On the surface, Verizon (VZ 1.13%) stock looks like a no-brainer opportunity. Its 7.2% dividend yield alone looks attractive. Even more, shares trade at only 7x earnings. This is despite the fact that Verizon's business almost certainly isn't going anywhere.
With a large base of premium wireless customers and low customer churn rates, Verizon boasts an established brand that people rely on for a service that's critical to both everyday life and business. This is the sort of company investors can safely bet will likely still be generating significant profits a decade from now.
Despite the many reasons to be bullish on the stock as a good long-term investment given its cheap valuation today, there's one looming risk that should keep investors cautious: the possibility of Verizon opting to reduce or pause its regular dividend. While the odds of this occurring are low, it's still a risk investors should keep in mind.
Understanding Verizon's dividend
To understand just how impressive Verizon's 7.2% dividend is, consider this: It's more than 4x higher than the average dividend yield of stocks in the S&P 500. Even more, management regularly insists during many earnings calls and investor presentations that its dividend is a priority. Following its first priority of using its free cash flow to make prudent capital expenditures to drive business, Verizon's second priority for its free cash flow is to keep paying and growing its dividend.
The company has notably rolled out a dividend increase every year for the last 16 years straight. It's worth noting, however, that recent dividend hikes have been small. Verizon's last hike, which was announced in September of last year, amounted to just a 2% increase over its previous dividend. The company's dividend is already so high, any increase at this point is worth applauding.
Balancing debt and dividends
But here's the issue with Verizon's dividend. The company's current practice of paying out a substantial portion of its earnings in dividends means there's less money to pay off debt and virtually no money to repurchase shares. Because of the capital-intensive nature of the company's business, its aggressive plans to invest in infrastructure, its large debt load, and its commitment to a growing dividend (that currently amounts to about half of its earnings), Verizon needs to allocate the rest of its excess cash to deleverage its balance sheet.
Unfortunately, it may take some time before the company achieves its target leverage ratio to free up capital for repurchases. It's Verizon's goal to achieve a net unsecured debt-to-adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) ratio of 2. This compares to a current ratio of 2.7.
As Verizon's debt matures, a high-interest-rate environment could be a headwind for interest-rate expense. This is why it's so important for the company to bring its leverage ratio down. Specifically, it's management's goal to pay off this debt by the end of 2025. After it achieves its target leverage ratio, the company will consider repurchasing shares.
Theoretically, management could use some of its free cash flow to repurchase shares if it shifted its financial priorities. But every dollar spent on repurchases would be one dollar that could have been spent on paying off some of its debt.
The risk to Verizon investors, however, is that management's free cash flow comes in lower than anticipated and the company subsequently considers using some of the funds it currently allocates to dividends toward debt payments. This could disappoint the many income investors who have relied on Verizon for more than a decade-and-a-half of dividend growth, and ultimately cause a potential sell-off in the stock.
For now, however, the company's enormous free cash flow of $15.3 billion over the trailing-12-months is plenty to cover both its dividend payments and approximately $4 billion in annualized interest expenses. But its current priorities mean Verizon is missing out on an opportunity to buy shares for just 7x earnings.
