According to This Critical Number, AT&T's 4%-Yielding Dividend is Now on Rock-Solid Ground

There have been a lot of questions surrounding AT&T's (NYSE: T) dividend in recent years. The telecom giant already cut its payout by nearly 50% in 2022 to retain additional cash for debt reduction and to reinvest in expanding its fiber and 5G networks. Despite that cut, its leverage ratio remained elevated, causing concerns that another cut could be forthcoming.

Those worries should disappear now that AT&T has finally reached its target leverage ratio. It has the flexibility to start returning more cash to investors, which it initially plans to do by repurchasing shares. That also means the company's more than 4%-yielding dividend is on rock-solid ground.

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Reaching the target range

AT&T has been following a well-defined capital allocation strategy. The telecom company has been using its strong cash flow to invest heavily in growing its 5G and fiber networks while also maintaining its attractive dividend. It has been using any remaining excess free cash flow to repay debt, aiming to get its leverage ratio down to the 2.5 range.

While it took a few years, AT&T has finally reached its leverage target. The company produced $3.1 billion in free cash flow during the first quarter, more than covering its $2.1 billion dividend outlay. That provided it with excess free cash flow to continue whittling down its debt. As a result, its leverage ratio was a little more than 2.6 at the end of the first quarter, down from more than 2.9 in the year-ago period, as it has delivered a $9.6 billion reduction in its net debt over the past year.

The company noted that leverage has continued to fall in the early part of the second quarter and is now at its target. AT&T now expects to begin returning more cash to shareholders by starting to repurchase shares. The company plans to buy back as much as $20 billion of its stock over the next several years.

The dividend will only grow safer

AT&T expects to generate at least $16 billion in free cash flow this year. That will easily cover its dividend outlay, which is currently over $8 billion per year. Meanwhile, the company expects its free cash flow to grow by about $1 billion per year in 2026 and 2027, putting it on track to generate over $18 billion in annual free cash flow by 2027.

That growing free cash flow will steadily reduce the company's dividend payout ratio. Meanwhile, unless it starts increasing the dividend, which isn't currently in the plans, its actual cash payments will fall as the company starts repurchasing shares. That's because its outstanding shares will decline, meaning it will need less cash to fund its current per-share payment. As a result, the company anticipates its dividend outlay will be around $20 billion over the next three years.

Finally, with its leverage target achieved, AT&T will have additional borrowing capacity over the next few years while maintaining its current leverage ratio. When added to its free cash flow, the company estimates it will have over $50 billion of financial capacity it can deploy over the next three years. With $20 billion of anticipated dividend payments and another $20 billion of share repurchases expected, it will have about $10 billion of additional financial flexibility. The company could hold on to that flexibility by allowing its leverage ratio to fall below its target. It could also use it to opportunistically buy back more stock or to make an accretive acquisition that grows its cash flow. Any of those options would further enhance the sustainability of its dividend in the coming years.

A very bankable dividend

AT&T's capital allocation strategy has worked as expected. The telecom giant has now reached its leverage target, which positions it to start returning more cash to investors by repurchasing shares, putting the company's 4%-yielding dividend on an extremely safe foundation. That makes it a rock-solid option for those seeking a bond-like income stream from a high-quality company.

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Matt DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.