Once In A Generation Dividend Hike Coming From Verizon

Summary

• Verizon has hiked its dividend 11 years in a row.
• It offers a juicy yield, though at a modest growth rate so far.
• A solid business combined with tax cuts will drive dividend growth this year.

Every once in a generation or so, Uncle Sam decides to give investors a gift. Last time it happened was in the 80's and late last year it happened again -- the corporate tax rate was slashed.

For a steady business like Verizon (NYSE:VZ), which is used to low single-digit growth rates, a hefty tax cut really matters in terms of boosting after-tax EPS. For that reason, I believe that this year's dividend hike will be significantly higher than what investors have been accustomed to.

VZ data by YCharts

As anyone who has ever seen a chart before can see, this stock is not moving anywhere. For the last five years, it has basically been moving in a range of approximately $44 on the low end up to $56 on the high end. Surprising it should not be, though, as this is not a growth stock but an income stock. Even so, taking growth out of dividend growth investing surely leaves out a large pool of potential investors.

Capital gains have been close to zero over the last five years. When we include dividends of between 4.5%-5%, however, we do arrive at a total return that beats the bank and bonds but still is well below the overall market.

Historical Dividend Growth

As the company itself reported last September, that year's dividend hike was the eleventh straight increase for the company. The increase was a modest 2.2%, just about in-line with inflation. This is the kind of magnitude investors have become used to. The growth rate is low but the yield, currently at 4.5%, is solid.

VZ Dividend data by YCharts

Over the last five years the dividend has increased from $0.53 to $0.59 for a total increase of 11.3% or 2.7% annually. As stated above, this is putting off dividend growth investors, as the dividend can barely keep up with inflation. Purely income seeking investors, however, might still find the yield attractive.

There is not that much of a trend to discern when looking at the increases for each particular year. In 2014 it was boosted by a full 3.8%. This proved to be the highest percentage-wise increase of the late five-year period. For the next couple of years the growth rate stayed in the range 2.2% to 2.7%. If anything, the trend is pointing down, not up.

On a positive note, the payout ratio is moving in the right direction. From being at close to 100% in 2015 it has steadily trended down to the current level of 31%. That is a truly positive sign and should pave the way for future dividend increases -- hopefully comfortably above the rate of inflation.

September Dividend Hike

Ever since Verizon started its annual dividend increase back in 2007, the month the Board has chosen to do so has been September, and more specifically early September. Verizon investors can therefore be quite certain history will repeat itself and that they can expect a fatter dividend cheque to be announced in about a month's time.

In estimating the lowest likely increase, I will look at the lowest increase it has had in recent history. The last two years the hike was of 1.25 cents. If that were to be the increase this year, we would have a percentage-wise hike of 2.1%. That is below the 2.9% inflation rate reported for June.

If the Board were to look more at keeping the percentage growth steady, rather than the dollar increase, I would expect them to increase it by 1.5 cents, equalling a percentage increase of 2.5%. That sounds more reasonable than the low estimate, given that the business is doing quite well and the payout ratio is very low.

For the high end estimate, we should take account of the tax cuts implemented late last year. The company expects its tax rate for 2018 to come in at between 24 and 26 percent. It used to pay close to 35%. All else equal, this should increase EPS by about 15%. With all the stuff happening in this business, from investment in 5G networks to acquisitions, I will expect the Board to keep some of this windfall to themselves in order to have some loose powder for future M&A and other investments.

Even so, considering that the company continues to grow at low single-digits and it is getting a substantial windfall via the tax cut, there is no reason for the Board to hold back too much on the dividend. Conservatively estimated, I would expect them to offer the usual increase together with at least half of the windfall from the tax cut. This results in a predicted increase in the range of 10-12% for a new quarterly dividend of $0.65 to $0.66.

Risk Factors

The telecoms industry in the United States is very consolidated with two major players, AT&T (T) and Verizon (VZ) controlling approximately 70% of the market. The second two players control almost all of the remaining market. To top it off, T-Mobile (TMUS) is likely to finally close the acquisition of Sprint (S). This -- all else equal -- reduces risk of price wars and other margin-destroying plays in order to gain market share. Still, at least so far, T-Mobile has been quite aggressive on pricing in order to steal customers from the largest players. There is a risk that this will continue even after they have completed the acquisition of Sprint.

Further, there is a lot of change happening, even in such a stable business as the telecoms business. AT&T's acquisition of Time Warner and the investment in 5G networks are just two examples. There is a clear risk that one can be left behind if one doesn't succeed in navigating correctly in this changing landscape. Finally, increased interest rates have already, and might continue to, put downward pressure on the price of yield-sensitive investments like telecom companies.

Current Valuation

So now for the all-important valuation section. Everything is relative, and so we should analyse not only the valuation of Verizon, but the valuation of Verizon relative to its peers. As peers, I have chosen the two closest competitors, AT&T and T-Mobile.

	Verizon	AT&T	T-Mobile
Price/Sales	1.7x	1.3x	1.3x
Price/Earnings	6.9x	6.3x	11.4x
Yield	4.5%	6.2%	N/A

Click to enlarge

Source: Morningstar

The Price/Sales competition is lost by Verizon with first place tied between AT&T and T-Mobile. As for Price/Earnings, this one has a clear loser in T-Mobile and a winner in AT&T, just ahead of Verizon. Likewise for the yield, though the win for AT&T is by no means narrow. T-Mobile doesn't even pay a dividend so there was no doubt about them losing this game.

Looking at the numbers, AT&T looks like the more compelling investment with both a lower P/E ratio and a higher yield than any of the others. Still, Verizon is quite close, especially with regards to the P/E ratio and on its own looks like a fairly conservative investment.

The analysts expect Verizon to be able to grow its EPS at an average annual rate of 5.9% over the next five years. If we assume that it will achieve this and adding in the yield of 4.5%, we arrive at an expected annual total shareholder return of 10.4%. Mind you, this is before multiple expansion, which is not unlikely to happen given the current P/E ratio of 6.9x. An expected return of 10.4% from a very conservative investment like Verizon has to be considered quite good. It is in-line with the long term return for the market as a whole. And you get all of this at a low risk. This stock should be a cornerstone of any income portfolio. With the growth prospects over the coming years, it should even be added to dividend growth portfolios. Just don't expect massive capital gains in the short term.

Conclusion

Verizon has hiked its dividend for 11 years and is all but guaranteed to do it again this September. The yield is quite juicy but the growth rate of the dividend has not been -- at least so far. The business is doing just fine. Considering the substantial tax cut and its massive impact for Verizon, the EPS should improve quite substantially this year. If analysts are half right, the growth rate over the next five years will be really healthy as well. The stock should constitute a major part of any income-oriented portfolio but should now also be considered by dividend growth investors on account of the higher expected future growth rate.

Analyst’s 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.