More Dialing for Dividends at American Funds

The American funds have a penchant for dividends. Some funds, such as  American Funds Washington Mutual Investors (AWSHX), are more focused on dividends and deriving income from stocks than others, but, on the whole, American's managers, or counselors (as the firm calls them), like stocks that pay investors some income.

Recently, two of American's large dividend-paying holdings,  AT&T (T) and  Verizon Communications  (VZ), announced earnings for the first quarter of 2009. In this issue, we'll review the announcements and what they mean for American's positions in the stocks.

AT&T
First, AT&T's earnings per share fell to $0.53 from $0.57 from the first quarter of 2008, a decline of 7%. Total revenues fell slightly to $30.6 billion from $30.7 billion, including an increase in revenue from data (Internet service) to $6.3 billion from $6 billion and an increase from wireless to $11.6 billion from $10.6 billion. Overall, the slowing economy doesn't seem to have hurt the firm's sales very much. The push to bring data and video into homes and the popularity of  Apple's (AAPL) iPhone, which uses AT&T wireless service, are also clearly helping the firm. Indeed, the firm reported more than 1.6 million Apple iPhone 3G activations. Additionally, overall users of 3G wireless devices increased to 41% from 20%.

Moving to the balance sheet, we see that AT&T has $264 billion of assets against $167 billion in liabilities. The liabilities include $64 billion in long-term debt, which is up from $61 billion at the end of 2008, and $32 billion in postemployment benefit obligations. The firm can cover its interest payment ($849 million) by nearly 7 times with operating income, which is generally considered a very healthy margin, but its retirement obligations and deferred tax liabilities aren't insignificant.

AT&T's dividend appears safe for now. The firm generated $7.9 billion in cash flow from operations and spent $3.1 billion on long-term expenditures. The remaining $4.8 billion was enough to cover the $2.4 billion dividend payment.

Finally, Morningstar equity analyst Michael Hodel has awarded AT&T a narrow moat for the firm's scale, customer relationships, and network reach, and estimates the firm's fair value at $32 per share, which is 23% above its current $26 price. Because of increased competition from cable rivals, Hodel's discounted cash-flow model assumes lower revenues from fixed-line services and also lower margins overall than those the firm enjoyed in 2008. Hodel has also considered the drop in value of assets held to fund AT&T's postretirement obligations.

American's Stake in AT&T
Fund	% of assets in AT&T
Washington Mutual Investors (AWSHX)	4.6%
Investment Company of America (AIVSX)	3.2%
Income Fund of America (AMECX)	2.4%
American Balanced (ABALX)	1.7%
Capital Income Builder (CAIBX)	1.8%
American Funds' Total AT&T Ownership
Capital World Investors	3.0%
Capital Research Global Investors	3.2%

Thanks to telecommunications deregulation in the 1980s, AT&T is far from the monopoly that it used to be when it was called "Ma Bell." However, with the help of cable TV, Internet service, and the successful iPhone, for the time being the firm has retained its old characteristics of generating steady cash flow that can cover a plump dividend.

Verizon
Verizon, one of the original seven regional "baby bells" formed in the 1980s, has developed its business similarly to AT&T since deregulation, providing broadband into homes and businesses and competing successfully in wireless communications in addition to traditional wireline services.

The firm's quarterly numbers reflect somewhat stronger growth than what AT&T experienced, however, partly due to the recent acquisition of wireless provider Alltel. Total operating revenues for Verizon grew 12% for the quarter to around $15 billion, including the acquisition. Adjusted for the acquisition as if it had occurred at the start of 2008, revenues grew 3.3%.

Verizon managed to deliver earnings growth in a difficult environment. The firm posted earnings per share of $0.58, which was up 1.8% from the first quarter of 2008. Hodel mentions, however, that wireless growth is slowing across the industry, though Verizon remains the strongest player in that business, in his view. Although the firm added 1.3 million customers for the quarter, this was less than the 1.5 million new customers that the firm added in the first quarter of 2008 before the Alltel acquisition. On the positive side, as Hodel notes, Verizon has produced growth in its wireless business without dependence on a popular device such as the iPhone.

Verizon increased the long-term debt on its balance sheet to around $56 billion from around $47 billion. Assets also increased to $223 billion from $202 billion as a result of the Alltel purchase. Total liabilities stand at around $146 billion. The firm's equity/asset ratio is 28%, which means it's carrying more debt relative to its assets than AT&T, whose equity/asset ratio is around 37%. Still, Verizon generated $4.7 billion in operating income, which covers its $925 million interest payment handily. The firm also generated 2.7 billion in free cash flow, which covered its $1.3 billion dividend comfortably.

Finally, Hodel appraises Verizon's fair value at around $36 per share, based on his estimates of future free cash flow. The stock currently trades at around $30, clearly below his estimate, but not enough to put it in buy range given the margin of safety Hodel requires based on his medium uncertainty assessment and narrow-moat rating.

American's Stake in Verizon
Fund	% of assets in Verizon
Capital Income Builder (CAIBX)	2.6%
Washington Mutual Investors (AWSHX)	2.7%
Income Fund of America (AMECX)	2.6%
Investment Company of America (AIVSX)	1.8%
American Mutual (AMRMX)	1.6%
American Funds' Total Verizon Ownership
Capital World Investors	3.5%
Capital Research Global Investors	5.1%

Some of American's largest funds have significant positions in AT&T and Verizon. Regarding AT&T, Washington Mutual Investors has 4.8% of its assets in the stock, while  American Funds Investment Company of America (AIVSX) has 3.2% of its portfolio in the stock. Among the moderate-allocation and global-allocation funds,  American Funds Income Fund of America (AMECX) has 2.8% of its assets in the stock,  American Funds American Balanced (ABALX) 1.8%, and  American Funds Capital Income Builder (CAIBX) 1.8%. The stock is one of the top five holdings of all these funds. These funds, with the exception of Investment Company of America, are also Morningstar Analyst Picks.

Regarding Verizon, Capital Income Builder and Washington Mutual Investors both have 2.9% stakes in the stock. Income Fund of America has a 2.7% position, while Investment Company of America and American Mutual have 2.1% and 1.8% positions, respectively. The stock occupies a top-10 slot in each of these funds. Capital Income Builder, Washington Mutual Investors, and Income Fund of America are Morningstar Analyst Picks.

From an organizationwide perspective, American's two main investment units, Capital World Investors and Capital Research Global Investors, own 3.2% and 2.7%, respectively, or nearly 6%, of AT&T's outstanding stock. They also own 3.4% and 5.1%, respectively, or nearly 8.5%, of Verizon's outstanding stock. American has apparently made a bet on continued steady, if mildly decreasing, revenue from both firms' wireline business and some offsetting growth from the data and wireless businesses, all the while getting paid with a hefty 6% dividend yield (based on the current $30 and $25 share prices for AT&T and Verizon, respectively). Despite the giant telecoms' stock prices slightly underperforming the S&P 500 Index so far this year through May 6 (negative 3.4% for AT&T and negative 6.6% for Verizon stock versus a 2.8% positive return for the S&P 500 Index), it appears from the earnings reports that the thesis for owning these businesses remains intact.

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