In December of 2017, CenturyLink (NYSE: CTL) received an “F” for dividend safety. At the time, it paid out more in dividends than it generated in free cash flow.
However, I mentioned that its acquisition of Level 3 Communications was expected to increase cash flow, which could result in an upgrade.
CenturyLink more than hit those expectations.
Through the first three quarters of 2018, the telecommunications company generated $2.8 billion and has guided Wall Street to expect at least $4 billion in free cash flow for the full year.
Wall Street analysts actually predict even better results: The consensus estimate is $4.3 billion.
If these analysts are right, that gives the company a payout ratio of just 54%, well within my comfort zone.
As a general rule, I like to see stocks that pay out 75% or less of their free cash flow in dividends. That way, if cash flow slips, the dividend is not in jeopardy.
CenturyLink is a perfect example. While free cash flow should spike in 2018, it’s expected to decline to $3.45 billion in 2019. However, if the company continues to pay out $2.33 billion in dividends, free cash flow still easily covers the payout to shareholders.
Should free cash flow fall again in 2020, we could be entering dangerous territory where the dividend would be in jeopardy. For now, it has a moderate risk of being cut, which is much better than the “F” rating and imminent danger it faced in late 2017.
The reason the risk is still moderate, even though the dividend is easily covered by cash flow, is that cash flow is forecast to drop in 2019. Falling free cash flow is always a concern.
A one-year dip isn’t an immediate problem, but it is an early warning sign, so CenturyLink’s dividend safety rating will drop at least one notch on expected lower cash flow.
CenturyLink also gets penalized for a dividend cut in 2013. While reducing a dividend is sometimes necessary, once a company lowers its dividend, it is more likely to do so again.
A company that has never cut its dividend usually tries very hard to keep that track record intact.
So a lowered dividend is often a harbinger of future cuts.
As predicted in December 2017, CenturyLink did receive an upgrade.
The next rating will depend on whether free cash flow in 2019 is still comfortably above the amount paid in dividends, as well as the forecast for 2020.
For now, investors collecting the 14% yield can breathe a little easier.
Dividend Safety Rating: C
Source: Wealthy Retirement