AT&T stock can provide bond-like income for retirees. Here's how.
It's been a tough stretch for retirees in this age of low yields, where bonds and savings accounts pay almost no interest. Dividend stocks have been a natural alternative, often offering the highest yields, but are riskier, which can be troubling for investors who want to generate income without the risk of losing their money.
Telecom company AT&T (NYSE: T) stands out as a stock that can check many boxes for retirees. While no stock is risk-free and AT&T happens to be down 25% over the past year, I think that AT&T represents a solid option for income-craving retirees right now.
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A very stable business model
Just about anyone with a cellphone in the United States knows what AT&T is and what the company does. It's one of three major U.S. wireless networks, along with Verizon and T-Mobile.
Today more than ever, wireless communications are almost as crucial to households as electricity and water. About 97% of Americans own a cellphone and often use it to replace landlines or connect to the internet where wired internet service is hard to come by.
The phone bill ranks high in terms of important in most consumers' monthly budgets, so AT&T's business has proven very stable over the years. People tend to pay their phone bills through all economic conditions, during good times and bad.
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People lost homes they couldn't afford during the financial crisis in 2008-2009, one of the worst economic crises since the Great Depression. Still, AT&T saw virtually no drop-off in its business. This kind of sales stability is a welcome sign for retirees.
The dividend is remarkable
A 10-year bond from the U.S. government pays just about 1.5%, while inflation in the U.S. hit 6% this year. Fortunately, AT&T's dividend yield is a whopping 9%, enough to outpace even the high inflation we have seen this year.
A common rule of thumb is that very high dividend yields can be a red flag for investors – a sign that investors are not confident in a company, so they sell its stock, which increases the dividend yield. We want to focus on whether AT&T can afford this payout using the money that its business generates instead of borrowing to pay the dividend.
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AT&T has steadily grown its free cash flow over the past decade and that the dividend payout ratio remains manageable at 58%. In other words, AT&T is spending 58% of its cash flow on the dividend, and its business would need to dramatically decline for it not to afford that payment.
But we've already seen how durable AT&T's business is, so it's probably fair to say that this isn't likely. Instead, the company has raised its dividend for the past 36 years in a row, making it a Dividend Aristocrat.
It's important to note that AT&T has a pending deal to spin off its entertainment assets as a new company. The deal will result in a lower payout, so AT&T's dividend yield will probably not remain at 9% once the spin-off closes. We'll revisit this in a moment.
Why AT&T is down so much
AT&T has had a rough year, down 25% over the past 12 months. One potential reason for this is the company's debt-heavy balance sheet. AT&T's made two massive mergers, DirecTV for $48.5 billion in 2015 and Time Warner for another $85.4 billion in 2018.
These deals left AT&T with a colossal mountain of long-term debt, totaling $155 billion today. All of this debt creates interest expense, and with the potential for rising rates, the market could be afraid that AT&T's debt will continue to cost more in interest payments.
Addressing the issue
AT&T has admitted the failure of its entertainment business; it sold DirecTV over the summer for less than it paid for it. The rest of its entertainment business, mainly the media assets like HBO and Warner Bros, is being spun off to form a new company in a deal with Discovery.
The benefit of this deal for AT&T shareholders (aside from receiving shares of the new media company) is that the company will be unloading $43 billion in debt when the deal closes. A little more than a quarter of AT&T's total debt load, it will go a long way in freeing up more financial breathing room.
Management is projecting that as it continues to pay down debt, the company should hit its long-term debt target in about 24 months. This includes reducing the dividend payout ratio, another way of saying they will cut back the dividend to free up more cash for paying down debt. But with such a sizable existing yield, investors should still receive a generous dividend from what will be an even more financially sound company.
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Justin Pope has no position in any of the stocks mentioned. The Motley Fool recommends Discovery (C shares), T-Mobile US, and Verizon Communications. The Motley Fool has a disclosure policy.
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