Should I Invest In AT&T And Verizon For High Dividend Income?

Most readers are probably aware that it has been getting more difficult to find decent values in the current environment. When I ran my screens for valuation, I stumbled upon AT&T (T) and Verizon (VZ), which are telecom behemoths in the US.

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Verizon earnings
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AT&T (T) has increased dividends for 33 years in a row. In the past decade, it has managed to increase dividends by 3.70%/year. Between 1984 and 2016, the company has managed to increase dividends by 4.40%/year. The stock trades at 12.70 times forward earnings and yields 5.30%. The dividend is adequately covered with a dividend payout ratio of 67.60%, based on forward earnings. Check my previous analysis of AT&T for more information about the company.

Verizon (VZ) has increased dividends for 12 years in a row. In the past decade, dividends grew by 3.40%/year. Between 1984 and 2017, the company has managed to increase dividends by 3.30%/year. The stock trades at 11.60 times forward earnings and yields 5.30%. The dividend is adequately covered with a dividend payout ratio of 61.70%, based on forward earnings. Check my analysis of Verizon for more information about the company.

The telecom industry in the US is very competitive. Companies like AT&T (T) compete with the likes of Verizon (VZ), Sprint and T-Mobile. In the past, almost all of the profits have been made by Verizon (VZ) and AT&T, at the expense of smaller competitors. An investment in AT&T and Verizon today would presume that the status quo would remain unchallenged, and that Sprint and T-Mobile would be kept weak forever. The service that telecom companies is essentially a commodity. Telecom companies are not utilities, because there is the possibility for switching the provider. Try moving to Saint Louis, Missouri, and then switching your gas, water or electric utility – you can’t. But anywhere in the US, you can switch to another wireless carrier, plus you have other alternatives and very low customer loyalty. There is nothing to stop a customer from switching to another carrier after their contract expires.

It also takes an enormous amount of capital to maintain and continuously upgrade a network that would cover 300 million people in dispersed area such as the US. Long gone are the days when telecom only meant providing voice calls between users in different locations. Now there are technologies such as 3G, 4G, LTE that require constant costly investment to upgrade network. Barriers to entry are steep of course, since it takes tens of billions of dollars to build a network. However, the main competitive advantages available to Verizon and AT&T are those of scale.

There is a risk of technological obsolescence, since new technologies are requiring that telecom companies engage in multi-billion dollars upgrades, merely to keep up with competitors. In addition, there are new technologies which could leverage existing network infrastructure but could be directly competing with telecom companies. For example, 20 – 30 years ago, the price of a long-distance call between New York and San Francisco would have been quite expensive. Today, I can call anyone in the world using Viber or WhatsApp for free, using wi-fi from a device that is connected to the internet.

Currently both AT&T and Verizon have the advantages of scale, which allows them to spread costs of upgrading and maintaining their network over larger pools of customers. This has allowed them to earn hefty profits, and pay the high dividends to shareholders. For example, if you want to advertise your service, it is much easier to outspend your competitor in advertising by spending twice as much as them when you have three to four times as much customers. On a per customer basis however, this advertising is still going to be cheaper.

Another advantage is the fact that in the traditional telecom model, it would be very difficult for someone to set up a new wireless network. This would take tens of billions of dollars to get the network equipment on tens of thousands of cell towers across the US, plus get valuable spectrum rights. Today however, it is quite possible that competing technology platforms might end up destroying some value at the traditional telecom companies. In addition, we do not know if the future doesn’t hold another technological breakthrough, which could replace the cellphone the same way the your landline has become obsolete.

For both AT&T and Verizon, the dividend has not had a very good coverage out of earnings. I always require that there be a margin of safety in dividends when I analyze a dividend paying company. There is a higher than average risk that the dividend be cut sometime in the next decade, given the competitive pressures, high payout ratios, constant requirement for new capital to invest, and commoditized type of service. If you add in the competitive pressures to the high payout ratio, one could see why I have not been excited about AT&T and Verizon as dividend growth stocks. The best probable scenario that I could see for AT&T and Verizon  income shareholders is that their dividend keeps up with the rate of inflation. Even during the past 25 years, the best that AT&T and Verizon could do was grow dividends by 3% - 4%/year. These companies will not make you rich overnight. However, they could be decent holdings for someone who needs high current income for the next decade, and is fine that this income maintains its purchasing power over time.

An investor in a high yielding company company like AT&T could reinvest their dividends and grow dividends by the 5% dividend yield and the 1-2% organic dividend growth. This means that a holder of AT&T shares worth $30K will receive approximately $1,500 in annual dividend income, which would be then used to purchase 5% more shares. In the next year, the dividend will increase by 2% and the investor will earn the higher dividend on the increased amount of shares. If you rinse and repeat this exercise for 18 - 20 years, it is highly likely that the investor will be earning $6,000 in annual dividend income from this position. This is due to the power of reinvesting high dividends into more shares of a high dividend yielding stock that has some dividend growth. If I stop reinvesting dividends however, I income will only keep up purchasing power to inflation at best. The risk is also that a high dividend yield is due to a high payout ratio. If the business faces strong headwinds, this increases risk that dividend is cut if times get rough. Using history as a guide, major acquisitions with lots of debt have usually sapped a company's ability to maintain dividends. This is what you need to be on the lookout for, when holding AT&T and Verizon. The other side of the coin however is that both companies have historically managed to pull off mergers and acquisitions successfully. Therefore, it is also possible that the next big acquisition works out pretty well, and defies the odds.

The opportunity cost of investing in an AT&T is a company like Johnson & Johnson (JNJ), which yield around 2.50% today, but grow dividends at 6% - 7%/year. Of course the 6% - 7% figure is very conservative and at the low range of my projections for those companies. In 18 years, I will be earning over $3,000 in annual dividend income, if I reinvest those growing dividends. In addition, once I stop reinvesting dividends and live off them, the dividend growth will protect purchasing power of income from inflation. To top it off, the portfolio would also have much higher appreciation potential relative to the AT&T centric portfolio. The drawback is that forecasting dividend growth over an 18 year period is tough, since no one knows what the world will look like in 2035.

In the matter of full disclosure, I do have a tiny position in Verizon, as a result of my investment in Vodafone (VOD) last year, which distributed those shares after selling their Verizon Wireless stake to Verizon. I think that Verizon owning 100% of Verizon Wireless is a good thing for the company, and could end up being accretive for long-term holders. I would probably hold this, since this tiny position is spread out in several tax-deferred accounts. At least I am able to reinvest those distributions automatically. Other than that, I am not planning on adding any money to either AT&T or Verizon, since I believe there are better uses for my capital. I usually invest for the next 30 years, which is why companies that have poor growth prospects are usually at the bottom of my list for purchase.

Full Disclosure: Long VZ and VOD

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