Telecom stocks usually offer large dividends with fairly stable price performance, making them ideal investments for long-term income investors.
AT&T (NYSE:T) and Verizon Communications (NYSE:VZ), the two largest telecom companies in the U.S., pay respective forward annual dividend yields of 5.7% and 4.8%. But before investors assume that makes AT&T a better income stock, we should compare both companies' payout ratios, free cash flow, and income growth.
Payout ratio and free cash flow use
In addition to a higher yield, AT&T seems to be the more generous company on a payout ratio basis.
Over the past 12 months, AT&T paid out 55.8% of its net income as dividends, compared with 42.4% at Verizon. However, net income can be distorted by one-time charges, gains, and changes in accounting methods. By comparison, free cash flow (FCF) -- a company's operating cash flow minus capital expenditures -- often offers investors a clearer view of its financial health.
Over the past 12 months, AT&T paid out 84.4% of its FCF as dividends, compared with 45.8% for Verizon. During that period, Verizon's FCF fell 27.5%, compared to AT&T's 18.4% decline. Verizon's steeper FCF decline shouldn't alarm income investors, since its FCF payout ratio remains much lower than AT&T's.
Also keep in mind that generous payout ratios don't necessarily mean that a company is a better long-term dividend stock. AT&T's high payout ratios certainly mean that it values investors, but Verizon's lower payout ratios give it more room to grow its dividend, since payout ratios over 100% are unsustainable over extended periods.
Neither AT&T nor Verizon are near that threshold on either a net income or FCF basis, so both companies should be able to safely grow their dividends over the next few years.
Clash of the telecom titans
AT&T and Verizon each control around 34% of the U.S. wireless carrier market, according to Chetan Sharma Consulting.
Verizon's new postpaid user growth has been steady, rising from 549,000 to 1.4 million between the first two quarters of the year, before climbing to 1.52 million by the third quarter. AT&T's new postpaid users rose from 625,000 to 1 million between the first two quarters but abruptly plunged to 785,000 in the third quarter.
Over the past year, AT&T and Verizon slashed prices and raised data caps in a fierce pricing war. Unfortunately, that battle caused AT&T's and Verizon's net incomes to respectively fall 21% and 32% YOY in their most recent quarters.
Future plans for growth
Earlier this year, Verizon gained full control of its wireless business through its acquisition of Vodafone's 45% stake in the segment.
Meanwhile, AT&T is trying to expand into the pay TV industry with its proposed $48.5 billion acquisition of DirecTV (NYSE:DTV.DL). That merger, if approved, will combine AT&T's 5.7 million U-verse customers with DirecTV's 20.25 million users, creating the largest pay TV provider in America. However, Comcast's (NASDAQ:CMCSA) proposed merger with Time Warner Cable (UNKNOWN:TWC.DL) might top that deal with nearly 30 million subscribers. Both plans face notable hurdles and AT&T's DirecTV deal faces the rise of cord-cutters across America, who are fleeing to on-demand streaming services such as Netflix and Hulu.
Meanwhile, Verizon's Vodafone deal, worth an estimated $130 billion (including $59 billion in cash), more than doubled the company's debt load. A higher debt load is definitely a negative development, but Verizon's 46% FCF payout ratio means that it can probably pay back debt and raise its dividend at the same time.
What do those plans mean for margins?
The companies' plans matter to dividend investors since both will affect margins.
Verizon's wireless segment posted an operating margin of 31.9% last quarter. DirecTV had an operating margin of 14.8% last quarter. This means that Verizon is willing to double down on a high-margin business, while AT&T is diversifying into a lower-margin one that might generate stronger revenue growth over the next few years. Last quarter, AT&T's revenue rose 2.5% YOY to $33 billion, while DirecTV's revenue climbed 6% to $8.4 billion, partially because of robust growth in Latin America.
As AT&T expands into lower margin businesses, its net income and FCF growth could decline, causing dividend payout ratios to climb to uncomfortable levels.
The road ahead
Both AT&T and Verizon are solid, conservative income investments for 2015, but both companies are clearly in the midst of major transitions.
I'm not a fan of AT&T's plan, since it means sacrificing margins for revenue growth in the wobbly pay TV industry. Meanwhile, Verizon might have overpaid to own 100% of its wireless business, but it's still a high-margin business that could earn higher long-term profits.
Both companies also trade with comparable multiples -- AT&T trades at 10.5 times trailing earnings, while Verizon trades with a ratio of 10.3. Investors looking for pure yield should probably go with AT&T, while those looking for a chance of higher margin growth might want to consider Verizon instead.
Leo Sun has no position in any stocks mentioned. The Motley Fool recommends Moody's, Netflix, and Verizon Communications and owns shares of Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.