Dial 'T' for Dividends

Income investors in search of high yields have a tendency to purchase high-risk securities. However, investors should remember that the highest dividend yields, such as those at 10% or above, are often a red flag.

Falling share prices cause a dividend yield to rise, which means a collapsing share price will result in excessively high yields. While extreme high-yielders are appealing on the surface, they can often be the result of a deterioration in the company's fundamentals (and its share price).

Investing in stocks with high yields can be dangerous, if the company cuts or suspends the dividend payout. To avoid these dividend traps, investors should understand a company's fundamentals to make sure that it can afford to maintain its dividend payout, especially in uncertain economic climates.

AT&T (T)  is a high-yield stock with a dividend above 7.5%, but more importantly, the dividend is highly secure. AT&T has a long history of increasing its dividend each year, and it continues to generate more than enough free cash flow to maintain the dividend, even in recessions.

Diversified Business Model

AT&T is a large telecommunications company providing a wide range of services, including wireless, broadband, and television through its cable operations and its DIRECTV satellite business. AT&T is the largest communications company in the world, operating in three distinct business units: AT&T Communications (providing mobile, broadband and video to 100 million U.S. consumers and 3 million businesses); WarnerMedia (including Turner, HBO, Warner Bros. and the Xandr advertising platform); and AT&T Latin America (offering pay-TV and wireless service to 11 countries).

In the 2020 third quarter, AT&T generated revenue of $42.3 billion, along with operating cash flow of $12.1 billion. Among the highlights, AT&T recorded more than 5 million total domestic wireless net adds along with over 1 million postpaid net additions. The company's postpaid churn was an impressive 0.69% for the quarter. AT&T still expects free cash flow of at least $26 billion for the full year. This will help the company continue to invest in growth, pay dividends to shareholders, and also pay down debt.

AT&T took on a great deal of debt to finance the Time Warner acquisition. The deal is considered to be a primary growth engine for AT&T, as it provides the company with multiple premier media properties including HBO and many more. The company's deleveraging process continued in the most recent quarter, as AT&T reduced its net debt by $2.9 billion from the previous quarter. AT&T's net debt-to-adjusted EBITDA ratio was 2.66x at the end of the third quarter.

AT&T's future growth will be aided by the company's competitive advantages. AT&T's primary competitive advantage is its scale. The U.S. telecom industry is dominated by three major players: AT&T, Verizon (VZ) , and T-Mobile (TMUS) . It is very difficult for a new telecom company to build a network with the necessary scale to compete with the established industry giants. This gives AT&T a wide economic moat and a durable competitive advantage.

During the last recession, AT&T posted annual earnings per share results of $2.76, $2.16, $2.12 and $2.29 for 2007 through 2010. The company remained highly profitable each year of the recession but experienced a minor dip in EPS in 2009. Even in the current recession, AT&T still generates positive free cash flow, as consumers are highly reluctant to cut out wireless or Internet service, even in a difficult economy. We expect AT&T to remain highly profitable in a recession, and continue to increase its dividend each year.

Dividend Analysis

AT&T currently pays a quarterly dividend of $0.52 per share, or $2.08 per share annualized. This represents a high yield of 7.7% right now. Even better, AT&T's dividend is highly secure, and the company increases its payout each year. Based on company forecasts for free cash flow in 2020, AT&T expects to have a payout ratio in the high 50% range. This indicates a highly secure dividend that is easily covered by free cash flow. It also means AT&T can continue to increase the dividend each year.

AT&T has raised its dividend for 36 years in a row. This qualifies it as a Dividend Aristocrat, an exclusive group of just 65 companies in the S&P 500 with at least 25 consecutive years of dividend increases. AT&T's dividend increases are not very aggressive -- the company typically hikes its dividend by around 2% per year. But this at least meets inflation, while simultaneously providing a very high yield that is significantly above the average S&P 500 yield of 1.7%.

Therefore, AT&T not only pays a very high level of income to shareholders in the near-term, it also raises its dividend annually to provide investors with growing income over the long run.

Final Thoughts

Investors need to tread carefully when it comes to high-yield stocks. Extremely high yields can vanish in an instant with a dividend cut or suspension. A dividend cut also usually results in a falling share price, meaning investors should try to avoid dividend cuts whenever possible.

For this reason, it makes a lot of sense for income investors to focus on dividend safety, and not just on the yield alone. AT&T is a good example of a stock that not only offers a high yield, currently at 7.7%, but its dividend is also sustainable, thanks to its high-quality business segments and strong free cash flow. This makes AT&T a highly attractive pick for income investors.

At the time of publication, Ciura had no positions in any securities mentioned.