2023-10-20 12:31:49 ET
Summary
- I am taking a closer look at AT&T's recent quarterly results, which were a breath of fresh air for shareholders.
- Given the recent momentum, AT&T should be able to gradually improve margins going forward.
- Dividend safety and high debt levels will likely continue to weigh on returns in the coming months, but this could change in 2024.
Holding AT&T ( T ) over the past 10 years has been every shareholder's nightmare. Over the period, the stock fell more than 40% at a time when the equity market experienced some of its best years on record.
Bad management decisions resulted in significant shareholder value destruction , competition in the sector has been fierce and last but not least, inflationary pressures have made it very hard for wireless carriers to keep up with rising costs at a time when they are still investing heavily into their 5G and fiber networks.
So far 2023 has been yet another disastrous year for AT&T after the stock fell more than 16%, making it the worst performer among the three largest wireless carriers and registering a wide gap with the S&P 500.
With the report of the Q3 results, however, AT&T jumped nearly 7% as management lifted its free cash flow guidance and reported better than expected results.
It appears that the downtrend in AT&T stock could finally be over, provided that momentum from the most recent quarter is sustained beyond the current fiscal year. On top of that, management has indicated that abnormal capital expenditures will slowly normalize over the next fiscal year which bodes well for free cash flow in the medium term.
In addition to a higher probability of a turnaround and an upward multiple repricing, the quarter also brought much needed good news for dividend investors. Better than expected free cash flow and profitability would significantly reduce the risk of a cut in AT&T's high dividend yield of nearly 8%.
The yield is so high for a large cap company that it is only AT&T and Verizon ( VZ ) which stand out from the largest 150 companies by market cap as of this week.
But before we go into the key points of cash flow, dividend safety and of course - debt, we must first take a closer look at AT&T's operational performance during the quarter.
Digesting Q3 Results
On the revenue side, there was nothing to be too excited about as modest growth in Mobility and Consumer Wireline largely offset the weak performance of the Business Wireline segment
The headwinds in Business Wireline are likely to be sustained for the time being as pressure from lower demand for legacy voice and data services intensifies from the prior quarter.
Business Wireline revenues for the third quarter of 2023 were $5.2 billion, down 7.9 percent versus the year-ago quarter, primarily due to lower demand for legacy voice and data services as well as product simplification , partially offset by growth in connectivity services.
Source: AT&T 8-K SEC Filing (Q3 2023).
This, however, is hardly a cause for concern as it is the Mobility segment that matters far more for investors. Within it, growth in postpaid phone subscribers has accelerated after gradually declining for a number of quarters.
As insignificant as this might seem, it is a positive sign that AT&T's strategy and high business reinvestments are allowing the company to catch up with peers.
Churn rate in postpaid phones also noted a decline to 0.79% as AT&T's value propositions improved customer loyalty.
As a result, AT&T is now more in line with its two main peers - Verizon and T-Mobile ( TMUS ).
The last piece of the puzzle was yet another quarterly improvement in Average Revenue Per User (ARPU) which shows that tailwinds from the previous quarters are still at play.
The primary drivers of ARPU growth are : higher ARPU on legacy plans from last year's pricing actions; a continued mix shift to higher value rate plans with higher margins; and continued improvement in consumer international roaming trends .
Source: AT&T Q2 2023 Earnings Transcript.
After noting a decline during Q4 of 2022 and Q1 of this year, ARPU in postpaid phones is once again creeping up. Likewise, ARPU in AT&T Fiber is also on an upward trajectory which in combination with higher subscriber numbers would allow AT&T to continue to expand its margins.
This is exactly what we saw during the quarter as EBITDA in Mobility and Consumer Wireline grew at much higher rates than revenues in these segments, thus resulting in higher margins.
In addition to this optimistic trend, inflation is also coming down which would provide a much needed macroeconomic tailwind, not only for AT&T but for telecom carriers more broadly.
Dividends, Free Cash Flow and Debt
As operational performance improves, investors are looking increasingly at AT&T's dividend safety and the company's ability to reduce its huge debt pile.
At first glance, on a non-adjusted GAAP basis, the situation does not look pretty after the company recorded enormous asset impairments in FY 2022.
But even once we adjust for the $27bn of asset impairments and restructuring charges during the last year and also apply the statutory tax rate of 21%, we still end up with a very high dividend payout ratio.
What that means is that AT&T's dividend yield will remain at risk, even as revenue and margins continue to improve. Given the stability of earnings in the sector, it would likely take a worse than currently expected recession for AT&T to once again cut its dividend.
The good news is that on a cash flow basis, once we account for the currently elevated capital expenditure and the annual dividend payments, there is a significant amount left for AT&T to continue to reduce its enormous debt load.
The nearly $12bn left would likely be lower in 2024 given the higher tax expense once asset impairments are out of the picture. This amount would also be used to cover other items, such as payment of vendor financing and cash acquisitions.
Nonetheless, at present AT&T is in a good position to continue reducing its debt load by $2bn to $3bn on a quarterly basis.
This takes us to the final priority , and that's how we're putting our improving operating leverage to work. In the third quarter, we reduced our net debt by more than $3 billion and are on track to achieve our 2.5 times net debt to adjusted EBITDA target by the first half of 2025.
Source: AT&T Q3 2023 Earnings Transcript.
The problem is that maturities of outstanding long-term debt (not accounting for short-term debt), are well above this number (see below). Of course, these will likely be refinanced, but at much higher rates.
This leaves, the expectation of higher profitability and lower capital investment next year as the only hope for shareholders to finally see a meaningful reduction in debt levels. In my view, the latter would be a far more important area for AT&T's shareholders to keep a close eye on. After years of abnormal investments, management expects these to cool off as we enter 2024.
Capital investment was $5.6 billion in the quarter and this reflects continued historically high levels of investments in 5G and fiber . We expect to move past elevated capital investment levels as we exit the year .
Source: AT&T Q3 2023 Earnings Transcript.
This is a high probability scenario and could be a strong catalyst for AT&T's share price going forward. Unfortunately, it won't be until next year until it happens and the key development that could derail this much anticipated improvement in AT&T's debt levels would be a major economic slowdown.
In spite of all the talk about a 'soft landing' the sharp deterioration of the Conference Board Leading Economic Index® ((LEI)) and the steepening of the yield curve are going against the current narrative.
Conclusion
The recent quarter was a much needed breath of fresh air for AT&T shareholders and I expect the slow momentum in connections growth and ARPU to be sustained for the time being. The other key area is the anticipated drop in capital investments which would allow the company to step up its efforts in deleveraging. It won't be until sometime next year, however, when Capex should be reduced meaningfully which allows for caution. In the meantime, a sustained improvement in the company's postpaid ARPU over the next months will be something that I will closely look for, in order to upgrade AT&T as a buy.
For further details see:
AT&T: The Nightmare Is Finally Over, But A Turnaround Won't Happen Overnight