I believe that AT&T (NYSE:T) can comfortably sustain both its dividend and its dividend growth rate without significantly increasing their payout ratio. These conclusions suggest that AT&T's future dividend streams are undervalued.
AT&T has shown decent revenue growth in the last few years, and the free cash flow has grown as well, which is a good sign. AT&T has a few growing segments that make it possible to grow the free cash flows. To demonstrate this, I present historical data, use growth outlooks by management, and extrapolate data to calculate the value of the future dividend stream.
The average growth and average payout ratio were calculated by using historical data of the last five years.
The chart above illustrates the dividend growth and payout ratio of the last five years. We can notice a pretty steady dividend growth. The average dividend growth between 2012 and 2016 was 2.1%, which seems like a reasonable rate. On the other hand, the payout ratio has been fluctuating quite over the last five years. The average payout ratio though between 2012 and 2016 was 70.5%. Now that we have the average growth rate and payout ratio, we can move on to the next part of the analysis.
In the next part of my analysis I will show whether AT&T's dividend stream is over or undervalued under certain circumstances. This is done by analyzing whether the dividend growth rate of 2.1%, and a payout ratio of 70.5% will be sustainable in the future. After which the future dividend streams will be discounted to their net present value.
The table above shows the dividend stream at a growth rate of 2.1%, and the FCF stream at a payout ratio of 70.5%, for the next 9 years. At first this seems doable, the dividend growth rate is not very high, and the FCF needed in 2025 is about $4 billion more than in 2016. Based on the historical free cash flow growth of the last 5 years, it would appear likely that AT&T will be able to grow its free cash flow by an additional $4 billion. However, to really conclude whether the average growth rate and average payout ratio are sustainable, we have to take a closer look at the revenue growth and FCF growth forecasts. First, we take a look at the historical revenues of the 4 main segments for the last 3 years.
The 3 tables above show the income statements by AT&T's 4 main segments. The only 2 segments that showed a decent growth were the entertainment group and the international segment. Management is not giving away much information about the 2017 outlook, however, a few things can be found in the transcript, which will be important for the analysis.
"And we expect to see continued free cash flow growth with free cash flow in the $18 billion range and continuing our drive towards $20 billion" - John Stephens CFO
"First, we see revenue growth in the low single digits. Growth in IP services and video is expected to offset competitive pressures, soft business investment and declines in legacy services. We expect adjusted earnings growth to continue in the mid single-digit range." For Business Solutions. - John Stephens CFO
We will use this information for the revenue growth expectations, which can be found in the table below. Management has not provided an outlook for all 4 different segments. To adjust for this, I'll be extrapolating the 2016 results.
The chart above illustrates my revenue growth expectations for the next 9 years. The business solutions is expected to grow in low single digits, therefore I used a conservative growth rate of 1%. The high growth rate in the entertainment segment in 2016 was a onetime thing I believe. It will still grow, but not as fast. The same applies to the International segment. The growth of the Consumer Mobility segment has been extrapolated. By using these growth rate we get the following table:
We can see that the estimated FCF is not enough to cover the dividends in 2023. However the difference is not a lot, therefore management could decide to up the payout ratio to 73.25%.
Theorizing about future payout ratio's
It's always good to make a few different scenarios about the future, since no one knows what will happen. Therefore I will use 2 scenarios.
A) Payout ratio stays at 70.5%
B) Payout ratio will be changed to 73.25%
By using a growth rate of 2.1% and a payout ratio of 70.5%, we can see that this is sustainable until 2022. Now by using the DDM-model we can calculate the stock price potential. As discount rate we use the WACC, 3.96%, which can be found on Gurufocus. The final year 9 uses a 2% growth rate, as to keep up with historical inflation.
This scenario results in a 13% upside potential.
A payout ratio of 73.25% means that the dividend growth rate can be sustained for the next 9 years.
The upside potential in this scenario is 16%. This scenario is a bit less likely than the scenario in A since it would require a higher payout ratio. However, the difference in payout ratio is only 3%, which is not very substantial on a relative basis.
By using the growth rates I used for the next 9 years AT&T will be able to sustain its dividend. I even believe that most of my growth rates can be seen as conservative. The upside potential in both scenarios seem conservative. I do believe that this stock is very interesting. AT&T has a dividend yield of 4.9%, and has a few growing segments which make it possible to grow the free cash flows in the future. This in turn means that AT&T will be able to sustain its dividend growth rate.
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.