3 Reasons to Worry About AT&T’s Dividend

A high dividend payout ratio is just one of the reasons investors in this income stock should be worried.

Jul 20, 2014 at 11:00AM

AT&T (NYSE:T) is often thought of as a stock that income investors can buy and put away for years, without having to worry about the company's future. While it's true that AT&T and Verizon (NYSE:VZ) largely dominate the telecom industry, there are new challenges on the horizon. Unfortunately for AT&T investors, several of these challenges would seem to threaten the company's dividend.

Transitions are rarely easy
In management speak, the word "transition" is often used to describe a period of turmoil. Investors don't like hearing the company is going to have a bad year, so management says it is "transitioning" into a better company.

Transitions can take months, or many years, depending on what's going on in the industry. For example, AT&T and Verizon have strong wireless businesses to rely on when things get tough in their wireline businesses, but what about a company like Frontier Communications (NASDAQ:FTR)?

Frontier is in an ever-present transition phase. The company is attempting to move away from traditional landline connections toward high-speed Internet and video services. The strategy seems to be working, as high-speed Internet and video net additions both grew by about 7% annually, and switched access minutes of use dropped by about 8% over last year.

Verizon seems to be content with being the postpaid provider of choice, and reported better than 7% revenue growth in the wireless division. In contrast, AT&T is attempting to transition further into a prepaid provider through the Cricket brand.

On the company's last conference call, management said a big piece of capital expenditures in the near term would be transforming the Cricket network away from CDMA to GSM.

This is the first reason investors should worry for AT&T's dividend. Transitioning customers from devices they have already paid for to new devices, for the sake of the company's network, is a difficult task.

Customers could decide, if they have to get a new device anyway, that perhaps another carrier makes more sense. With "70% of Cricket customers use(ing) smartphones," this is no small issue. If AT&T sees lower growth in prepaid connections, or experiences losses, this could cut into the company's cash flow, threatening the dividend.

This was supposed to solve the problem, right?
The second threat to AT&T's dividend is the move in the postpaid wireless market away from subsidies and toward installment plans for phones. With wireless providers subsidizing smartphones at a rate of about $400 per phone, in theory, installment plans would help AT&T and Verizon avoid this huge upfront cost.

However, it may not work out that way. First, customers have been willing to go on an installment plan for their phones, but only if the monthly price is cheaper than on contract. What happens is AT&T accepts a lower monthly price so that customers pays for their phones. The problem, of course, is the longer customers keep their phones, the less profitable they are relative to an on-contract customer.

The second part of the problem is these phones are not free. When AT&T sells direct, the company must purchase the phone from the manufacturer. On a $600 phone, the installment plan might be $30 per month for 20 months. Needless to say, spending $600 up front to get it back over an almost-two-year period will have a direct effect on AT&T's cash flow. Getting lower monthly income from these plans will certainly hurt the company's cash flow as well.

The ultimate question
The third reason to worry about AT&T's dividend is the fact that the payout ratio doesn't look good relative to the company's peers. In fact, if this were a different company, analysts might already be speculating about a dividend cut.

In its last quarterly results, AT&T's core free cash flow (net income + depreciation – capex) payout ratio was 92%. In comparison, Frontier (which already cut its dividend) has a free cash flow payout ratio of 54%, and Verizon's payout is even lower at 25%.

With AT&T predicting roughly $11 billion in free cash flow for 2014, at the current dividend rate, the payout percentage would be 87%. Of course, this assumes that AT&T can generate four quarters like the first quarter of this year.

Final thoughts
If the Cricket transition doesn't go according to plan, or the move away from subsidies doesn't play out as expected, AT&T's cash flow may come in lower. What happens when a company with a relatively high payout ratio also faces potential cash flow challenges? I would suggest investors don't stick around to find out.

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Chad Henage owns shares of Verizon Communications. The Motley Fool has no position in any of the stocks mentioned. 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.

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