic business services. Its recent acquisitions will materially bolster its geographic footprint and diversify its offerings, but the high level of debt the company has taken on gives us cause for concern, as it relates to the pace of dividend growth. We're keeping a close on free cash flow generation in light of the firm's acquisition spree. Income investors may find themselves with slowing dividend growth during the next recession.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we 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.