Retirees should generally buy low-risk stocks that generate reliable income. But in today's frothy market, it may seem risky to buy dividend stocks -- especially if interest rate hikes convince investors to dump richly valued income stocks in favor of bonds with comparable yields.
However, there are still plenty of dependable dividend stocks on the market with below-average valuations. Today I'll examine one of my favorite long-term income plays, AT&T (T 0.94%), and explain why it could still be a solid dividend stock for retirees.
A dividend aristocrat
After a company raises its dividend annually for 25 straight years, it becomes an elite "dividend aristocrat" and highly valued by income investors. AT&T has hiked its payout annually for 32 straight years, which puts in on that short list of 52 companies.
That coveted status indicates that AT&T won't stop raising its dividend anytime soon. AT&T's closest rival, Verizon (VZ 0.88%), has only raised its dividend annually for ten straight years.
A high yield and sustainable payout ratios
AT&T pays a forward dividend yield of 5.1%, which is more than double the S&P 500's current yield of 2%. It's also slightly higher than Verizon's forward yield of 5%.
A high yield is tempting, but we should always check a company's payout ratio -- the percentage of its earnings or free cash flow (FCF) which is spent on dividends -- to see if the dividend is sustainable. If that ratio exceeds 100% for an extended period, a dividend cut could be in the cards.
Over the past 12 months, AT&T spent 95% of its earnings and 70% of its FCF on dividend payments. Verizon spent 77% of its earnings on dividends during the same period, but those payments used up over 100% of its FCF -- which remained negative over the past year due to declines in its wireless business, debt and pension obligations, and its planned buyout of Yahoo's internet business.
A low valuation and reliable growth
AT&T trades at 19 times earnings, which is lower than the industry average of 21 for domestic telecom companies. That's slightly higher than Verizon's P/E of 16, but investors may be willing to pay a premium for AT&T's slightly higher yield and more sustainable payout ratios.
As for the growth of its core business, AT&T has been expanding aggressively with two major deals. First, it acquired DirecTV in mid-2015, which made it the largest pay TV provider in the world and broadened its bundling options for wireless and wireline plans.
Second, it agreed to buy Time Warner (TWX), which will add valuable media properties like HBO and Warner Bros. to its portfolio. AT&T intends to bundle all these products together with cross-platform streaming and "sponsored data" -- which offers data-free streaming to its wireless subscribers.
For now, analysts expect AT&T's revenue to slip 1% this year and rise 1% next year. Earnings are expected to rise 3% this year and 2% next year. However, those estimates don't include the benefits of the Time Warner deal yet, since the megamerger still hasn't been fully approved by regulators.
Predictable stock performance
AT&T's 16% gain over the past five years underperformed the S&P 500's 70% growth, but retirees will likely value price stability and steady dividends over price appreciation. AT&T's stock has held steady all these years due to two factors.
First, its moat is so wide that only a handful of companies, like Verizon, can keep competing. That moat will be further widened by the DirecTV and Time Warner deals. Second, AT&T's high dividend yield and low valuation set a floor under the stock, enabling it to rebound from even the worst market meltdowns.
So is AT&T an ideal retirement play?
I believe that AT&T is one of the safest income-generating retirement stocks on the market. However, retirees should still be aware of the company's two main weaknesses. First, its postpaid wireless growth is slowing down due to market saturation and tougher competition from rival telcos.
Second, AT&T is taking on a lot of debt to finance the DirecTV and Time Warner deals -- although the overall threat to its long-standing dividend is minimal. If you believe that AT&T can counter those two challenges, it's probably time to add this high-yielding, classic dividend play to your retirement portfolio.