Clearing the Air on Verizon’s Dividend Safety

A number of readers have emailed me in recent weeks wondering about Verizon’s (VZ) dividend safety.

 

Their anxiety developed after reading several articles online that suggested Verizon’s dividend was no longer sustainable because the company’s free cash flow did not cover it last year.

 

However, Verizon scores a 93 using our Dividend Safety Scores, indicating that its payout remains very secure.

 

I believe Verizon is one of the best high dividend stocks for current income, so I was interested to review what all of the fuss was about.

 

I will do my best to walk through Verizon’s financial statements (grab some coffee now to stay awake) and objectively review the company’s dividend safety.

 

Let’s start with a close look at the main argument against the safety of Verizon’s dividend – abysmal free cash flow coverage.

 

What is Free Cash Flow and Why Does It Matter?

Free cash flow is one of the most important financial metrics to understand for successful dividend investing.

 

Free cash flow represents the cash flow remaining after a company has made the investments necessary to maintain and grow its operations.

 

Free cash flow can be used to return capital to shareholders, acquire businesses, and repay debt.

 

Companies that consistently fail to generate free cash flow are unlikely to be able to pay sustainable dividends, repurchase shares, or have enough funds available for acquisitions or debt repayments.

 

Free cash flow is calculated using the company’s statement of cash flows.

 

According to Verizon’s non-GAAP reconciliations file, “free cash flow is calculated by subtracting capital expenditures from net cash provided by operating activities.”

 

Capital expenditures primarily consist of money spent on property, plant, and equipment to maintain and grow a business.

 

Cash provided by operating activities essentially adjusts net income for non-cash charges such as depreciation and accounts for changes in working capital accounts, such as inventory and accounts receivable (e.g. a company’s cash decreases if it buys inventory that hasn’t been sold yet).

 

Let’s take a look at Verizon’s cash flow.

 

Analyzing Verizon’s Free Cash Flow

Verizon reported $5.7 billion in free cash flow in 2016, which can easily be checked by subtracting its $17 billion in capital expenditures (circled in red below) from its $22.7 billion in net cash provided by operating activities (circled in green below).

 

 

You can see that Verizon’s annual report pulls out those two figures in the table it uses to display free cash flow:

 

 

Many dividend investors pay close attention to a company’s free cash flow to see how well a dividend payment is covered.

 

The company’s $5.7 billion in free cash flow last year did not come close to covering the $9.3 billion in dividend payments that Verizon made.

 

Even scarier, you can see that Verizon’s free cash flow per share dropped significantly in 2016 to reach $1.38, well short of the $2.285 per share paid in dividends.

 

 

As a result, Verizon’s free cash flow payout ratio spiked well above 100% in 2016. The company’s payout ratio had never exceeded 70% going all the way back to 2005, so this change really stands out.

 

 

Before running for the hills and assuming that Verizon’s dividend is doomed, a much closer look at the company’s full statement of cash flows is warranted.

 

Certain accounting issues can be quite hairy at times, potentially distorting the reality of an investment situation.

 

I believe that is the case with Verizon’s 2016 financials and its dividend safety.

 

Why Verizon’s “As-Reported” Free Cash Flow Is More Than It Appears

Remember how free cash flow is calculated by subtracting a company’s capital expenditures from its net cash provided by operating activities?

 

That means a change in free cash flow from one year to the next has to be driven by a change in one of those variables.

 

Upon closer inspection, we can see that Verizon’s capital expenditures were lower by $716 million in 2016 compared to 2015, but its net cash provided by operating activities decreased by more than $16 billion in 2016.

 

 

Why the big drop in operating cash flow?

 

If the decrease was due to accounting noise and/or one-time events, Verizon’s true cash flow (adjusting out the noise) could have reasonably covered its dividend despite the headline free cash flow number.

 

I believe Verizon’s true operational cash flow in 2016 is being misunderstood when a mechanical free cash flow formula is applied for two primary reasons.

 

Free Cash Flow Adjustment #1: Cash Taxes Paid from an Asset Sale

Verizon investors might recall that the company recently divested some of its wireline businesses to Frontier for approximately $10 billion. The transaction was announced in 2015 but closed on April 1, 2016.

 

The proceeds Verizon received from the sale are classified as an investing activity (“Proceeds from dispositions of businesses”) on Verizon’s 2016 statement of cash flows.

 

 

In other words, the proceeds from the sale did not affect Verizon’s free cash flow because they were not part of cash provided by operating activities or capital expenditures.

 

However, Verizon’s sale resulted in a large tax bill that the company had to pay. Accounting rules require this cash outflow to be classified as an operating activity, which does affect Verizon’s free cash flow.

 

Verizon’s cash taxes for 2016 included $3.2 billion of taxes related to its asset divestiture. Here’s what management said during the company’s fourth-quarter earnings call:

 

“In 2016, cash flows from operations totaled $22.7 billion, which is impacted by payments of cash income taxes of $3.2 billion associated with the gain on the divested wireline properties.”

 

These taxes won’t be repeated in 2017 and beyond, but they reduced Verizon’s reported net cash provided by operating activities (and thus its “as-reported” free cash flow) by $3.2 billion in 2016.

 

I think it makes more sense to think about these taxes as an “investing activity” because they are completely related to the asset sale, not Verizon’s ongoing business activity.

 

Therefore, I decided to move the $3.2 billion in cash taxes that Verizon paid out of operating activities and into investing activities, netting the taxes against the proceeds Verizon received from its divestiture.

 

You can see the adjustment below. Verizon’s total change in cash is the exact same, but net cash provided by operating activities increased by $3.2 billion to $25.9 billion, and cash used in investing activities decreased by $3.2 billion to -$14.2 billion.

 

The column on the far right shows the actual figures Verizon had to report under accounting rules.

 

The middle column shows the adjustment I made to reclassify the company’s cash taxes related to the asset sale to better reflect Verizon’s ongoing operational cash flow.

 

 

As a result, Verizon’s free cash flow increases to $8.8 billion ($25.9 billion in cash from operations less $17.1 billion in capital expenditures) from its as-reported figure of $5.7 billion.

 

However, $8.8 billion in free cash flow is still not enough to cover the $9.3 billion in dividends paid last year.

 

Free Cash Flow Adjustment #2: Monetizing Payment Plan Receivables

The other primary issue weighing down Verizon’s 2016 “as-reported” free cash flow is a change the company made with monetizing its mobile device sales.

 

Until recently, wireless carriers typically subsidized the price of new phones for customers who signed a service contract.

 

With major carriers largely eliminating subsidized phone plans, monthly service prices are now lower but customers must pay for the full price of a new mobile device.

 

Rather than pay hundreds of dollars upfront, buyers usually pay for their new devices in installments over the course of 24 months.

 

Verizon will still receive cash from new device sales – just not all of it immediately.

 

As a result, when Verizon records a new device sale on a payment plan, it records an increase in accounts receivable (i.e. cash owed from that customer but not yet received).

 

You can see that the company’s receivables balance from device payment plan agreements jumped significantly in 2016, increasing from $3.1 billion to $10.6 billion.

 

 

Without diving deeper into accounting mumbo-jumbo, an increase in accounts receivable reduces net cash provided by operating activities, which is used to calculate free cash flow.

 

You can see that the increase in Verizon’s accounts receivable reduced the company’s net cash provided by operating activities (and thus its reported free cash flow) by about $5 billion in 2016:

 

 

But should any adjustment really be made to the $5 billion hit Verizon’s free cash flow took from the increase in accounts receivable?

 

After all, the cash flow decrease makes sense since Verizon isn’t getting the cash from customers upfront.

 

In most cases, I would agree with that sentiment.

 

However, Verizon has found a new way to monetize this future income stream it is owed in order to free up cash today.

 

In the past, Verizon would sell its device payment plan receivables to a group of banks, and those receivables were no longer considered assets of Verizon.

 

In fact, Verizon received $7.2 billion of cash proceeds related to new sales of wireless device payment plan agreement receivables in 2015.

 

Cash received from these receivable sales were counted in Verizon’s “Net cash provided by operating activities,” increasing free cash flow.

 

Last year, however, Verizon began to securitize its receivables from payment contracts.

 

Instead of selling its receivables to banks, which removes the receivables from the company’s balance sheet and increases free cash flow, Verizon began issuing a new type of debt security that is backed by claims against the company’s device payment plans, which are still held on Verizon’s balance sheet rather than transferred to a buyer (e.g. banks).

 

“The monthly payments people make on their phones would be used to pay interest and principal to buyers of the securities, most of which are expected to be rated triple-A by Fitch Ratings,” according to The Wall Street Journal.

 

You can see below that Verizon raised approximately $5 billion in debt by securitizing its receivable assets, immediately increasing its cash on hand while it waits for customer payments to come in.

 

 

This financing activity resulted in lower cash flow from operations (reducing free cash flow) because Verizon still owned the payment plan receivables on its balance sheet unlike in 2015 (remember that an increase in receivables reduces reported cash flow).

 

However, the financing decision does not really affect Verizon’s dividend safety. In fact, securitizing its receivables could actually be a positive for the company’s dividend safety.

 

A Bloomberg article stated that “regular issuance of the securities could also help Verizon elevate its corporate debt rating to A-…S&P currently has a BBB+ rating on the company.”

 

Here is what Verizon stated about the impact its securitizations had on operating cash flow (page 26 of its 2016 annual report):

 

“During 2016, we changed the method in which we monetize device payment plan receivables from sales of device payment plan receivables to asset-backed securitizations. While proceeds from sales of device payment plan receivables were reflected in our cash flows from operating activities in our consolidated statements of cash flows, proceeds from asset-backed securitizations are reflected in cash flows from financing activities. This change will result in lower cash flow from operations, but will not reduce the cash we have available to run the business.”

 

Verizon clearly states that this financing decision has no impact on the cash it has to run its business (and pay dividends).

 

It simply reflects the company’s move to issue asset-backed debt rather than sell its receivables to banks.

 

As long as Verizon continues to monetize the accounts receivable it generates from mobile device payment plans through securitization (which it started doing in 2016) rather than selling their receivables to banks (which it did previously), Verizon’s “as-reported” free cash flow will continue to appear low relative to past years.

 

While the cash Verizon gets is practically the same, issuing securitized debt is a financing activity that keeps receivables on the balance sheet and therefore reduces as-reported free cash flow, while selling receivables to banks takes receivables off the balance sheet and increases free cash flow.

 

Verizon could easily decide to go back to straight up selling receivables to banks if it wanted to, but issuing asset-backed debt is a more attractive financing option for them.

 

The key is to realize that the net change in cash from the different approaches Verizon takes to monetizing its accounts receivable is really no different, but each path is required to be classified a different way and can affect the mechanical calculation of “as-reported” free cash flow.

 

Therefore, if we are trying to get a sense of Verizon’s true free cash flow available to pay its dividend, I think it makes sense to move the $5 billion in proceeds received from asset-backed borrowings to its cash flow from operations for analytical purposes.

 

This adjustment (along with the cash taxes) can be seen in the yellow cells below. The dollar value of both adjustments cancel out, so the net change in Verizon’s cash for the year is unchanged (i.e. I am not double counting anything).

 

 

After making the adjustments above for cash taxes and the debt securitization, Verizon’s adjusted net cash provided by operating activities stands at $30.9 billion, which is meaningfully higher than the $22.7 billion it had to report under the current accounting rules.

 

Subtracting the company’s $17.1 billion in capital expenditures yields a total “adjusted” free cash flow amount of $13.8 billion.

 

I believe this figure is more relevant for income investors because it more realistically represents the cash flow Verizon has that it can return to shareholders.

 

Using Verizon’s 2016 dividend payments of $9.3 billion, the company’s adjusted free cash flow ratio for 2016 stands at a more reasonable 67% ($9.3 billion in dividends divided by $13.8 billion in adjusted free cash flow).

 

However, some will argue that Verizon’s overall cash still decreased by $1.6 billion in 2016, regardless of where you classify its cash taxes and securitized debt transactions.

 

And that decrease even includes $6.7 billion in cash proceeds (net of taxes) that Verizon received from its asset sale!

 

Once again, the devil is in the details because there are a lot of noisy parts to a cash flow statement.

 

While it’s true that Verizon received $6.7 billion from its asset sale, the company also chose to reduce its unsecured debt by more than $6 billion, incur early debt redemption costs of $1.8 billion, and spend $3.8 billion on acquisitions, among other unique items in 2016 that dropped the overall change in cash.

 

Simply put, these cash flow changes are driven by management’s capital allocation decisions any given year and do not reflect the steady operational free cash flow that Verizon’s ongoing business generates.

 

Verizon’s adjusted free cash flow continues to cover the dividend while leaving several billion dollars available that the company can use to continue paying down unsecured debt, and its investment-grade credit rating should continue to provide it with access to capital markets.

 

You can see that Verizon’s long-term debt maturity schedule (as of 12/31/16) over the next several years looks reasonably manageable, especially given the $8.9 billion in unused borrowing capacity available from Verizon’s $9.0 billion credit facility.

 

This credit facility is good through September 2020 and does not require Verizon to comply with financial covenants or maintain specified credit ratings (it even permits Verizon to borrow if its business has incurred a material adverse change):

 

 

While Verizon certainly does face growth challenges and have a high debt load to manage (the company remains on track to return to its pre-Vodafone credit rating profile by 2018-19), I don’t believe it makes sense to claim that the company is in trouble.

 

There are simply many moving parts that can affect a company’s overall change in cash any single year, so I prefer to stay focused on operational free cash flow.

 

As long as Verizon continues generating stable free cash flow and improving its balance sheet like it plans to, the company’s outlook should remain stable for the foreseeable future.

 

Longer-term (i.e. 5+ years), the telecom industry’s economics could look quite different as the world continuously evolves, perhaps altering the attractiveness of investing in telecom stocks for income if their earnings power deteriorates and their debt loads remain heavy.

 

Closing Thoughts on Verizon’s Dividend Safety

Barring a decision to make a major acquisition that could further strain the balance sheet (and require a new dividend safety analysis), I believe Verizon’s dividend remains safe based on the information we have available today.

 

A couple of unique accounting items caused most of the variation in Verizon’s free cash flow in 2016.

 

Articles claiming that Verizon will have to cut its dividend because of its lack of free cash flow appear to be misguided, in my opinion.

 

Such articles make for attention-grabbing headlines that generate clicks and page views, but their arguments lack substance.

 

Verizon increased its dividend for the 10^th consecutive year in 2016, and I expect its dividend growth streak to continue this year.

 

While it’s true that Verizon’s wireless and wireline revenues declined by 2-3% in 2016 (excluding divestitures), price competition remains fierce in the wireless industry, and finding meaningful growth opportunities is challenging, the company is not in any imminent danger.

 

In fact, analysts project Verizon’s earnings to be about flat in 2017 with low single-digit annual growth thereafter.

 

I plan to continue holding Verizon in our Conservative Retirees dividend portfolio, and I admire your tenacity if you made it to the end of this grueling accounting lesson!