Verizon Communications (VZ 1.17%) stock has appeared to become a buy. After enduring a three-year downtrend, the stock has gained about 25% from its October low.
However, its dividend is in danger of being cut. After 17 straight years of increases, the yield and dividend costs have risen to elevated levels as its ongoing costs have risen. Hence, while Verizon is probably a buy, one should prepare for a reduction and possible elimination of the dividend. Here's why.
Why Verizon faces much higher costs
Aside from T-Mobile, which recently introduced a payout, telecom stocks like Verizon and AT&T have historically paid dividends. This was because they had long relied on landline networks that experienced more gradual technological changes. Since that reduced the need for capital expenditures, telcos could derive revenue from the same network for decades, leaving plenty of cash for dividends.
That started to change in the late 20th century. First, the internet led Verizon and AT&T to build extensive fiber networks. Additionally, Apple's iPhone took the internet into the wireless world, increasing the usage of wireless networks. Hence, each telco has had to build a new wireless network every few years to keep up with the changing technology.
In 2022, Verizon spent $23 billion on capital expenditures and $20 billion the previous year. Moreover, Verizon spent an additional $14 billion in the first nine months of 2023, and since it will have to build a 6G network in the foreseeable future, investors should not expect this expense to go away.
How it affects Verizon's cash situation
Not surprisingly, such costs are a drag on free cash flow. Verizon generated $14 billion in free cash flow in 2022 and an additional $15 billion in the first nine months of 2023. In comparison, Verizon spent almost $11 billion in dividends in 2022 and $8 billion so far in 2023, meaning that the dividend claims most of the cash the company generates.
With the recent increase, the payout is now $2.66 per share annually, taking the dividend yield above 7%. This is far above the 1.5% average for the S&P 500.
Investors may also look at the dividend in a new light, considering the total debt of $147 billion. That debt could ultimately force a dividend cut, with almost $13 billion in debt maturing over the next year alone. Thanks to higher interest rates, Verizon will likely have to refinance much of the debt at a higher interest cost, weighing heavily on net income and, by extension, free cash flow.
If the company suspended the dividend, it could apply the $11 billion in dividend costs toward the debt maturing within one year, helping the company avoid taking on additional, higher-interest debt.
Moreover, it is no coincidence that T-Mobile has delivered the highest returns over the last few years without offering a payout. That indicates the dividend may have hurt Verizon investors more than it has helped.
VZ Total Return Level data by YCharts
Why Verizon is probably a buy anyway
Admittedly, walking away from a 17-year streak of payout hikes will almost certainly hurt Verizon stock in the short term as income investors flee the investment. Nonetheless, Verizon is only one of three wireless service providers, a necessity in today's society. And with the tens of billions in annual capital costs, additional competitors are unlikely to enter the industry. This should make Verizon's revenue stream safe as long as it can maintain its network.
Additionally, the stock has become cheap by any measure. Even after the recent climb, the P/E ratio is less than 8. Although one can argue that Verizon stock is low cost for a reason, such an earnings multiple implies a limited downside for a business as stable as Verizon's.
Consider Verizon stock
Ultimately, investors have to adjust to a new reality with Verizon. The company now has to spend cash on capital expenditures and debt service, money that might have funded a dividend in the past.
But even with a high risk of a dividend cut, Verizon shareholders have T-Mobile's example from which to draw inspiration. The possibility of making up for a dividend cut with stock price growth may justify buying Verizon stock, despite the risks related to the payout.
