AT&T's Exceptional Dividend Safety Just Got Better

Summary

• T's FCF guidance for this year is very bullish.
• T is getting a permanent reset higher for its FCF and that's great news on a couple of fronts.
• T doesn't need TWX as much any longer and it could potentially pay down some debt as well.
• It also opens the possibility for larger dividend raises going forward.

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I’ve been pounding the table for AT&T (NYSE:T) for some time now as I’ve found the stock to be attractive on a valuation basis, but obviously for the dividend as well. The company’s dividend prospects have improved markedly in the past couple of years, and with strong FCF guidance from this past year’s Q4 report, it looks like the trend of improving its dividend coverage is going to continue. In this article, using data from company filings, I’ll take a look at AT&T’s all-important dividend financing and how its recent FCF guidance is bullish for those of us who love its dividend.

T's dividend financing continues to improve

Let’s begin with a look at T’s dividend expenditures and FCF going back to 2013 and including guidance for this year that was present in its Q4 report.

Source: author’s chart using data from company filings

We can see that T’s FCF has been pretty steadily moving higher during this period and that has helped immensely with the growing burden of the dividend. The dividend has grown from $9.7B in 2013 to my projection of $12.3B for 2018, but FCF has been more than up to the task. That number has moved from $13.6B in 2013 to T’s guidance of $21B for 2018, greatly increasing the gap between the company’s cash need for the dividend and its ability to produce that cash.

Tax reform provides a permanent reset higher

T’s FCF growth for this year is due largely to tax reform benefits it will accrue starting in 2018. Capex has been pretty steady for years at around $21B so operating cash flow has really been the wild card. For this year, operating cash flow is going to see a ~$3B benefit from the lower tax rate and thus FCF is going to move up by about that same amount. This is not something T is going to be able to replicate going forward. But importantly, the gains it's accruing for this year are a permanent reset higher, not a one-time boost. In other words, assuming there isn’t huge movement in either capex or other items that are part of operating cash flow, we can assume T will see $21B or so in FCF in years going forward.

Why is this important? I’d venture a guess that most people who own T do so at least mostly for the yield. After all, it is a utility and that's what they are for if you’re an investor. T’s ability to raise the dividend was somewhat in doubt in past years because its payout and FCF were almost the same in 2014. We also all know that T is extremely highly leveraged so its ability to come up with extra cash during a downturn made some investors – including me – doubt its ability to continue to raise the payout in the past. But recent years have proven much better and T’s dividend is actually in fantastic shape as of now, as we shall see below.

This chart shows the amount of FCF that is used to pay the dividend for each year, giving us an idea of how much cushion there is to weather downturns and, importantly, room for growth.

Source: author’s chart using data from company filings

After the spike in 2014, we haven’t seen a value in excess of 70%. That’s a very reasonable – and kind of low – value for a utility and in particular, one with such a big yield. I don’t get concerned for a company’s ability to raise the payout until this number is in excess of 85% and T is miles away from that. Further, if you look at 2018 estimates, we are talking something like 58% of FCF being used for the dividend. Whether exactly 58% ends up being the right number isn’t the point. The point is that T is in absolutely tremendous shape when it comes to paying its dividend. This means future raises will be no problem at all to finance even if T gets away from its 2% bump cadence.

Fringe benefits

The other benefits that are afforded T by this newfound FCF include the fact that the Time Warner (TWX) merger is less crucial now from a dividend perspective as well as the potential for T to use its excess cash for paying down some of its prodigious debt load. I said in December that T really could use the additional FCF that TWX would provide in order to bolster its ability to finance dividend increases down the road. I still hope T lands TWX. But at this point, the dividend doesn’t need the help. That makes owning T outright much more palatable without sweating whether or not TWX gets picked up. With the circus that has surrounded the TWX merger, that's a welcomed respite from the constant noise.

T is a top-tier income stock

I was bullish on T before the full impact of tax reform became known. But given the billions of dollars of additional FCF T is going to reap from the deal, I’m even more bullish than I was. Essentially, T has seen its FCF profile improved markedly without having to do anything like cut costs or boost prices. This is a truly win-win situation. It is great news for the dividend, and given just how well-financed the dividend is now, I’m hoping T will use some of that extra cash to pay down some debt. Either way, I’m uber-bullish on T here as there are few other income stocks I can think of I want to own more right now.

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Analyst’s Disclosure: I am/we are long T. 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.