Image Source: Mike Mozart
The question on everyone’s minds: Is AT&T’s dividend sustainable?
By Brian Nelson, CFA
AT&T (T) has been on a spending spree. Its agreement to acquire Time Warner (TWX), the merger with DirecTV, and wireless acquisitions in Mexico are just a few tie-ups the company has pursued in recent years. Regardless of what you think about the incremental financial risk associated with a larger balance sheet, AT&T has increased its quarterly dividend for 30+ consecutive years and has frequently returned $20+ billion to shareholders annually through dividends and share buybacks. The company’s Dividend Cushion ratio is 0 (which isn’t great), but let’s put some color around that number. Per AT&T’s dividend report:
Key Strengths
AT&T has paid an increasing dividend for more than 30 years thanks in part to its strong free cash flow generation. The company continues to integrate newly-acquired assets–DIRECTV, lusacell, and Nextel Mexico. The DirecTV deal, for one, gives the company a more diversified list of products/services, while transactions in Mexico will help to bolster its international reach. With a well-known brand name and a long history, AT&T continues to make strategic moves to continue to grow its business, not resting on legacy positions. Such a strategy should help it remain competitive, though investments in Mexico and a staggering ~$133 billion long-term debt position are cause for at least some concern. Debt-averse investors should look elsewhere.
Potential Weaknesses
Even with strong free cash flow generation year after year, we expect the pace of AT&T’s dividend growth to slow as investments and refinancing risks come back home to roost. Our biggest concern is the company’s massive long-term debt position (~$133 billion) post DirecTV closing, and the Time Warner deal will add more than $60 billion in debt. Deleveraging will become a focal point, and we doubt AT&T will maintain a free cash flow dividend payout ratio in the 70% range. Moody’s has placed the firm’s ratings on review for downgrade following the Time Warner announcement as the majority of the acquired free cash flow stream will be absorbed by additional cash dividend obligations and interest expenses.
AT&T’s second-quarter results, released in July, weren’t as strong as we would have liked them to be. We like to look at the numbers because the numbers tell the real story of what’s behind a company’s business. For the first half of 2017, revenue fell to $79.2 billion from $81.1 billion, while company-reported adjusted free cash flow dropped to $6.9 billion from $8.1 billion in the year-ago period. Though there were a number of items that we liked in the second-quarter report, including an expanding adjusted operating income margin, it’s hard to overlook the capital intensity of the company’s business, which is weighing on free cash flow generation, and the need for deal-making to grow the top line, which is threatening the balance sheet. Here’s what Moody’s had to say July 27, 2017:
AT&T’s strong competitive position, stability, scale and diversity of revenues result in tremendous qualitative credit strength. AT&T is the market leader in nearly all of its businesses and has valuable assets, predictable revenues, healthy margins and consistently invests for the long term. Yet, these qualitative strengths are offset by weak financial metrics, anemic growth and a broad vulnerability to disruption. Its balance sheet size could test the depth of the credit market, while its free cash flow after dividends is very limited. AT&T is susceptible to tighter credit, further competitive pressure, technological disruption and macroeconomic trends. We think this risk profile is asymmetrically skewed to the downside, especially if these potential negative developments were to simultaneously occur.
We think AT&T’s risk is amplified by its balance sheet size and being positioned at a low investment-grade rating, but we think AT&T has multiple shock absorbers that could help it defend its rating. In a downside scenario, AT&T could sell assets, cut capex and opex, reduce or eliminate its dividend or issue equity capital. Given its slim margin of safety, we will manage AT&T’s ratings with a narrow tolerance relative to our quantitative ratings limits. AT&T’s 2015 acquisition of DirecTV and its pending acquisition of Time Warner have reduced its reliance upon the wireless business, which will insulate AT&T from the intense competitive pressure in the US wireless market. Pro forma for Time Warner, we forecast that AT&T will derive 37% of revenues and 47% of EBITDA from wireless, down from 57% and 63% respectively in 2014.
The closing of the Time Warner deal will only further muddy the company’s GAAP accounting statements, which reveal a balance sheet that is already getting stretched. Through the first six months of 2017, reported free cash flow has covered cash dividends paid in the period, but cash dividends gobbled up more than 80% of reported free cash flow, and almost 90% of the adjusted measure provided on the company’s second-quarter presentation slide deck (pdf). The long-term picture of AT&T’s dividend isn’t as bright as it once was, especially as competition from Verizon (VZ) and T-Mobile (TMUS) heat up, but do income investors need to panic? Not really. AT&T could engage in asset sales or seek cost-cutting maneuvers before it would dare touch the payout, in our view. AT&T investors, however, should be taking note of the increased risk presented by a dividend yield now north of 5% at last check. We’re keeping a close eye on it.
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