Investors count on the major telecommunications companies like Verizon Communications (VZ 1.17%) and AT&T (T 0.44%) for reliable cash flow and hefty dividends. Indeed, both Verizon and AT&T pay high yields that tower above both the yield on the S&P 500 Index as well as the 10-Year U.S. Treasury bond. Even better, Verizon and AT&T are able to raise their dividends modestly on an annual basis, thanks to their growth.
But of course, no dividend is an absolute guarantee. As investors, it's critical to analyze the underlying business performance of a company, to make sure it's covering its payout with sufficient free cash flow. After all, a company can only pay a dividend without the supporting cash flow for so long. Avoiding companies in danger of cutting their dividends is one of the most important things an income investor can do.
With that in mind, let's take a closer look at Verizon to see whether it has the financial strength to keep paying its strong 4.3% yield.
Dividend track record provides confidence
As previously mentioned, Verizon has a good track record of paying, and even raising, its dividend. To that end, Verizon has increased its distribution for the past seven years. Its most recent increase came last fall, when the company bumped up its payout by 3%.
Likewise, AT&T also has a long history of rewarding shareholders. Last December, AT&T raised its dividend by 2%, representing the 30th consecutive year of a dividend increase.
While Verizon's dividend history doesn't seem very well established, you should know it's only traded publicly since 2000. Prior to then, it was known as Bell Atlantic. But rest assured, Verizon is just about as committed to providing shareholders with a compelling dividend as any company can be.
Robust free cash flow should allow for future dividend increases
Verizon has had two key strategic priorities over the last few years, both of which are now completed. The first was to obtain all of Verizon Wireless from European telecom Vodafone. Verizon forked over $130 billion to acquire the remaining 45% stake in Verizon Wireless that it didn't already own. This made a great deal of sense, since Verizon Wireless is the largest and most profitable wireless carrier in the United States, according to the company.
The second core objective was to invest in fiber optics. Verizon's investments in its infrastructure over the past several years have really paid off. Verizon reported nearly 15% growth in FiOS revenue last year, boosted by 536,000 new FiOS video subscribers and 648,000 FiOS Internet additions. Verizon also added 4.5 million wireless customers in 2013. All of these additions should allow Verizon to build on the $22.2 billion in free cash flow it generated just last year.
Amazingly, Verizon produced 45% growth in free cash flow last year versus the previous year.
Based on Verizon's roughly 4.1 billion shares outstanding, the company generated approximately $5.36 per share in free cash flow last year. When you consider Verizon's annualized dividend stands at $2.12 per share, it becomes abundantly clear how strong its business really is. Verizon's free cash flow payout ratio, which measures how much of its free cash is distributed to investors via the dividend, stands at just 39%.
Also, Verizon's free cash flow payout ratio is measurably better than AT&T's, which stands at 71%.
Such a low payout ratio not only means Verizon can easily afford its current payout, but it also means the company should have no trouble granting investors another solid dividend bump this year.
The Foolish takeaway
Investors depend on telecommunications companies for high dividends, and if that's your aim, Verizon won't disappoint you. It's made huge investments in acquiring Verizon Wireless and building out its fiber optic network, both of which will pay off going forward. Verizon has had to incur a fair amount of debt to finance these initiatives, but the huge free cash flow generated by its various businesses means its 4.3% dividend is extremely safe.
Future dividend growth is likely, too, thanks to Verizon's low payout ratio and prospects for future growth of free cash flow.