TBC - AT&T Stock: 3 Reasons Why Retirees Should Steer Clear

2023-08-29 08:00:00 ET

Summary

• AT&T Inc. stock initially appears attractive for retirees seeking passive income with its defensive business model and 8% dividend yield.
• However, we think that it is not as attractive as it first appears.
• We share three reasons why.

AT&T Inc. ( T ) stock looks quite attractive at first glance for retirees looking to generate passive income from their investments:

1. It has a fairly defensive business model that generates pretty stable cash flow.
2. It offers a very attractive 8% NTM dividend yield.
3. Its dividend appears to be very well covered by earnings, as its 2023 payout ratio is expected to come in at a mere 46.1%.

However, we believe these high-level metrics are misleading and that retirees would be better served by steering clear of the stock and allocating their hard-earned capital elsewhere. Here are three reasons why.

#1. AT&T Stock's Dividend Is Not As Safe As It First Appears

While T's payout ratio appears quite low and we ourselves do not think T's dividend is in any imminent danger, keep in mind that T's payout ratio was quite low when it cut its dividend previously. As a result, investors should realize that the dividend is not as safe as its payout ratio makes it appear at first.

The reasons for this include:

• T still has a pretty heavily leveraged balance sheet in an elevated interest rate environment that has management prioritizing debt reduction over everything else:

[we] now expect to use an increasing amount of our free cash flows after dividends to accelerate our debt reduction efforts. We remain committed to achieving the 2.5 times range for net debt to adjusted EBITDA in the first half of 2025.

• T is facing risk from the recent lead cable investigation of telecom companies by the Justice Department and EPA. T's CEO largely deflected the question when asked about the investigation's implications for the safety of the dividend. His lack of conviction in answering this question - while it is far from signaling a dividend cut - shows that the dividend is far from rock solid in the face of this risk.
• T has a very capex heavy business model. The telecom industry is constantly changing as communications technology continues to advance. This means that T must constantly invest in upgrading its infrastructure to sustain its competitive positioning. Meanwhile, the commoditized nature of the industry is such that T has practically no pricing power and in fact service prices have tended to drop in recent years despite the high level of inflation in the economy. As a result, it is hard to see how T's profit margins expand meaningfully over time and the company is likely doomed to suffer from continued low returns on invested capital and returns on assets for years to come.

As a result, T appears likely to remain a capital-guzzling business in a higher cost of capital environment that will need to prioritize as much free cash flow as possible towards debt reduction for the foreseeable future. While T can and likely will sustain its dividend in the meantime, there is not much margin of safety for it. This means that investors should not delude themselves into thinking of it as a very safe payout as any unforeseen meaningful headwinds could threaten its safety once again.

#2. T Stock Has A Weak Business Model And Management Team

Another reason to be skeptical of T as a long-term core holding in a retirement portfolio is that it has a weak business model and management team. This is easily seen in the significant declines in stock price and return on equity for the company over the past decade:

This decline in return on equity is particularly shocking given that T's debt burden has ballooned over the years through highly leveraged acquisitions, which normally would juice the return on equity, even if the returns on invested capital are poor. The reason for this is because T made numerous ill-fated acquisitions (e.g., DirectTV), that destroyed tens of billions of dollars in shareholder value while leaving the balance sheet in a tight spot. This is why T had to slash its dividend previously and - given that management has of yet to give us a reason to believe things have changed - we still do not trust management today.

On top of that, though it does benefit some from economies of scale and name brand recognition, T's business model lacks any clear moat. The industry is highly commoditized and very competitive, with constant technological changes forcing T to constantly adapt to retain customers against numerous competitors such as Verizon ( VZ ) and TMobile ( TMUS ). While as of yet unsubstantiated, the recent rumor that Amazon ( AMZN ) may be considering entering the wireless space sent T stock tumbling. This shows just how fragile T's business model truly is, making it a bit of a risky place for a retiree to depend on for long-term income.

#3. T Stock's Dividend Likely Will Not Keep Up With Inflation

Finally, while the current yield is attractive and management may be able to sustain its current payout for years to come, it is highly unlikely that T's dividend will be able to keep pace with inflation moving forward.

Given the aforementioned strains on the current payout (heavy debt burden, large capex needs, and highly competitive industry), T is expected to barely grow its payout moving forward, with analysts expecting a meager 0.7% increase in both 2023 and 2024 and a 0.9% increase in 2025. Meanwhile, CPI is sitting north of 3% and core CPI is still over 4%. Even if the Federal Reserve can succeed in bringing inflation down closer to its 2% target, T's payout growth will still be less than half the rate of inflation. As a result, retirees who invest in the stock will have to take into consideration that over the long-term, the purchasing power of T's dividend payments will be meaningfully eroded by inflation.

Investor Takeaway

T stock offers an attractive current payout and has a fairly stable cash flow profile. That being said, the margin of safety for the dividend is not very large, management has given little reason to trust them, T's competitive positioning is less than impressive, and T's dividend growth profile looks quite abysmal. As a result, the risks seem to be to the downside here, ranging from inflation eroding the purchasing power of the payout, potential headwinds threatening the safety of the current payout level, and debt remaining an anchor weight around management and preventing them from growing the dividend more aggressively and/or investing for true growth.

As a result, we do not think that the 8% yield - especially in the current higher interest rate environment where there are a plethora of other attractive high yielding opportunities - is enough on its own to make T worthy of a retiree's investment.

For further details see: