Ben Reynolds' Top Dividend Aristocrats: Part 4

Investors looking for high dividend yields should consider the telecommunications sector. Telecoms broadly enjoy a number of qualities that make them attractive options for income investors, explains Ben Reynolds, editor of Sure Dividend.

The two major U.S. telecoms—AT&T (T) and Verizon (VZ)—both have dividend yields more than twice the average yield of the S&P 500 Index.

AT&T offers a particularly high yield of 5.3%, and it has also raised its dividend each year for 36 consecutive years. It is a Dividend Aristocrat, a group of 57 companies in the S&P 500 Index with at least 25 consecutive years of dividend growth.

There should be plenty more dividend increases to come, due to the company’s growth potential, thanks in large part to the Time Warner acquisition. AT&T stock offers a rare combination of growth and a high dividend yield, with a low stock valuation as well. As a result, AT&T is one of our top-ranked Dividend Aristocrats.

AT&T’s Major Transformation

AT&T is an industry giant, with over 100 million customers in the U.S., as well as a significant presence in Latin America. It provides a wide range of telecom services, including wireless, broadband, and television through cable and DIRECTV satellite service.

AT&T generates more than $180 billion in annual revenue, while the stock has a market capitalization of approximately $283 billion.

Investors typically purchase telecom stocks for their consistent financial results, and AT&T is no different. The company reported 4.4% growth in adjusted earnings per share in the most recent quarter.

While revenue declined 3%, margin expansion fueled another quarter of steady earnings growth. Revenue has declined 1% through the first three quarters of 2019, but adjusted EPS increased 0.4% in the same time period.

Certain legacy services continue to be a drag on AT&T, such as business wireline, but the company’s growth segments will lead its future growth. AT&T is a giant telecommunications company, and has been for the last several years.

Although it will continue to hold a leadership position in core telecom services, the company has targeted a new area for future growth. AT&T has its eyes set on becoming a giant in content, through the $85 billion acquisition of Time Warner that closed last year.

AT&T’s primary competitive advantage is its scale. The U.S. telecom industry is dominated by two major players: AT&T and rival Verizon. This gives AT&T a wide economic moat and a durable competitive advantage.

As a massive distribution company, AT&T already possesses the infrastructure to instantly scale its recently acquired content assets into new service offerings.

Through the acquisition of Time Warner, AT&T now owns multiple valuable content properties including TNT, TBS, CNN, and HBO. Time Warner also owns the Warner Bros. movie studio, as well as rights to live sporting events across the NFL, NBA, MLB, and NCAA.

In the age of cord-cutting — in which consumers cancel their high-priced cable or satellite TV subscriptions in favor of smaller packages and Internet streaming —it is increasingly important for content distributors to own and produce their own content.

This helps distributors insulate themselves from commoditization of traditional telecom services. With more content options than ever before, it is vital for Internet and television distributors to keep their customers from switching to a competitor.

Other companies have followed suit by acquiring content brands. For example, Comcast (CMCSA) has made numerous acquisitions in content, such as the nearly $4 billion purchase of DreamWorks Animation, as well as the acquisitions of NBCUniversal and Sky.

Overall, we believe a reasonable EPS growth estimate for AT&T is 4% per year through 2024, consisting of revenue growth and a minor expansion of profit margins. Growth in content will allow AT&T to continue rewarding its shareholders with a high dividend yield. And, it will also allow AT&T to maintain its long and impressive history of dividend increases.

Dividends On Speed Dial

AT&T is a particularly attractive stock for income investors, as it is a rare combination of a high dividend yield, and steady dividend growth. AT&T recently increased its quarterly dividend by 2%, to $0.52 per share. On an annualized basis, the forward payout of $2.08 per share represents a dividend yield of 5.3% based on the recent share price of ~$39.

The company has the ability to distribute such a high yield to shareholders, while simultaneously continuing to raise the dividend each year, thanks to its strong business model. AT&T produces a great deal of cash flow, as it offers services that are in high demand, regardless of the state of the economy.

AT&T generated $21.88 billion of free cash flow through the first three quarters of 2019. Consumers are clearly fond of their devices, and are unwilling to go without Internet, cable, and wireless services—even in a recession.

AT&T has had the ability to raise its dividend each year for over 30 years, a period of time that included multiple recessions. Even in the Great Recession of 2007 to 2009, the company continued to hike its dividend, as its profits held up very well.

AT&T remained steadily profitable through the recession, with diluted earnings-per-share of $1.94, $2.16, and $2.12 in 2007, 2008, and 2009 respectively. AT&T’s recession resilience and strong cash flow help it sustain its dividend payments to shareholders.

Why AT&T’s Dividend Is Highly Sustainable

Along with its most recent quarterly results, AT&T also provided a three-year plan on its financial expectations and capital allocation. AT&T expects 2022 adjusted EPS in a range of $4.50 to $4.80, which would represent roughly 10% annual growth at the midpoint.

Revenue is expected to increase 1% to 2% each year, while adjusted EBITDA margin is expected to expand ~200 basis points to 35% of revenue by 2022.

AT&T targets free cash flow of $30 billion to $32 billion by 2022. The company will use the remaining cash after dividend payments to buy back ~70% of the shares issued for the Time Warner acquisition, as well as retiring 100% of the debt issued in the transaction.

Such a high level of free cash flow allows AT&T to buy back stock, repurchase shares, invest in growth, and pay dividends to shareholders all at the same time. As a result, we view AT&T stock as an attractive mix of growth and dividends.

We also view AT&T as an undervalued stock. The company expects to generate earnings-per-share of $3.65 in fiscal 2019. Based on this, the stock has a price-to-earnings ratio of 10.7. This is a low valuation multiple in our view, for a highly profitable Dividend Aristocrat with positive growth potential.

We believe a price-to-earnings ratio of 12 is a better fair value estimate for AT&T, which means valuation expansion to a P/E ratio of 12 could boost shareholder returns by approximately 2.3% per year over the next five years.

Including the 5.3% dividend yield and 4% expected earnings growth, expected returns could exceed 11% over the next five years. As a result, we rate AT&T a buy for income investors.