Key Points

  • AT&T’s high dividend yield makes it a favorite among income investors.
  • The company is not shouting it, but a dividend cut is likely coming.
  • And this will likely be a good thing for investors in the long run.

This isn’t clickbait: U.S. telecom giant and beloved dividend stock AT&T (NYSE:T) will very likely cut its dividend in 2022. Management hasn’t shouted it from the mountaintops, but the evidence is right in front of us if we look closely enough.

Nonetheless, dividend investors need not panic. The cut doesn’t mean the business is in trouble, and AT&T’s payout will still provide a solid passive income. So what’s the deal? Here is what investors need to know about the state of its dividend.

The cut is in the details

AT&T has a pending deal to spin off WarnerMedia, AT&T’s streaming and entertainment assets, and merge them with Discovery to form a stand-alone, new streaming company. AT&T shareholders will receive 71% of the shares of this new business, and shareholders of Discovery (also the proposed name of the new company) will receive the other 29%.

The deal does two things for AT&T: It gets the company entirely out of the entertainment business after having already sold off DirecTV over the summer, and it will receive $43 billion in debt relief, helping its balance sheet.

But what investors could be missing is that AT&T has quietly restated its dividend policy amid all the excitement. Management is projecting that the business will generate $20 billion or more in free cash flow following the spinoff; it could do more, but $20 billion is the baseline number that has been announced.

It also stated that the company’s dividend payout ratio will be 40% to 43% of anticipated free cash flow. In other words, the company will dole out $8 billion for dividends.

In the chart above, we can see that AT&T is paying almost double that for its current dividend, which means that a significant cut will be coming to make the math behind the new payout ratio make sense.

What will the new dividend look like?

AT&T currently pays a quarterly dividend, which adds up to an annual total of $2.08, a 7.7% dividend yield. It’s hard to know what the share price will look like following the merger because nobody knows whether a stock can go up or down in the short term. However, the amount per share will be somewhere near $1, which is a 3.7% yield on today’s share price.

This isn’t nearly as high as 7.7%, so it’s understandable if this sours some income-focused investors on the stock. It’s important to know that the cut isn’t because the company is in financial trouble. The current payout is relatively safe because of AT&T’s strong 58% dividend payout ratio.

Why this is potentially a good thing

So why the cut then? AT&T seems very focused on paying down the massive debt load on its balance sheet from its $67 billion acquisition of DirecTV in 2015 and its $85 billion acquisition of Time Warner in 2018.

Management has outlined a goal of reducing the company’s leverage to below a 2.5 ratio of net debt (total debt minus cash on hand) to EBITDA (earnings before interest, taxes, deprecation, and amortization) by the end of 2023. Freeing up more cash by using less on the dividend should help accomplish this.

At that point, the company will be paying less interest on its debt (interest expenses reduce net income), and that might empower management to begin buying back shares, or grow the dividend more aggressively. These are things that shareholders can get excited about.

AT&T has become a “zombie” stock, down 10% over the past 10 years on a share-price basis. However, it’s making the necessary moves to focus on its main telecom business and get out of the financial mess that its entertainment dreams got it into. But as they say, “No pain, no gain,” so get ready for that dividend cut when AT&T’s spinoff happens.

— Justin Pope

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Source: The Motley Fool