AT&T’s Love Affair with Debt

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Image Source: Mike Mozart

AT&T’s free cash flow performance during 2016 was solid, and the company’s outlook for 2017 wasn’t bad. What concerns us the most, however, is the company’s unwieldly debt load, which will only be exacerbated by the Time Warner deal. Income investors should take note.

By Brian Nelson, CFA

On January 25, AT&T (T) wrapped up 2016 with a rather solid fourth-quarter report, and full-year results weren’t bad. We have no qualms with AT&T, but as with Verizon (VZ), we worry the company has stretched its balance sheet too far this late into the economic cycle.

Contributions from AT&T’s acquisition of DIRECTV and gains in IP services and video helped drive consolidated revenues 11.6% higher during 2016, while adjusted operating income came in at $31.8 billion versus $27.7 billion in the prior year. Importantly, AT&T’s full-year cash flow from operations was a record $39.3 billion, up from $35.9 billion in 2015, while capital expenditures, including capitalized interest, came in at $22.4 billion, versus $20 billion in 2015, translating to free cash flow generation of $16.9 billion in 2016, up a cool billion from 2015. AT&T’s free cash flow dividend payout ratio for the full year was a comfortable 70%, and we like companies that continue to generate free cash flow far in excess of cash dividends paid.

AT&T looks to continue to build on the transformational year that was 2016, and we’re encouraged by its 5G evolution plans and improved spectrum position, even as industry pricing competition from the likes of Sprint (S) and T-Mobil (TMUS) remains intense. The company’s deal to acquire Time Warner (TWX) for a total transaction value of more than $100 billion, announced in October, looks like it will shake up the industry. HBO and CNN, prized assets at Time Warner, would serve to complement AT&T’s distribution network nicely, and Time Warner’s film/TV studio and unrivaled library of entertainment is simply hard not to like. In light of management’s demonstrated ability to deliver on the $1.5 billion in DIRECTV cost synergies, we’re also optimistic about what the potential Time Warner transaction may bring to margin improvement (operating income margin was 19.4% in 2016 versus 18.8% in 2015). The regulatory road may still have obstacles to overcome, however, as President Trump seems to privately oppose the deal; after all, how can we forget his claims that CNN is “fake news:”

As we watch steps toward deal completion, AT&T’s financial outlook for 2017, excluding any impact from the pending Time Warner tie-up, is pretty good. AT&T expects consolidated revenue growth in the low-single-digits, adjusted earnings per share growth in the mid-single-digits, and ongoing adjusted operating margin expansion. Capital spending will be roughly at 2016 levels, and free cash flow is targeted to advance to the $18 billion range, implying ongoing improvement over last year’s levels. In the twelve months ending December 2016, the company paid out $11.8 billion in cash dividends, so free cash flow coverage of the dividend will remain robust. AT&T is doing a lot of things right.

That said, what keeps us up at night is the incremental debt that will be needed to finance the pending Time Warner transaction. Though AT&T expects its net debt to adjusted EBITDA to be in the 2.5 times range at the end of the first year after closing, adding ~$40 billion to its existing balance sheet (it took out a $40 billion bridge loan related to the deal) brings its total net debt load north of $157 billion, a number that includes debt maturing within one year. Corporate America’s love affair with debt-funded deal-making could come home to roost in a big way at AT&T, much to the detriment of income investors. AT&T’s negative Dividend Cushion ratio considers its massive financial liabilities as an impediment to the pace of future dividend growth.

Now read: “AT&T Targeting Disruption in Transformational Merger (October 2016)“