AT&T (NYSE:T) is still one of the best performing stocks of 2016, but the stock has lost just a bit of momentum recently along with other income stocks. The company is set to report its earnings on Tuesday, April 26th and analysts have started revising estimates as the big day nears.
In a recent report covered on Seeking Alpha, Pac Crest slashed estimates for both AT&T and Verizon (NYSE:VZ) due to lower iPhone upgrades. But the report fails to take into consideration the fact that everyone knows a new iPhone is on its way in September and most people would avoid upgrading until then unless forced to do so (broken phone, change of carriers, etc). However, we aren't too keen on the iPhone numbers for this quarter or even the next few ones for that matter. iPhone is a known story and demands are fairly predictable, especially given the fact that we are talking about AT&T here and not Apple (NASDAQ:AAPL), which is viewed as a iPhone-only story these days.
The number we are looking forward to is the free cash flow, as AT&T has just completed three quarters after the official closing of its DIRECTV acquisition. The first two quarters since the acquisition showed that dividend coverage based on free cash flow improved drastically. To put that into numbers, dividends consumed 71% and 183% of the free cash flow in Q3 and Q4 for 2014. The post-DIRECTV AT&T consumed only 55% and 95% of the free cash flow for the same quarters in 2015.
In the first quarter of 2015 [ending March 2015], AT&T reported free cash flow of $2.89 billion and had 5.19 billion shares outstanding. The company was paying 47 cents per share/quarter in dividends and hence needed around $2.43 billion to cover its dividends. This represented about 84% of its free cash flow for that quarter.
Based on the current dividend of 48 cents per share/quarter and share count of 6.15 billion, the company needs to report at least $2.95 billion in free cash flow to cover its dividends. To show meaningful improvements due to DIRECTV, we are looking for a total free cash flow of at least $3.60 billion in this quarter. We believe this is easily achievable due to two reasons:
- DIRECTV, when it was a stand-alone company, generated $927 million in free cash flow in the first quarter of 2015. If you add that number to AT&T's $2.89 billion reported in the same quarter, we arrive at $3.817 billion that the integrated company should be able to achieve at least to maintain its standing.
- When one major company acquires another, operating efficiency tends to improve over time due to cost-savings and process integrations.
Keep in mind, we aren't looking at whether the dividends are safe. They are safe, especially given the company's rich history. Instead, we are closely monitoring the impact DIRECTV has on AT&T's free cash flow. The DIRECTV deal has been expected to improve the company's dividend coverage, and it's important that investors monitor the same. We've always advocated using free cash flow to determine a company's ability to cover its dividends. This makes more sense for a capital intensive business like AT&T. Earnings per share [EPS] could mislead investors due to special events, one-time charges, and credits. Free cash flow is immune to these situations.
- Friday's closing price of $38.07 gives the stock a current yield of 5.04%, which is a psychological barrier for many income investors just like the 4% mark is for those who use the 4% withdrawal rate. Expect the stock to garner some support around the 5% yield mark given the low interest rates.
- Another thing we are closely watching is the fact that AT&T is still in the race to get some piece of Yahoo's (NASDAQ:YHOO) core business units. Verizon is the front runner, but AT&T is backing Yellow Pages owner YP in this contest. Getting a core online advertising platform through Yahoo will most certainly divert more traffic to AT&T as we explained in a prior article. It will be interesting to see if the earnings call sheds some light on this move.
The way this market has been acting recently, even fairly good earnings are punished as the general market is priced for perfection. If AT&T satisfies the free cash flow number we are looking for, we will be looking at adding more shares if the stock goes down after earnings. Make no mistake about it, a 5% yield is still very meaningful in spite of all the noise about increasing rates. In addition, there aren't too many safe stocks in the market that yield 5%.
Disclosure: I am/we are long T, AAPL.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.