TBB - AT&T: Why Isn't Anyone Talking About This?

2023-03-27 08:00:00 ET

Summary

• It was another very volatile week for stocks.
• We see multiple sources of trouble on the horizon for the economy, including a pending catalyst that could shock consumer budgets.
• For now, cash flow is strong and the dividend is secure, but if things get worse later this year, the narrative could quickly change.
• We are selling pops and waiting for substantial drops to redeploy capital.

Well it was another week where we squeezed out gains on the averages while the VIX ( VIX ) moved over 20% in both higher and then lower directions this past week. The market is very unhealthy right now in our opinion. It seems like everyone is "in a rush to buy". But friends, sometimes the best thing to do is nothing. At our investing groups we have guided for gold and big tech as buys earlier in the month and that remains true, while energy is near levels that have to be bought in our opinion as well. We have also been guiding on how to trade around investor's personal core positions. Each time the market dips a little it is tempting to buy, but for the most part, in our opinion, earnings outlooks are far too high for the market as a whole. We are very concerned with the action. We kind of want to see the market just break lower, test the key levels it needs to test, then we can get back to business. But all of this uncertainty, we are pretty surprised at the action after decades of doing this that the market has held on like this. It is really amazing, frankly. The averages are not reflecting what some sectors are screaming, and they are screaming "recession is imminent." So, Mr. Market, let us simply get on with it. But do not get impatient. Do you know what impatience leads to in markets? It least to losses more often than not. Look we teach trading, including how to hedge and how to protect yourself. We encourage investors scale into quality names or quality in sectors unloved to position for the rebound. We think the market is going lower, but that does not mean we will not have green shoots. Our opinion is that you sell big pops, then add back to positions on big drops. The macro situation is a mess, and interest rates continue to rise. With rates continuing to rise there is a possible disaster brewing for one of our investors beloved dividend stocks, which is AT&T Inc. (T).

We will be honest here, we just do not love the stock even as a dividend name like we once did, and that is not because there is a lack of growth (there is), but that the dividend is no longer being raised. One could argue for a dividend raise being possible this year if cash flow remains strong and earnings meet projections. We just are truly starting to doubt the market. One thing no one is talking about is that millions of Americans will need to start repaying student loans very soon. So while there is already a ton of pressure on markets and stocks, add in to the mix all of the money that will be pulled out of the circulation of this economy to go to loans, and you can see we have a consumer discretionary crisis brewing.

We do believe AT&T will be hit by this. We think consumers delay phone upgrades, and opt for lower cost more cost efficient plans. It is human nature to tighten their belts when times get tough and for many families those student loan repayments, coupled with the effects of rampant inflation, job layoffs, and a tightening credit crunch from banks are going to lead to pain. Stocks will likely go down more this year. If the market is truly pricing in rate cuts, then you must realize that the economy will be in pretty bad shape for the Fed to cut rates. Meanwhile, while this crisis of confidence in consumers is pretty clear to us, the high rates for longer spell disaster for AT&T because of their immense debt.

So, we think AT&T heads lower, and the dividend is not going to get raised. We think a cut is unlikely, though we have previously hypothesized a few impacts a cut or elimination could have. Ultimately, AT&T will need to refinance debt at higher rates in the future and that is going to mean an earnings squeeze as interest payments increase, even if AT&T is selling off assets and chipping away at debt.

For now, the dividend will hang on, but its safety is somewhat questionable longer term as this crisis brews, in our opinion. Right now forecasts show no growth for the company, and it could get worse. Cash flow should remain sufficient near-term to cover the dividend, but each passing quarter, if recession hits, which the massive drop in the two-year yield strongly suggests, then we are in some trouble. We recommend selling pops and building cash to deploy when we do get a flush. Our base case is as test of 3750 with likelihood of the October lows being tested for markets if earnings estimates come down and the economy really starts to soften. We view upside in markets the next 3-4 months as limited, but see the market as having a run in late 2023 or early 2024 when the outlook looks a little stronger and rate cuts are likely to be on the table (in 2024).

So while AT&T stock which if it holds here at $19 and the dividend is never cut is a great income stock, and we continued to hold it, we are selling the pops. When it recently reported earnings they were quite mixed indeed. If the economy holds up and earnings estimates are raised, then our thesis will be incorrect. Look, we continue to believe AT&T is a great income stock, but do think this market overall has downside ahead. We really think new money should wait until about $15-16 to buy, but at least $17. That may not seem like a lot but it is 10-20% lower from here. As of this very second the risk of free cash flow not covering the dividend is not reality, but the risk of more and more cash flow going to debt servicing in the future is very real. It is a prevalent risk.

AT&T is slowly seeing its financial position improve, while investing in the future. It is a fine line to walk, but management, after years of poor decision-making, is on the right track in our estimation.

For the most recent quarter analysts covering the company were targeting a consensus of $31.4 billion. With $31.3 billion in revenues, this was a miss versus consensus. We hypothesize there will be pain for discretionary spending on phone upgrades and believe people will opt for cheaper plans. This could lead to churn, especially as consumers adjust to repaying student loans right as we are heading into a recession. It is a risk that is underappreciated and no one is really talking about. We think it is time to change that narrative.

Now, the most recent quarterly data available measures the end of 2022, which feels like a lifetime ago. We have banks failing. People afraid. Layoffs on the rise, and interest rates that have been hiked several more times. But customer adds were strong in Q4. Wireless postpaid growth saw 0.656 million adds, and these were once again boosted by 5G availability and wise promotions put into place. For the year postpaid growth was 2.9 million adds and also reported 0.280 million fiber net adds. It is worth noting that the fiber adds mark the 12th straight quarter of 0.2 million adds or more. For 5G, they are now covering 150 million people. All of this is very positive.

But it is what lies ahead that has us nervous. Barring big time sales and discounts which hurt margins, we think these adds decline later this year due to issues we have highlighted.

Growth is already anemic and now we have real problems brewing. The Q4 revenue grew just 0.7%, though earnings expectations for $0.57 per share were surpassed by $0.04. Even with that reality, expenses still remain a bit higher than we would like, but these costs are top of the pecking order for management to reduce to preserve earnings. Operating expenses were $52.4 billion, but this included a huge $26.8 billion goodwill charge associated with Business wireline and Mexico reporting units. Backing that out, operating expenses were $25.6 billion. We were happy to see that operating income grew from last year to $5.7 billion, up $700 million. Yet, this can easily be reversed if we see economic activity slow.

So what is the big deal? Has AT&T stock not really balanced out? While it is true AT&T stock has traded in a tight range the last few months, so has the market, and we expect that to change. We have always liked AT&T as a dividend play, but we think you get a better price to buy. While free cash flow has been more than sufficient to cover the dividend, the cushion of safety has been reduced and in time, while the debt is being worked on, future debt is going to be much more costly. That is a real problem.

Free cash flow was $6.1 billion in Q4. That is really solid. At the same time. dividends paid were $2.01 billion, so there was about $4.1 billion in excess free cash flow after the dividend was paid. Without question the payout ratio was a very safe 33.0%. As an income investor for the long term, this is critical. For all of 2022 the payout ratio for the year was 69.7%. The funny thing is if the macro situation was not getting so ugly, there was room for a dividend hike, and with management forecasting about a 509% payout ratio in 2023, it looks safe. We think it comes in higher than this as we see the situation weakening in H2 2023. But we must acknowledge the possible pressures we have brought up, in addition to the debt issue.

As always the debt here is by far the biggest risk to the company. But now debt refinancing or new debt taken on will be at much higher rates and increase interest expense dramatically. The only way this is not true is if rates are cut so much they are sub 2% in a few years. That is the reality here. While a full schedule of the debt is beyond the scope of this column we plan to look at this in a future column. For now, we have to realize that this is a real problem, and one of the biggest risks with holding AT&T stock through this period.

Now, we are not trying to paint a dire picture in which AT&T is going bust. But there are real issues brewing in this market. It is a stock pickers market but we think that a debt laden income name like AT&T should be sold and bought back much lower, if not in favor of more stable income names for your long-term portfolios. We will credit management with improving the balance sheet by selling off assets and paying down its debt. The net debt was $132.2 billion to end the quarter, with net debt-to-adjusted EBITDA of 3.19X. The debt-to-adjusted EBITDA ratio is coming down regularly, and the free cash flow was strong. But debt needs to be paid down. As we look ahead to 2023, we see revenue growing low single-digit percentages at best here. We think there will be better pricing and more customer adds, but the impact of a weaker economy and the hidden risk of student loan repayments starting up again will take its toll. It may not hit the financial aspects of the company until the end of this year, or early 2024, so there is time for this to play out. We are cautioning investors and trying to bring attention to this underappreciated issue. We see earnings coming in around $2.30-$2.50 for the year. That puts shares at 8X FWD EPS still which is pretty attractive.

For the bulls, this is a great price, and the cash flow is strong, and for now the dividend is secure. But much like the broader market, the stock is stuck in a range. That is great for income, a stable stock, but we see the market heading lower until rates are eventually cut, which will be done because the economy is about to get hit hard in our opinion. We strongly encourage investors consider the impact of student loan repayments starting up again on discretionary cash flow. While mobile connectivity is a necessity, we see consumers easily delaying upgrade cycles, competing for the best deals even harder, and being willing to buy into lower level plans to save money. This will in our opinion squeeze margins, and ultimately free cash flow.

Your opinion matters

Have you considered the impact of a return to repayment of student debt? It has been 3 years of consumers adjusting to a budget without this anchor on it. Do you think AT&T Inc. should prioritize debt? Do you think AT&T will actually raise the dividend? Should they cut the dividend? Is it better to just hold forever or do you like selling and buying back lower? Do you sell calls? Let the community know below.

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