AT&T (NYSE: T) is a fascinating case to look at when it comes to dividend safety.

The company is a Dividend Aristocrat, which is an elite status revered by dividend investors. To be an Aristocrat, a company must be a member of the S&P 500 and have raised its dividend for at least 25 years in a row.

AT&T has done so for 36 years.

It generates plenty of cash flow – more than enough to pay the dividend. Yet cash flow is declining.

AT&T’s free cash flow slipped in 2020 and is expected to do so again in 2021.

Dividends are paid out of cash flow because cash flow represents actual cash coming into the company. Contrary to popular belief, dividends are not paid out of earnings, which has all kinds of noncash items in its formula.

You can’t pay dividends with money “earned” because of depreciation, which is a non-cash item.

So when it comes to dividends, cash flow is king. And SafetyNet Pro does not want to see declining free cash flow.

In 2019, AT&T generated $29 billion in free cash flow. That fell to $27.4 billion last year and is forecast to dip to $26 billion this year.

No bueno.

Here’s where it gets interesting. In 2020, the company paid out 54% of its free cash flow in dividends. This year, it is projected to pay out 57%. That percentage is called the payout ratio.

Prior to the pandemic, my threshold for what represented a healthy payout ratio was 75%. In other words, if a company paid less than 75% of its free cash flow in dividends, that was a positive sign it could withstand a drop in cash flow without cutting the dividend.

If the payout ratio was above 75%, the dividend safety rating was lowered.

When the pandemic hit and the economy went on the skids, I lowered that limit to 50%, as companies were forced to conserve cash.

I am in the process of changing the threshold back to 75% as the economy starts to open up again. But it hasn’t happened yet. That change should take place in the next week or so.

With the current 50% limit, AT&T’s dividend would be considered dicey. Free cash flow is falling, and the payout ratio is too high.

Once that 50% boundary is lifted back to 75%, the dividend will look fairly secure, as the payout ratio is well below 75%.

Additionally, on its fourth-quarter conference call, management said it is committed to sustaining the dividend. That is not a guarantee and is not factored into SafetyNet Pro‘s ratings, but it is a positive factor nonetheless.

When the payout ratio limit changes shortly, AT&T will receive an upgrade to “B.” But at this exact moment, its low rating is a bit misleading.

Dividend Safety Rating: D