TBC - AT&T's Dividend During Market Chaos

2023-06-26 15:05:24 ET

Summary

• We have been guiding our membership to rotate out of growth and tech and into more defensive and income-generating names.
• We are projecting a market selloff, and in the chaos, we want to own and trade around core positions in dividend-paying names.
• AT&T Inc.'s Q1 free cash flow failed miserably to cover the dividend.
• The debt is the biggest risk to the AT&T dividend, but 2023 cash flow is now accelerating.
• Expect lower leverage.

In the last month or so, with the market scraping to one-year highs in the face of so many macro headwinds, our firm as well as our investing group has shifted a bit from finding growth and momentum, to focusing more on defensive names and income generation. Right now, with markets where they are, we believe this is a prudent idea in the next few months. Of course long-term, we guide on how your trading shorter-term should generate income to feed a long-term dividend growth type portfolio. In short, we like to trade to generate funds to invest. But right now, we are pretty defensive.

As we have previously guided to our membership, we expected 4200 on the S&P 500 (SP500) to be a battleground, but when surpassed it would be a straight shot to 4350, maybe a touch higher. But from there, we expected a selloff. Last week we then had our first down week in 6 weeks, and we had 3 consecutive red days for the first time in two months.

With that said, we are moving toward trading income names to pick up stable stocks, that will pay a high yield, and also allow us to further generate income by selling covered calls. One name that we recently started to leg back into was AT&T Inc. ( T ). We laid out a sample trade here for the public, that we think you should review. While this trade was at higher levels and with less structure than what we provided for the investing group, the point was that sub $16 we were turning more bullish after being bearish. Previously we had warned investors , and in a controversial but since the correct call, told you to dump AT&T stock at $20 and buy back in the mid-teens. Well, that play is what we forecast, and it is what we are running.

Now with that said, we see both value and income potential for AT&T. But recently, when you look at the many columns covering AT&T on Seeking Alpha, you will note a number of them have called into question the dividend. Still others have never lifted their buy ratings, preventing outsized returns by simply buying low and selling high.

When executed remotely effectively, traders and investors can significantly increase their returns by trading around a core position. This is a key tenet to our investing philosophy. In this column we discuss the possibility of a dividend cut, and what it could mean. In short, a cut would crush our newfound bullish investing thesis here, but we do not see that in the cards given the cash flow outlook.

AT&T's dividend

We have liked buying the new AT&T in the $15-$16 range, generally speaking here, but this is entirely reliant on the fact that a bountiful 7% plus dividend yield is being offered at those levels. We have maintained that the dividend is the big reason to own this stock. Collect it for income, or reinvest the dividends for long-term compound gains to build a position and then live off of the dividends in retirement. For those wanting more, consider selling covered calls as well. As the stock ebbs and flows, we buy, or we sell, but here in the mid-teens capital growth seems possible.

But the dividend is the draw folks. If for some reason the dividend were to be cut significantly, shareholders would likely flee and the stock could fall as far as the single digits. This is because it is owned by income-seeking investors. Could there be positives to cutting the dividend? Well, we invite you to read this piece which caused a lot of discussions, assessing what would happen if the dividend was eliminated altogether:

AT&T's Dividend: The Impact Of Eliminating It Altogether

So here is the deal. Dividends, simply put, are a major source of income for many investors. AT&T has a long history of paying dividends, and many investors rely on this income to supplement their retirement or other financial goals. A dividend cut would mean that investors would receive less money each year, which could have a significant impact on their financial plans. As such, a cut, especially a sharp one, would lead these income-seeking investors to other names, in our opinion.

Is AT&T's dividend really at risk?

This is a question we are often asked a lot, not just for AT&T but for many tickers in general. Sometimes we are in trades that only capture one or two payments because we garner capital gains, and it does not matter. Other times, such as for long-term holdings, we really have to be on top of things. In the short term, the dividend is not at risk. In the longer term, it could be.

The number one risk to the dividend is the debt. The debt is massive. Cutting the dividend could actually save billions of dollars that would normally go to shareholders, and instead could be allocated to the massive principal balances of debt. The high debt burden in a time of rising interest rates, and interest rates staying high for a while means that AT&T's refinancing efforts could be at a higher interest expense, hurting the bottom line earnings figures. More cash flow will need to go to this need. Management had been improving the balance sheet by selling off assets and paying down its debt. When AT&T reported earnings for Q1 recently , we saw that at quarter end the net debt was $134.7 billion. Debt was actually up from the sequential quarter.

Moreover, that is still a pretty high leverage base, as net debt-to-adjusted EBITDA was about 3.2X. In 2022 through all of the divestitures and asset sales, the company cut debt by over $20 billion. AT&T is looking to trim another $30 plus billion by 2025, targeting about $100 billion in net debt, taking leverage under 3X. In fact, management is targeting a net debt-to-adjusted EBITDA ratio in the 2.5x range by early 2025. This means a lot more debt will be paid down. That said, clearly a lot of cash will be devoted to debt repayment. However, cash flow was weak in Q1, and that is a risk factor, should it continue.

AT&T Q1 revenue

Telecoms are stepping up their promotional activity to attract and retain customers and the competition is fierce. Overall, our revenue expectations for the quarter were slightly more conservative relative to consensus. Analysts saw a consensus of $30.24 billion. We expected revenue to be right at $30.2 billion, with minimal year-over-year growth. With $30.14 billion in revenues, this was a bit weak, but about in line. The company is enjoying ongoing wireless postpaid growth, as AT&T saw 0.542 million adds. AT&T also reported 0.272 million fiber net adds. AT&T's postpaid adds continue to be industry-leading. Over 160 million people are now covered by AT&T's 5G network. Domestic wireless service revenues were up 5.2%, and they had strong mobility operational performance. Consumer broadband revenues were up 7.3%.

However, the CFO recently warned that Q2 subscriber adds will be below estimates. This is a potential problem. At a recent Bank of America Conference, CFO Pascal Desroches said new phone customers could be about 300,000, about 40% lower than analysts saw. However, with this weak data point, the CFO also stated that AT&T will "meet or exceed its goal" of $16 billion in free cash flow this year. In our opinion that is the green flag for ongoing safe dividends.

AT&T Q1 free cash flow

Cash flow is key. The best gauge we have for dividend coverage with AT&T is free cash flow. We had some concerns in Q1 because we targeted Q1 free cash flow of around $2.5 billion, but free cash flow was just $1.0 billion. With dividends paid of $2.01 billion, after dividends, the free cash flow was negative by $1 billion. Overall, the payout ratio was 200%. With the recent reiteration that free cash flow will hit $16 billion, that means for the year, the payout ratio is still projected to be under the 60% range.

Final thoughts

When Q2 is reported, we will closely be watching the cash flow metrics and progress (or lack thereof) on debt. We still like AT&T as a dividend play. We do believe the market is headed lower, and it is time to rotate out of growth and into some more defensive and income-related names.

There will still be wonderful momentum and/or short-term trades to make in this market, but we think the market is set to take a deep breath. We believe markets will challenge the 4200 level on the S&P 500 soon, and from there either break much lower or form a base for another run higher, depending on sentiment. Given the uncertainty, and the huge run we have had, we want to be in more income-generating names. While holding an income name, we teach our members how to trade around a core position and increase their overall returns. This is on top of call selling against long positions that pay a dividend.

For the dividend, it is all about cash flow, and to see the dividend reiterated is a very positive sign.

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