Warren Buffett sold AT&T (NYSE:T) out of Berkshire Hathaway's (NYSE:BRK.A) (NYSE:BRK.B) portfolio of high-yield dividend stocks during the first quarter of 2016. Warren Buffett acquired his stake in AT&T during the third quarter of 2015 as a result of AT&T's acquisition of DirecTV.
Buffett had owned DirecTV prior to the acquisition (his first purchase was in 2011), so his shares converted into AT&T stock once the deal closed because the acquisition was a stock and cash transaction.
Despite AT&T's high dividend yield near 5% and seemingly cheap price-to-earnings multiple (14.2), Warren Buffett apparently thought there were more attractive options to put his money to work.
Let's take a closer look at the safety and growth potential of AT&T's dividend as well as the company's overall appeal as a potential investment opportunity for dividend investors.
Upon closing its $49 billion acquisition of DirecTV in 2015, AT&T expanded its reach to offer connectivity services (e.g. voice/data, pay-TV, broadband Internet) to 355 million people and businesses in the U.S. and Mexico.
AT&T is the largest carrier in the world with approximately 128 million subscribers. No other telecom business has ever had as many subscribers across each service line as AT&T does now.
New Segments Following DirecTV Acquisition
Business Solutions (49% of 2015 sales): AT&T provides mobile and IP networks and integrated solutions to 3.5 million businesses, including nearly all the Fortune 1000.
Entertainment Group (24%): AT&T provides video, Internet, and voice communication services to U.S. customers. The company is the largest pay TV provider in the world. Most of DirecTV's operations reside in this segment.
Consumer Mobility (24%): AT&T provides consumers with nationwide wireless voice and data service, including Internet, video, and home monitoring services.
International (3%): AT&T's wireless operations in Mexico and DirecTV in Latin America. The company's LTE network in Mexico will cover 75 million people by the end of 2016.
Most of AT&T's markets are characterized by very high barriers to entry and are dominated by just a handful of companies, resulting in fairly predictable earnings.
Imagine trying to launch a competing wireless network. Not a single rational consumer would sign up for your wireless voice and data service if you couldn't offer them nationwide coverage, which requires billions of dollars to be invested in spectrum and network infrastructure alone.
Over the last five years, AT&T has invested more than $140 billion to build and maintain one of the largest wireless, fiber, and IP networks in the world, and the company's capital spending runs around 15% of service revenues.
AT&T spent over $20 billion on capital expenditures each of the last three fiscal years and invested nearly $18 billion for acquisitions of spectrum licenses last year to keep its leading wireless network performing.
New entrants lack the financial firepower to effectively compete with AT&T's low cost structure, asset efficiency, and hard-to-replicate networks. To make matters even more challenging for new competitors, most of AT&T's markets are very mature. The number of total subscribers is simply not growing much.
In other words, it would be almost impossible for new entrants to accumulate the critical mass of subscribers needed to cover the huge cost of building out a cable, wireless, or satellite network.
In addition to covering network costs, AT&T's scale allows it to invest heavily in marketing and maintain strong purchasing power for equipment and TV content. Smaller players and new entrants are once again at a disadvantage. Barring a major change in technology, it seems very difficult to uproot AT&T. It's much easier to maintain a large subscriber base in a mature market than it is to build a new base from scratch.
AT&T's acquisition of DirecTV in 2015 strengthened its competitive advantages and marked a significant shift in strategy for the company. Prior to the deal, AT&T generated close to 75% of its income from wireless operations. DirecTV made AT&T the largest pay-TV provider in the world and launched the company down a path focused on cost synergies and bundling services to drive earnings higher.
In a mature market such as pay-TV, it can make sense to acquire more subscribers and cut out costs. AT&T expects $2.5 billion in annual synergies by the end of 2018 from the integration of DirecTV. Most of the synergies will come from negotiating lower video content costs (AT&T's pay-TV base expanded from 6 million subscribers to more than 25 million with DirecTV), streamlining installation, and integrating customer support activities.
As the largest integrated communications company in the world, AT&T sees a number of opportunities to bundle its phone, TV, and broadband services.
Bundles can be more price-effective for consumers while also raising switching costs. AT&T has noted that approximately 15 million DirecTV customers currently do not use its wireless products, and more than 20 million of its wireless customers do not have DirecTV. It remains to be seen if AT&T's bundling strategy will be effective, but there is certainly some potential for market share gains over the coming years.
Outside of the U.S., AT&T recently acquired Nextel and Iusacell to go after the wireless market opportunity in Mexico. The company now provides coverage nearly across the entire country and expects to invest several billion dollars to continue developing its network in the country.
While the company's International segment only accounted for 3% of total sales last year, AT&T believes its Mexican operations could eventually grow to be at least 25% of the size of its U.S. wireless business over the long term.
DirecTV's exposure across Latin America provides additional opportunities for incremental growth in markets that are much less mature than the U.S., but these initiatives will take time to move the needle for a company as large as AT&T.
At the end of the day, AT&T seems to enjoy a strong economic moat due to its ability to provide customers with their video, data, and communication needs anytime, anywhere, and on any device. Few companies have the financial firepower and brand strength to effectively compete.
However, the telecom industry and consumer preferences are constantly evolving, making incremental earnings growth more challenging for the large incumbents.
With the boom in smartphone demand hitting a plateau, Verizon and AT&T are both in search of new areas for growth outside of traditional wireless services.
The "Internet of Things" could bring new wireless data growth opportunities in areas such as smart cars and automated homes, but these categories are much smaller than the total revenue generated from smartphones today.
If growth in the wireless market remains weak, the battle for existing subscribers could intensify between carriers, pressuring the industry's strong margins. AT&T's acquisition of DirecTV was perhaps a move to lessen its dependence on the wireless market, but it also increased the company's exposure to another area struggling for growth - pay-TV.
Perhaps the biggest long-term risk facing AT&T is the increasing pace of change in its saturated markets. The company took on substantial amounts of debt to acquire DirecTV, but it's no new news that consumers are increasingly seeking out ways to avoid paying for TV. Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN) Prime are two examples of streaming services that are enjoying strong demand.
AT&T is developing a set of DirecTV-branded streaming services that will launch near the end of 2016 in an effort to target cord-cutters. However, it remains unknown what impact this will have on DirecTV's overall subscriber growth, which was rather weak prior to AT&T's acquisition of the business.
DirecTV's total U.S. subscribers expanded from 19.2 million in 2010 to just 20.3 million at the end of June 2015, representing a 1% annualized growth rate. As the Internet's speed has increased and a number of new connected devices have been adopted over the last decade (e.g. smartphones, tablets, smart TVs), online streaming is a threat to traditional pay-TV that won't be going away any time soon. In fact, total cable TV subscribers fell for the first time last year.
AT&T's wireless and Internet businesses diversify away some of the pay-TV risk and should benefit from increased streaming (i.e. more data and bandwidth consumption). However, you have to hope that AT&T's management was focused on the long-term outlook for the industry when it bought DirecTV and wasn't simply trying to maximize near-term earnings with cost synergies.
While AT&T is looking to drive growth across its wireless and pay-TV businesses with bundling, another part of the company's operations continue to struggle.
Legacy wireline voice and data products accounted for 16% of AT&T's total revenue last fiscal year and are in secular decline. Revenue generated from these products fell approximately 9% last year and will likely continue to decline at a similar pace as the market continues to migrate more to software and wireless solutions.
If AT&T wants to grow earnings over the long run, its bundling plan and strategic investments will need to overcome this headwind and combat potential technological disruptions.
Despite the flurry of changes rippling through industries such as pay-TV, I still expect most parts of the telecom industry to continue generating dependable cash flows for years to come. With that said, the threat posed by non-traditional competitors such as Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL), Amazon, and Netflix should not be ignored - especially in pay-TV.
Should the pace of technological disruption accelerate in any of AT&T's major markets, the company's debt load could become a more legitimate concern.
Let's take a look at the company's dividend.
Dividend Analysis: AT&T
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Dividend Safety Score
Our Safety Score answers the question, "Is the current dividend payment safe?". We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher are very good, and 25 or lower are considered weak.
AT&T's Dividend Safety Score of 88 suggests that the company's dividend is very safe. The company's strong dividend safety is driven by its reasonable payout ratio, non-discretionary services, excellent free cash flow generation, and proven commitment to its dividend. Over the last four quarters, AT&T's dividend payments have consumed 64% of the free cash flow the firm has generated.
As seen below, we can see that AT&T's free cash flow payout ratio has been pretty consistent over the last decade, generally remaining between 50% and 70%. I like to see a steady payout ratio because it can indicate that the company's dividend growth (if any) has been fueled by underlying growth in earnings and free cash flow. While a payout ratio near 70% is getting to be on the high side of what I prefer to see, it is more acceptable for companies with very predictable earnings such as AT&T.
Source: Simply Safe Dividends
Speaking of business stability, AT&T performed well during the last recession. We can see that the company's sales edged down just 1% in fiscal year 2009, and AT&T's free cash flow per share actually grew from $2.35 in 2008 to $3.01 in 2009.
Consumers and businesses continued to rely on AT&T's Internet, voice, video, and data services during the economic downturn. The rise of smartphones didn't hurt either.
Source: Simply Safe Dividends
One of the best qualities about AT&T is its free cash flow generation. Without free cash flow, companies cannot sustainably pay dividends unless they issue debt or equity.
AT&T has generated positive free cash flow for more than a decade. Maintaining communications networks is extremely capital intensive, but AT&T's subscriber base is so large and sticky that it more than covers the company's capital spending requirements each year.
Source: Simply Safe Dividends
A company's return on invested capital is important to analyze because it provides clues about their moat and ability to quickly compound earnings. Simply put, businesses that earn high and steady returns are creating economic value and usually have a stronger ability to pay steady, growing dividends.
Since AT&T is a capital-intensive business, it's not a big surprise to see that it has historically earned a return on invested capital in the mid-single digits, which is about in line with the average return earned by all stocks in the market.
While the company's return is nothing to get overly excited about, it has remained pretty consistent over time, highlighting its predictability.
Source: Simply Safe Dividends
If there is one knock against AT&T's dividend safety, it would be the company's balance sheet. As a result of AT&T's acquisition of DirecTV in 2015 and purchase of additional spectrum, the company's debt level exceeded its historical norm. The company expects to reduce its debt back to its target range within three years using the cash flow it has left over after paying dividends.
Source: Simply Safe Dividends
Despite its elevated debt level, AT&T's dividend safety remains strong in my view. The company's non-discretionary services, consistent free cash flow generation, and reasonable payout ratios all support its ability to continue making dividend payments as it works down debt in the coming years.
It also has assets it could sell off (e.g. Mexico/Latin America operations) if there was an unexpected shock to the business, which I view as a highly unlikely event.
Dividend Growth Score
Our Growth Score answers the question, "How fast is the dividend likely to grow?". It considers many of the same fundamental factors as the Safety Score, but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher are very good, and 25 or lower are considered weak.
AT&T's Dividend Growth Score is 35, which indicates that the company's dividend growth potential is below average despite its status as a member of the Dividend Aristocrats list.
AT&T has increased its quarterly dividend for 32 consecutive years. However, as seen below, dividend growth has remained in the low-single digits for a long time.
Looking ahead, I expect dividend growth to remain between 1% and 3% per year. AT&T expects its dividend payout ratio to remain in the 70s as a percentage of free cash flow going forward. In other words, there is little room for the dividend to grow faster than the company's growth in underlying free cash flow.
With a number of technological changes gradually impacting a number of AT&T's markets such as pay-TV and wireless, it's hard to imagine a company of this size growing much faster than a couple of percentage points per year. Dividend growth will follow a similar path.
AT&T's shares trade at a forward-looking P/E ratio of 14.2 and have a dividend yield of 4.7%, which is lower than their five-year average dividend yield of 5.4%.
Telecom, utilities, and consumer staples have been bid up, thanks to investors' thirst for yield. Given the relatively low earnings growth profile of these sectors (generally speaking), it's hard to feel overly excited about most of their valuations today. In the case of AT&T's total return potential, the company has increased its free cash flow per share by 2.2% per year over its last five fiscal years.
I believe low growth will likely to continue due to continued customer losses in legacy wired voice and data products and the mature state of the pay-TV industry.
Assuming low-single-digit earnings growth continues over the long term, the company' stock appears to offer annual total return potential of 6-8% (4.7% dividend yield plus 1-3% annual earnings growth). After returning more than 20% over the past year on expectations for "lower for longer" interest rates, AT&T's stock would be more interesting to me on a pullback and at a 5%+ dividend yield.
AT&T's dividend track record has not been achieved by most businesses, and the company's current dividend continues to look very safe. Despite the company's resiliency and status as a blue-chip dividend stock, it's hard for me to feel overly excited about investing in AT&T today.
The stock doesn't look particularly cheap after its run over the last year, and it's hard to gain conviction in the company achieving much earnings growth over the next five years. AT&T has placed itself in a handful of markets undergoing different levels of technological change while taking on a lot of debt in the process. While management's big bet on DirecTV could pay off, I would rather take a "wait and see" approach today.
For investors seeking reliable income, there is no shame in owning AT&T for its dividend. However, there are enough reasons to see why Warren Buffett decided to part ways with AT&T after it acquired his shares of DirecTV.
Disclosure: I am/we are long VZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The author has no position in T.