AT&T (T): High Yield And Improving Dividend Safety

AT&T (T) is well known as an income stock and a dividend growth stock. The current high yield of AT&T is attractive, and the dividend safety is now improving since management is making a serious effort to pay down debt. The current dividend yield is over 7%. The dividend has been raised for 36 consecutive years making AT&T a Dividend Aristocrat and Dividend Champion. The dividend payout ratio is roughly 65% but was higher immediately after the Time Warner acquisition. Other dividend safety metrics were also concerning from the perspective of a dividend growth investor. AT&T took on an enormous amount of debt to acquire Time Warner. The company must reduce leverage and execute well in the face of the COVID-19 pandemic. The pandemic is negatively impacting the top and bottom lines and cash flow. This combined with long-term subscriber losses in the satellite television business and lower revenue in the Warner Media business means that 2020 and possibly 2021 will be a challenging year. Though there are challenges, investors may want to take another look at AT&T since the dividend yield is high, total and net debt is coming down, and dividend safety is improving. Total return for AT&T stock may be solid if the company can execute well.

Overview of AT&T

AT&T traces its history back to 1874 when Alexander Graham Bell created Bell Patent Association. In modern times, consolidation of the telecommunication industry led SBC Communications, a baby bell (former spin out of AT&T), to acquire AT&T Communications in 2005 forming the modern-day AT&T Inc. SBC took the name of AT&T. Today AT&T is the largest communications company in the world based on revenue. AT&T operates through three business segments: Communications, Warner Media, and Latin America. AT&T acquired Time Warner for $85 billion in 2018. Communications is comprised of Mobility, Entertainment Group, and Business Wireline. Warner Media consists of Turner, Home Box Office, and Warner Bros. Latin American includes Mexico and Vrio. 

The largest segment by revenue (40% of total revenue) and most important is Communications due to the wireless business. This business has approximately 100 million connections. In wireless, AT&T shares an oligopoly with Verizon (VZ) and T-Mobile. The three companies have a combined market share of 90% postpaid and prepaid customers in the U.S. Entertainment Group (20% of total revenue) includes DirecTV, U-verse, AT&T TV, and broadband. This segment has about 20 million television and 14 million internet access customers. The Business Wireline unit (14% of total revenue) is important but less profitable than the other units in the segment. Warner Media is the newest business and accounts for 20% of total revenue. Latin American is the smallest business (3% of total revenue) and includes satellite TV and wireless in Mexico. Total revenue was approximately $181 billion in 2019.

AT&T’s Dividend and Growth

AT&T has a long dividend history having paid a continuous dividend for over 100 years dating back to 1893 in the predecessor organization AT&T Corp. AT&T Inc has paid a continuous dividend since 1983 The company has also paid a growing dividend for 36 consecutive years making it a Dividend Aristocrat and Dividend Champion. The resilience of AT&T’s dividend is derived from selling a basic necessity, which is communication services. The dividend has also been a source of income for many retirees and small investors, which is why AT&T stock is very popular. For context, AT&T has over 497 thousand followers on Seeking Alpha.

The chart below shows the dividend payout and dividend growth rate over the past decade with the stock price superimposed (green). The growth in the dividend has been roughly 2% to 2.5% for the past decade. This is mostly due to the lack of consistent growth from AT&T’s business as a whole. Mobile has grown rapidly, but this has been offset by declines in the landline and satellite TV business. Additionally, the dividend payout ratio has been elevated at times.

The second chart shows that the dividend yield at over 7% is the highest it has been in the past decade. The dividend yield is currently higher than many other dividend income stocks including utilities, REITs, and MLPs. The dividend yield is less than another investor favorite long-term dividend growth stock, Exxon Mobil (XOM), which has a higher dividend yield and but arguably very low dividend safety. In contrast, AT&T stock has an attractive and high dividend yield, and the dividend safety is now improving.

AT&T High Yield and Improving Dividend Safety

I like to take a look at three dividend safety metrics: earnings, cash flow, and debt. It is important to me as a dividend growth investor for all three to meet my criteria. Granted, there can be short-term fluctuations that results in a stock not meeting my criteria. But those are usually transient and not long term. Let’s do a deep dive into AT&T’s dividend safety.

For the first dividend safety metric, from an earnings perspective the dividend is not well covered on a consistent basis. In 2019, AT&T’s dividend was $2.05 per share and diluted earnings per share was $1.89 based on data from TIKR*. This meant that the dividend payout ratio was 107% and the dividend was not covered by earnings. On a temporary basis, a high payout ratio is not problematic. But the challenges being faced by AT&T in 2020 and possibly 2021 include COVID-19 effects, declining revenue in the satellite TV business, high debt, and higher interest expense. 

However, the forward dividend payout is $2.08 per share in 2020 and the company is expected to earn $3.17 per share this year. This means that the forward payout ratio is 65%. This is not a bad value although it is just at my cutoff for dividend safety. The problem for AT&T is that if we look at the past decade the dividend payout ratio has been erratic due to volatility in diluted earnings per share. The payout ratio has been near or over 100% periodically. Granted, the payout ratio has improved on a non-GAAP basis, which is a positive for AT&T.

The dividend is better covered by cash flow, which is the second dividend safety metric. On a trailing basis, operating cash flow was $44,991 million in 2019 based on data from TIKR*. Capital expenditures were $17,075 million giving free cash flow of $27,916 million. The dividend payout requires about $15,028 million ($2.08 x 7,225 shares) annually. The dividend-to-FCF ratio was about 54%, which is below my threshold of 70% and a decent value. That said, the cash flow required to pay the dividend has increased dramatically from $9,916 million in 2010 to $15,028 million in the LTM. Not all of this increase was due to rising dividends per share. The share count has risen by ~22% in the past decade meaning that the cost to the pay a rising dividend will remain elevated.

Capital expenditures were actually higher in the past 5 – 6 years than in 2019 or in the LTM. However, it is not likely that capital expenditures will be lower going forward. AT&T’s mobile, broadband, and business line units require a decent amount of investment simply to stay competitive. The roll out of 5G will continue to require investment. There is really no alternative for this since both Verizon and T-Mobile are also rolling out 5G. In broadband and fiber, AT&T must compete with the Fios from Verizon and also offerings from cable companies. AT&T is arguably behind its competitors in broadband, which suggests that the company must invest more to close the gap in this market.

Of major concern is AT&T’s debt load, which has risen dramatically and almost tripled in the past decade as seen in the chart below. This is almost all due to major and minor acquisitions including DirecTV for about $67 billion in 2015 and Time Warner for roughly $85 billion in 2018 including debt. At the end of Q3 2020, short-term debt was $1,754 million, the current portion of long-term debt was $5,444 million, and long-term debt was $153,026 million and this was offset by only $9,758 million in cash, equivalents, and short-term investments according to data from TIKR*. Capital leases add another $27,445 million to liabilities.

The main problem for AT&T from the context of debt and dividend safety is that interest coverage has weakened due to the high debt load. Interest expense is about $2 billion per quarter or $8 billion annually at the moment. Ten years ago, total annual interest expense was about $3 billion. Interest coverage is ranging from 3.0X to 3.5X each quarter, which is low. The leverage ratio is also problematic since it went over 3X after the Time Warner acquisition. This is coming down though and was about 2.81X at end of Q3 2020, but this is still a high value.

Our deep dive into AT&T’s dividend safety shows a mixed picture based on earnings, free cash flow, and debt. The three dividend safety metrics do not clearly indicate that the dividend payout is at risk but ideally, I would like the metrics to be higher. On a positive note, the metrics are improving since AT&T is trying to reduce leverage.

Risks for AT&T 

AT&T is an acquisitive company. The current incarnation of AT&T was a result of splitting up the original AT&T monopoly and partly reassembling it by SBC. However, since then, the acquisition of DirecTV has been problematic even though the business is profitable. The satellite television subscriber business is declining due to competition and preference for broadband TV by customers. AT&T is reportedly trying to sell DirecTV to private equity investors. However, it is likely that offers will be much less than the price AT&T paid for it just five years ago. DirecTV had over 25 million customers in mid-2018 and the number is about 18.5 million in mid-2020. This is a risk for AT&T as a declining subscriber base means that DirecTV is worth less than AT&T paid for it, especially if the subscriber trends continue. It is not clear if AT&T will be able to sell DirecTV but with the focus on mobile, broadband, and content there is not a clear rationale on how DirecTV fits into AT&T’s strategy.

Warner Media is the newest business, but it is facing challenges due to the adverse effects of COVID-19. Latin American is the smallest business, but it is generating operating losses and it is also facing challenges resulting from COVID-19. According to AT&T, COVID-19 has resulted in higher incremental costs for protecting employees and contractors. There is also a loss of revenue from less advertising, lower television licensing and production, closure of movie theaters, postponement of movie releases, and less travel and wireless roaming by consumers. In third quarter alone, the impact was about $2,525 million lower revenues and $190 million in higher expenses. There will continue to be an adverse impact into fourth quarter and likely into 2021.

To put this in perspective let’s compare the stock prices of AT&T to Verizon, which is probably the closest competitor before the Time Warner acquisition changed AT&T’s business mix. Verizon also competes in mobile, broadband, and business but it does not focus as much on content. You can see in the chart below the difference in stock prices since the Great Recession. I made the chart using Stock Rover*. The market has rewarded Verizon more than AT&T.

Final Thoughts on AT&T High Yield and Improving Dividend Safety

AT&T is a company in transition. The company has made a large move into content, but AT&T has little experience with this. The market has not responded favorably as the stock price today is lower than before the acquisition of Time Warner. Further, the acquisition of DirecTV is increasingly looking like one that has little long-term benefit. Granted, the acquisitions have increased total revenue, but they have also increased total debt. Although AT&T has a high dividend yield and improving dividend safety, I am personally wary about the company due to the large acquisitions and high debt load.

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