AT&T (T) – Big Dividend Cut
AT&T (T) is a dividend growth stock that many people own due to its consistency in paying a dividend and high yield with improving dividend safety. AT&T’s dividend yield has been over 7%. The stock is a Dividend Aristocrat. However, revenue and earnings growth has been challenging to come by. The company tried to grow through two significant acquisitions. AT&T acquired DirecTV in 2015 for $67 billion, including debt. AT&T then wanted to become a content provider by acquiring Time Warner in 2018 for $85 billion. But arguably, the capital allocation has been poor, and both acquisitions failed to provide value to shareholders. AT&T is now trying to undo the acquisitions by spinning off DirecTV and WarnerMedia. There are benefits to AT&T, but there are costs as well. More on that below. However, shareholders of AT&T will experience a big dividend cut that was largely unexpected.
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Overview of AT&T
AT&T traces its history back to 1874. The current incarnation of AT&T is a result of consolidation in the telecommunication industry. SBC Communications, a former spinoff of AT&T, acquired AT&T Communications in 2005, forming the modern-day AT&T Inc. SBC took the name of AT&T. AT&T acquired DirecTV for $67 billion in 2015 and three years later acquired Time Warner for $85 billion in 2018. Today AT&T is the largest communications company in the world based on revenue. AT&T operates through three business segments: AT&T Communications, WarnerMedia, and AT&T Latin America. AT&T Communications is comprised of Mobility, Consumer Wireline, and Business Wireline. WarnerMedia consists of Turner, Home Box Office, and Warner Bros. AT&T Latin America includes Mexico and Vrio.
The largest segment by revenue (81% of total revenue) and the most important is AT&T Communications. The Mobility business has approximately 100 million connections and $72.6 billion in revenue. In wireless, AT&T shares an oligopoly with Verizon (VZ) and T-Mobile (TMUS). Consumer Wireline has about $12.3 billion in revenue and includes DirecTV, U-verse, AT&T TV, and broadband. This segment has about 17 million television and 14 million internet access customers. The Business Wireline unit has approximately $25.1 billion in revenue. Warner Media is the newest business and accounts for 18% of total revenue at $30.4 billion. Latin American is the smallest business at roughly 3% of total revenue or $3.2 billion and includes satellite TV and wireless in Mexico. Total revenue was approximately $171.8 billion in 2020.
Spinoff of DirecTV
DirecTV was acquired by AT&T in 2015 for $67 billion, including debt. The original idea was for AT&T to market satellite TV with its wireless service as a bundle. But AT&T missed the dramatic changes occurring in the market as broadband speeds became faster and streaming services took hold. For example, consumers preferred to watch Netflix (NFLX) over broadband rather than DirecTV, a pay televisions service. Additionally, the onset of 5G made streaming movies and TV shows over cellular much easier and faster. The reality was that people didn’t want the hassle of dealing with a small satellite dish. AT&T lost over 3 million subscribers in 2020 alone as the number of streaming services increased and cord-cutting accelerated. DirecTV’s subscribers peaked in 2015 when the service combined with U-verse had 25.4 million subscribers in total. This number is down by over one-third to about 17 million at the end of 2020.
The spinoff will value DirecTV, AT&T TV, and U-Verse at about $16.25 billion in a deal with TPG, a private equity firm. AT&T will receive $7.5 billion in cash from the new DirecTV. The cash will be funded by new debt for DirecTV and cash from TPG. TPG will contribute $1.8 billion in cash to DirecTV and receive preferred shares and a 30% interest in common stock. The preferred shares will yield 10%. AT&T will still hold 70% in common stock and receive $4.3 billion in preferred shares, yielding 6.5%. There are a few other pieces to the deal. AT&T is responsible for losses of up to $2.5 billion from the NFL Sunday Ticket. DirecTV will assume $200 million in AT&T debt. The deal excludes DirecTV’s Latin America business.
Note that this spinoff was announced before the recently announced WarnerMedia spinoff, which will further impact revenue, earnings, the balance sheet.
Advantages of DirecTV Spinoff
AT&T’s foray into satellite TV was costly. The telecom giant needed to take a $15.5 billion write-down for DirecTV in 2020. But even with the subscriber losses and revenue declines, DirecTV was profitable. By spinning off DirecTV, AT&T is no longer exposed to subscriber losses and revenue declines and should have a slightly better revenue growth profile of ~1%. This fact is important as the stock market is currently rewarding growth instead of value. The spinoff also lets AT&T focus on its core operations of wireless and fiber. AT&T plans on using cash to reduce debt. The company’s CEO John Stankey stated,
“This agreement aligns with our investment and operational focus on connectivity and content, and the strategic businesses that are key to growing our customer relationships across 5G wireless, fiber and HBO Max. And it supports our deliberate capital allocation commitment to invest in growth areas, sustain the dividend at current levels, focus on debt reduction and restructure or monetize non-core assets.”
DirecTV benefits from a strategic perspective as it can now focus on its core operations and possibly pursue a merger with DishTV.
Dividend Safety after DirecTV Spinoff
On the other hand, AT&T will have lower revenue, cash flow, EBITDA, and dividend safety after the DirecTV spinoff. In 2020, DirecTV had about $28.6 billion in revenue, down 11%, and nearly $4 billion in EBITDA, down 12% from 2019. My earlier calculation for dividend safety based on free cash flow showed that the dividend-to-FCF ratio was 54%. This percentage will go up based on the spinoff of DirecTV. The dividend requires about $15 billion in cash, and free cash flow will be nearly $28 billion in 2020. DirecTV generates cash flows of about $4 billion annually. So, the new dividend-to-FCF ratio will be about 63%. On an earnings basis, I calculated a payout ratio of about 65%. The payout ratio too will go up since DirecTV is profitable with an operating income of approximately $1.7 billion.
The spinoff of DirecTV did not result in a cut to AT&T’s dividend. However, it did reduce the dividend safety. AT&T’s dividend cut is a result of the WamerMedia spinoff.
Spinoff of WarnerMedia
AT&T acquired Time Warner for $85 billion in 2018. The main idea was to merge AT&T wireless and broadband distribution capabilities with content. This move was another expensive acquisition, and arguably it did not work out. In hindsight, AT&T probably could have just partnered with content producers. Instead, the three-year trial ended abruptly after a series of missteps. In the end, cultural differences between a predominantly engineering telecommunications company and content creators probably reduced the chance of success.
WarnerMedia will be merged with Discovery (DISCA), creating a new standalone company called Warner Bros Discovery. The merger brings HBO, Warner Brothers, CNN, TNT, TBS, HGTV, food network, TLC, and other assets together. The deal is structured as a Reverse Morris Trust transaction. AT&T will receive $43 billion (subject to adjustment) of cash, debt securities, and retention of debt by WarnerMedia. AT&T shareholders would own 71% of the new company. Discovery shareholders would own 29% of the new company. The new WarnerMedia would have about $52 billion in revenue and adjusted EBITDA of approximately $14 billion.
Advantages of WarnerMedia Spinoff
There are advantages for both AT&T and WarnerMedia once the spinoff is completed. AT&T will be more focused on its core operations of wireless and fiber. As a result, it will be much easier to target capital investment and expenditures. AT&T expects to spend roughly $24 billion annually on capital investment. Of note is that T-Mobile has more wireless customers now after merging with Sprint and is now the second-largest wireless carrier. Hence, AT&T needs to catch up to its competitors. Annual revenue growth is expected to be in the low-single digits CAGR. Adjusted EBITDA and adjusted earnings per share growth are expected to be in mid-single digits CAGR.
Notably, financial flexibility will materially increase through significant debt reduction. The company expects net debt-to-adjusted EBITDA or the leverage ratio to be around 2.6X after completion and less than 2.5X by 2023. This ratio is much lower than the leverage ratio of over 3X after the Time Warner acquisition. AT&T also stated that it would have the option to repurchase shares once the leverage ratio is below 2.5X. The company’s CEO John Stankey stated,
“This agreement unites two entertainment leaders with complementary content strengths and positions the new company to be one of the leading global direct-to-consumer streaming platforms. It will support the fantastic growth and international launch of HBO Max with Discovery’s global footprint and create efficiencies which can be re-invested in producing more great content to give consumers what they want. For AT&T shareholders, this is an opportunity to unlock value and be one of the best capitalized broadband companies, focused on investing in 5G and fiber to meet substantial, long-term demand for connectivity. AT&T shareholders will retain their stake in our leading communications company that comes with an attractive dividend. Plus, they will get a stake in the new company, a global media leader that can build one of the top streaming platforms in the world.”
AT&T’s Big Dividend Cut
Despite the advantages of the DirecTV and WarnerMedia spinoffs, AT&T shareholders are looking at a dividend cut. The press release related to the WarnerMedia spinoff also said last month,
“Attractive dividend – resized to account for the distribution of WarnerMedia to AT&T shareholders. After close and subject to AT&T Board approval, AT&T expects an annual dividend payout ratio of 40% to 43% on anticipated free cash flow of $20 billion plus.”
This fact means that the free cash flow required for the dividend will be about $8 billion to $8.6 billion. Currently, the dividend requires about $15 billion in cash. So, AT&T shareholders are looking at a dividend that is almost half of the current dividend. So, if we estimate that the dividend is cut approximately in half, investors will have a dividend yield slightly below ~4% at the current share price. This dividend yield is not bad in absolute terms, but it is much lower than the current dividend yield of ~7.3%. However, the news is not all bad as the dividend safety based on earnings, free cash flow, and debt will be materially better. Furthermore, AT&T’s top and bottom-line growth potential and thus dividend growth potential will be better.
Investors will also get Warner Bros Discovery stock. There is a possibility that WarnerMedia will pay a dividend, but this is not known at this time. However, it is much more likely that free cash flow will be directed to new content to compete with other streaming services.
Final Thoughts on AT&T (T) – Big Dividend Cut
A dividend cut or suspension is not something most dividend growth or income investors like to see. The stock was punished after the announcement losing more than $30 billion in market value. The dividend cut will end AT&T’s 36-year stream of raising the dividend. The dividend cut will also mean that AT&T will no longer be a Dividend Aristocrat. A company dropping off the Dividend Aristocrat list is rare, but it does occur on occasion. I am personally not an AT&T stockholder and will not be buying shares. Future dividend growth is not well defined. I think that competition in wireless and fiber is intense. In addition, whether Warner Bros Discovery will pay a dividend is largely unknown.
Thanks for reading AT&T (T) – Big Dividend Cut.
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