How Safe Is AT&T's 4.9% Dividend Yield?

By Markets

AT&T is the second largest mobile carrier in America. Image source: Getty.

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AT&T (NYSE: T) stock is paying an attractive dividend yield of 4.9% at current prices. Needless to say, this can be remarkably tempting for investors, especially in times when interest rates around the world remain at historically low levels. But there is a major question to consider: Does AT&T have what it takes to sustain and increase dividend payments in the future?

Big dividends, slow dividend growth

The telecom industry is facing considerable challenges as internet and related technologies are reducing communication costs across the board and putting downward pressure on profit margins for telecom operators. Besides, it's not easy for big companies in such a mature industry to find new opportunities for organic growth.

On the other hand, scale is a valuable source of competitive strength in the business, generating efficiencies and cost advantages for big players in the sector. After years of industry consolidation, AT&T and Verizon (NYSE: VZ) are the two dominant players, and their leading positions allow them to generate big and stable cash flows.

AT&T made a big move into pay TV with the purchase of DIRECTV for $49 billion last year. This acquisition made the company the top player in the U.S. pay-TV market and opened up growth opportunities in this business in Latin America. According to recent press reports, the company is also looking for acquisition targets in the media sector in order to diversify its business with content production.

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Growth via acquisitions can be a smart way for AT&T to move beyond the stagnant telecom industry, but investors need to consider that acquisitions are seldom easy to implement. Besides, buying other companies can use up money that would otherwise be allocated for dividend payments.

AT&T and Verizon offer big dividend yields, but dividend growth has been under considerable pressure lately at both companies. AT&T has increased its dividends over the last 32 consecutive years -- quite an impressive track record of consistency. However, dividend growth rates leave much to be desired. The company has increased dividends by only $0.01 per share in every year since 2009; expressed in percentage terms, the hike in 2016 was a modest 2.1%.

The stuation at Verizon is not too different. Verizon stock pays a compelling dividend yield of 4.6% at current prices, but dividend growth has been deceleratingover the past several years, and the company raised dividends for 2016 by a minuscule 2.2%.

Looking at earnings and cash flow

The average Wall Street analyst forecast calls for AT&T to make $2.86 in earnings per share during 2016. Based on these predictions, the dividend payout ratio is around 67% of earnings estimations. The number is relatively high, but not necessarily excessive by industry standards. As a reference, competitor Verizon has a dividend payout ratio around 59% of earnings expectations for the current year.

Over the trailing-12-month period ended in the second quarter of 2016, AT&T produced $38.2 billion in operating cash flow, and free cash flow absorbed $21.5 billion of that money. This leaves the company with $16.7 billion in free cash flow to allocate to dividends, among other possible uses. Total dividend payments amounted to $11.2 billion, or 67% of free cash flow over the period, so dividends are also sustainable in comparison to free cash flow.

Importantly, cash flow from operation has remained strong over the long term, so as long as the company keeps capital expenditures under control, free cash flow will probably be enough to cover dividend payments.

T Cash from Operations (TTM) data by YCharts.

When it comes to earnings and cash flow, AT&T has the financial resources to sustain its current dividend payments. However, the company doesn't have a lot of room to increase dividends based on current cash generation, so dividend growth will most probably be in line with cash flow growth over the coming years. Since the business is mature, and AT&T is not finding many opportunities for organic growth, dividend increases are likely to remain underwhelming going forward.

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Andrs Cardenal has no position in any stocks mentioned. The Motley Fool recommends Verizon Communications. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.