A number of readers have emailed me in recent weeks wondering about Verizon’s (VZ) dividend safety.

 

Verizon
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Their anxiety developed after reading several articles online that suggested Verizon’s dividend was no longer sustainable because the company’s free cash flow did not cover it last year.

 

However, Verizon scores a 93 using our Dividend Safety Scores, indicating that its payout remains very secure.

 

I believe Verizon is one of the best high dividend stocks for current income, so I was interested to review what all of the fuss was about.

 

I will do my best to walk through Verizon’s financial statements (grab some coffee now to stay awake) and objectively review the company’s dividend safety.

 

Let’s start with a close look at the main argument against the safety of Verizon’s dividend – abysmal free cash flow coverage.

 

What is Free Cash Flow and Why Does It Matter?

Free cash flow is one of the most important financial metrics to understand for successful dividend investing.

 

Free cash flow represents the cash flow remaining after a company has made the investments necessary to maintain and grow its operations.

 

Free cash flow can be used to return capital to shareholders, acquire businesses, and repay debt.

 

Companies that consistently fail to generate free cash flow are unlikely to be able to pay sustainable dividends, repurchase shares, or have enough funds available for acquisitions or debt repayments.

 

Free cash flow is calculated using the company’s statement of cash flows.

 

According to Verizon’s non-GAAP reconciliations file, “free cash flow is calculated by subtracting capital expenditures from net cash provided by operating activities.”

 

Capital expenditures primarily consist of money spent on property, plant, and equipment to maintain and grow a business.

 

Cash provided by operating activities essentially adjusts net income for non-cash charges such as depreciation and accounts for changes in working capital accounts, such as inventory and accounts receivable (e.g. a company’s cash decreases if it buys inventory that hasn’t been sold yet).

 

Let’s take a look at Verizon’s cash flow.

 

Analyzing Verizon’s Free Cash Flow

Verizon reported $5.7 billion in free cash flow in 2016, which can easily be checked by subtracting its $17 billion in capital expenditures (circled in red below) from its $22.7 billion in net cash provided by operating activities (circled in green below).

 

Verizon Dividend Safety

 

You can see that Verizon’s annual report pulls out those two figures in the table it uses to display free cash flow:

 

Verizon Dividend Safety

 

Many dividend investors pay close attention to a company’s free cash flow to see how well a dividend payment is covered.

 

The company’s $5.7 billion in free cash flow last year did not come close to covering the $9.3 billion in dividend payments that Verizon made.

 

Even scarier, you can see that Verizon’s free cash flow per share dropped significantly in 2016 to reach $1.38, well short of the $2.285 per share paid in dividends.

 

Verizon Dividend Safety

Source: Simply Safe Dividends

 

As a result, Verizon’s free cash flow payout ratio spiked well above 100% in 2016. The company’s payout ratio had never exceeded 70% going all the way back to 2005, so this change really stands out.

 

Verizon Dividend Safety

Source: Simply Safe Dividends

 

Before running for the hills and assuming that Verizon’s dividend is doomed, a much closer look at the company’s full statement of cash flows is warranted.

 

Certain accounting issues can be quite hairy at times, potentially distorting the reality of an investment situation.

 

I believe that is the case with Verizon’s 2016 financials and its dividend safety.

 

Why Verizon’s “As-Reported” Free Cash Flow Is More Than It Appears

Remember how free cash flow is calculated by subtracting a company’s capital expenditures from its net cash provided by operating activities?

 

That means a change in free cash flow from one year to the next has to be driven by a change in one of those variables.

 

Upon closer inspection, we can see that Verizon’s capital expenditures were lower by $716 million in 2016 compared to 2015, but its net cash provided by operating activities decreased by more than $16 billion in 2016.

 

Verizon Dividend Safety

 

Why the big drop in operating cash flow?

 

If the decrease was due to accounting noise and/or one-time events, Verizon’s true cash flow (adjusting out the noise) could have reasonably covered its dividend despite the headline free cash flow number.

 

I believe Verizon’s true operational cash flow in 2016 is being misunderstood when a mechanical free cash flow formula is applied for two primary reasons.

 

Free Cash Flow Adjustment #1: Cash Taxes Paid from an Asset Sale

Verizon investors might recall that the company recently divested some of its wireline businesses to Frontier for approximately $10 billion. The transaction was announced in 2015 but closed on April 1, 2016.

 

The proceeds Verizon received from the sale are classified as an investing activity (“Proceeds from dispositions of businesses”) on Verizon’s 2016 statement of cash flows.

 

Verizon Dividend Safety

 

In other words, the proceeds from the sale did not affect Verizon’s free cash flow because they were not part of cash provided by operating activities or capital expenditures.

 

However, Verizon’s sale resulted in a large tax bill that the company had to pay. Accounting rules require this cash outflow to be classified as an operating activity, which does affect Verizon’s free cash flow.

 

Verizon’s cash taxes for 2016 included $3.2 billion of taxes related to its asset divestiture. Here’s what management said during the company’s fourth-quarter earnings call:

 

“In 2016, cash flows from operations totaled $22.7 billion, which is impacted by payments of cash income taxes of $3.2 billion associated with the gain on the divested wireline properties.”

 

These taxes won’t be repeated in 2017 and beyond, but they reduced Verizon’s reported net cash provided by operating activities (and thus its “as-reported” free cash flow) by $3.2 billion in 2016.

 

I think it makes more sense to think about these taxes as an “investing activity” because they are completely related to the asset sale, not Verizon’s ongoing business activity.

 

Therefore, I decided to move the $3.2 billion in cash taxes that Verizon paid out of operating activities and into investing activities, netting the taxes against the proceeds Verizon received from its divestiture.

 

You can see the adjustment below. Verizon’s total change in cash is the exact same, but net cash provided by operating activities increased by $3.2 billion to $25.9 billion, and cash used in investing activities decreased by $3.2 billion to -$14.2 billion.

 

The column on the far right shows the actual figures Verizon had to report under accounting rules.

 

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