Editor's note: This article has been corrected. T-Mobile US pays a dividend.
AT&T (T 1.02%) may finally have begun a long-awaited rebound. The stock surged 7% higher following its earnings announcement for the third quarter of 2023. A possible reason for the increase may have involved its guidance for free cash flow, which rose from $16 billion to $16.5 billion for 2023.
Unfortunately for income investors, the higher free cash flow may not significantly improve its ability to pay a dividend. Hence, rather than keeping the payout, AT&T has good reason to eliminate it despite more robust free cash flows. Here's why.
AT&T and its dividend
Although AT&T's dividend cut last year seemed devastating, shareholders still received a generous payout. Currently, they receive $1.11 per share in dividend payments annually. Even after the post-earnings surge in the stock, the dividend yield stands at almost 7.3%, approximately 4.5 times the average S&P 500 yield of 1.6%.
Moreover, like most dividend yields of this size, AT&T's dividend is in danger, but not for obvious reasons. Currently, this dividend costs AT&T approximately $8 billion per year, an amount the aforementioned $16.5 billion in free cash flow should easily cover.
The danger to the dividend comes from AT&T's ability to slash it. Before the dividend reduction in 2022, AT&T maintained a 35-year streak of increases to the payout. Those dividend hikes provided a sense of confidence in the stock and the payout.
Unfortunately, when the company removed that safeguard with the dividend cut, confidence in the stock fell along with the stock price. Also, AT&T has maintained the same payout since reducing the dividend. Without that long-term streak of dividend hikes, investors have to assume that the company could reduce or eliminate the dividend at any time.
Additionally, it is likely not a coincidence that the only telecom stock that did not offer a dividend until recently, T-Mobile US, offered the highest returns to investors over the last 10 years. This fact is an excellent argument for eliminating the payout rather than merely reducing it. Given T-Mobile’s past growth, it may actually profit AT&T’s investors if it stops returning cash to shareholders.
AT&T's debt burden
Moreover, AT&T has a strong incentive to make that move thanks to the company's massive long-term debt. This debt level now stands at $138 billion, up $4 billion from year-ago levels and well above stockholders' equity of about $118 billion.
Additionally, AT&T must spend heavily on its network to compete with Verizon Communications and T-Mobile. To that end, it spent a record $24 billion on capital expenditures over the last year. Since it expects to maintain that pace over the next year, it has less cash left to reduce its debt.
Furthermore, over the next year alone, $11 billion of AT&T's debt will be maturing. Even if it devoted all of the estimated $8 billion in free cash flow left over after paying the dividend, it would still have to refinance a portion of that maturing debt. In this rising rate environment, the costs of debt service will probably increase if it does not eliminate this maturing debt.
AT&T without a dividend
Considering AT&T's financial burdens and the growth of T-Mobile stock without a dividend, eliminating AT&T's payout is likely a better course of action for investors.
Indeed, many investors may have stayed with AT&T stock due to its long track record as a dividend stock. However, the need to spend heavily on capital expenditures and a massive debt burden have restricted the company's available cash. With the likely prospect of rising rates, cash may become more unavailable if the company must pay more in interest.
Eliminating the debt would not only pay off all maturing debt over the next year, but it would also place AT&T on more solid financial footing. After years of falling stock prices, this could return AT&T stock to a growth trajectory that has eluded it for many years.
