Is AT&T a Value Trap (Dividend at Risk)???

With T sitting at $28 with a dividend yield at 7.36% yield , the question you should be asking is it it too good to be true? I mean the company has been around forever, and they have consistently paid out their dividend while growing it for over 35 years, so what could go wrong?

I never invest purely on one metric, but some people may fall for the trap of seeking high dividend yields with the following thought process:

Well if the stock doesn’t move, I make close to 8% on my money! Compared to a savings account of 0.0000001%, that’s amazing!

While that is true, it is always good to check a couple things before throwing all of your money at “guaranteed” money! First look at the payout ratio which is the following formula.

Payout Ratio = Dividends/Net Income

What does this tell you? It tells you whether or not the dividend is sustainable from a glance of the %. If it is over 80% or even over 100% it could be concerning as the dividend you we’re going after may not be there for much longer. 

The company doesn’t want to pay out more in dividends than it is making in profits. At some point the company would have to reduce their payout otherwise the dividend will eat into any expansion opportunities or cause them to go into debt just to keep the payment going.

But you also don’t want to look at just the payout ratio, and I’ll explain. The net income is an accounting metric, and if you have one offs baked into that number it can skew the % in the short term. 

So let’s say the company had a one time legal expense which caused their payout ratio to spike. Well then it’s probably okay due to net income increasing back to a normal amount over the next few quarters. Or maybe you had a one time profit due to a reserve that was released. That may give the illusion that the dividend payout is safe.

With that being said AT&Ts TTM payout ratio is 137.75%. Uh Ohhhh! Well it’s time to dump all your AT&T! Hold on, let’s take a look and think about it. 

During Covid there has been a hit to earnings for companies. This period of time may be a bump in the road and if earnings return back to normal then this is only a temporary high %. And in the Q3 earnings reports AT&T did exactly that, it has identified Covid related impacts of around $0.21 of EPS.

Something else AT&T is guilty of is being acquisition happy. This can cause higher depreciation of goodwill along with impairment related expenses. These expenses though are non-cash, so they are lowering profitability but not effecting the cash flow or the ability to necessarily payout the dividend. In the TTM disregarding any depreciation of acquisitions, the company had close to $4 billion in impairments. That’s causing a drag on the TTM EPS and therefore increasing the payout ratio that we are looking at above.

So although the payout ratio may look extremely high, there are one-offs along with non-cash related expenses that is causing a drag on the current EPS, but should not be reoccurring down the road.

Let’s look at dividend as a % of Free Cash Flow

Another metric to take out the accounting mumbo jumbo is to actually look at the dividend as a % of free cash flow being generated by the business. This essentially is saying how much cash is the business making from continuing their normal operations? And then after spending cash on capital expenditures to keep the business running, how much money is left over for expansion or the ability to return capital to investors.

Free Cash Flow = Operating Cash Flow – Capital Expenditures

You take the dividends/free cash flow to come up with a %. For AT&T based on their 2020 projections they will be in the high 50% range.

This tells us that stripping out the non-cash expenses which may lower the profitability of the company due to poor acquisitions or paying down debt at a faster pace, the company can still afford to pay the dividend with the cash it is generating from the business.

So yes the dividend % for AT&T is high. But I don’t believe it will be cut as the company still can pay for it with their free cash flow generation.

I do own some AT&T in my portfolio, but I treat it as more of a bond and play on consistent cash generation that will grow over time. I expect the business to stay steady and grow at a small rate while maintaining a dividend payout. Although it may not outperform the market, it does provide as a defensive play if the markets go into a bear market.

Of course, you can’t blindly continue to pile in. If the free cash flow starts to shrink and the dividend as a % of free cash flow rises for a sustained period of time, then it may be time to consider abandoning ship.

So in a bull market, you look like an idiot investing in AT&T. But in a bear market, you may be happy to have a low growth business that generates a ton of free cash flow.