If you're an income-focused investor, no doubt Verizon Communications (NYSE:VZ) and AT&T (NYSE:T) have popped up on your radar. While the broader S&P 500 has a dividend yield of 1.9% and the 10-year U.S. Treasury bond of 2.3%, Verizon and AT&T yield 5.3% and 5.8%, respectively.
It's not just high dividend yields. Shares of AT&T and Verizon currently trade for forward price-to-earnings ratios of 11.4 and 11.7, respectively, versus the S&P 500's 21 forward multiple. It's clear Wall Street doesn't have high expectations for these companies. As of this writing, year to date, shares of Verizon and AT&T have lost 15% and 19%, respectively, while the overall market has advanced by 16%.
You must ask if these companies are good yield plays that will continue paying their dividend for years to come or if they're yield traps -- companies that lure investors in with high yields only to cut them or substantially underperform the market.
At the heart of AT&T and Verizon's issues are problems with their core business of wireless communications. While Big Red and AT&T are the two largest carriers in the United States by subscriber count, the business is becoming highly competitive. Led by T-Mobile's Uncarrier program, the industry has endured lower prices and more consumer-friendly terms, at the same time requiring huge capital expenditures to build out and maintain the network.
Both are also in the subscription-based television industry, with Verizon's FiOS offering and AT&T's purchase of DIRECTV. The subscription television business faces many of the same issues that affect wireless communications, including high capital expenditure requirements in a competitive market. In addition, the subscription television market is facing competition in the form of streaming-based substitutes and from a shift in consumer behavior as more "cut the cord" and forgo the service entirely.
Large, debt-fueled acquisitions
Verizon Communications can be partially absolved for its high debt sins. In 2013, the company engaged in the largest corporate debt offering ever, selling $49 billion. The company was forced to do so to buy its most lucrative business, Verizon Wireless. In 1999, before anyone had an idea just how important the wireless industry would become, Verizon (then GTE and Bell Atlantic) announced a joint venture with Vodafone to create a wireless company, with Verizon owning 55% and Vodafone owning 45%.
By the time Verizon was able to repurchase Vodafone's minority stake, it was worth $130 billion, forcing the company to take on large sums of debt to fully own its namesake wireless business. However, Verizon could not have had worse timing, as T-Mobile's Uncarrier program began in earnest shortly after the deal closed, eventually forcing Verizon to reoffer unlimited (and margin-lowering) data plans.
AT&T has also been active in the debt markets, selling $17.5 billion -- the then third-largest offering -- to buy DIRECTV. AT&T is also looking to take on $40 billion in more debt as it hopes to buy Time Warner. The combined company is expected to have $175 billion of total debt on its books. As of now, the federal government is challenging the merger, which may be good news for investors concerned about the company's balance sheet.
A commitment is a start
Verizon is committed to defending its dividend. At a September Goldman Sachs conference, CEO Lowell McAdam noted that the company has a target of $10 billion in cost savings over the next four years to pay the dividend through 2022. This was less than a week after the company raised its dividend for the 11th year in a row.
Not to be outdone, AT&T CEO Randall Stephenson remarked at the same conference:
Our owners expect the cash return, the dividend return, and we are committed to that. We've been a public company for over 30 years. We've increased that dividend every single year. And so, we are committed to the dividend. We think that's very, very important. But then the third use of cash obviously will be the debt pay down. So those are kind of the priorities that I think through the next three years.
Free cash flow seems supportive for now
Currently, both AT&T and Verizon are generating enough cash to pay their dividends. Over the past five fiscal years, AT&T produced enough free cash flow (cash from operations minus capital expenditures) to pay its dividend; Verizon did so in four of the five. However, with financial leverage ratios of 3.5 and 9.5, respectively, free cash flow can rapidly swing negative with small decreases in revenue or operating margins.
While I wouldn't go as far as calling either AT&T nor Verizon yield traps, I do think both are reasonably priced considering their high debt piles, large payout commitments, and huge capital expenditures. Even if these companies don't cut their dividend, I predict dividend raises will come less frequently or on a much smaller incremental basis.
Jamal Carnette, CFA owns shares of AT&T. The Motley Fool owns shares of and recommends Verizon Communications. The Motley Fool recommends Time Warner and T-Mobile US. The Motley Fool has a disclosure policy.