The Big Elephant In The Room For AT&T And 3 Things To Watch Out For In 2019

Summary

• We will see cash flow rising to new heights.
• We will see significant debt reduction.
• We will see a new AT&T with an all-new streaming service as it directly fights with Netflix and others.

2018, although it is not yet over, has been a dismal year for AT&T (NYSE:T) investors. While the dividends kept rolling in like clockwork, the rest of the business performed nothing close to Swiss clockwork, and as a result, the stock tanked up to 25% before making up some lost ground at the end of November.

Source: arstechnica.com, all image courtesy remains

This has pushed the yield to levels we haven't seen since the Great Recession and the current yield of 6.4% is by far the highest of any dividend aristocrat.

T Dividend Yield (TTM) data by YCharts

It is also substantially above that of its main rival Verizon (VZ) which, by the way, has had a great year.

T data by YCharts

Markets are always looking towards the future, and now that AT&T has given a first glimpse on what it expects for 2019, it is the perfect time to review that guidance, challenge it and put emphasis on three things investors should look out for in 2019. I have a very strong interest in AT&T's stock as it is my largest holding both in terms of cost basis and in terms of dividend income, and as such, it is vital to constantly review and reconsider this investment. Without further ado, here are three things that will shape AT&T's 2019.

1) We will see Cash Flow rising to new heights

For 2019, management is expecting to generate $26B in free cash flow, up from around $21B in 2018 and significantly higher than my conservative estimate of $23.9B I used for an in-depth analysis of AT&T's debt profile and its ability to service that giant pile of debt - but more on that later. Dividends in 2019, factoring in the usual $0.04 per share increase to be announced in December, are expected to amount to around $15.1B which will bring the free cash flow dividend payout ratio down to 58% which is very much in line with AT&T's guidance "in the high 50% range". That is a substantial reduction from the 70% payout ratio I am projecting for 2018 and leaves substantial leeway to factor in any type of execution risk.

This will ensure a very high degree of dividend safety, and while the current yield reflects the current level of risk as AT&T transforms from an "old-economy-like telecom" to a well-diversified, content-driven media enterprise, it does not mean that the sky-high 6.4% dividend is in danger.

AT&T has always been a cash flow king and substantial synergies from the Time Warner media are expected to hit $700M in 2019 and significantly more in 2020 ($2B) and 2021 ($2.5B). Although this is a far cry away from the giant $85B AT&T paid for Time Warner, should these synergies really be realized at that scale, that big bet suddenly no longer appears that big anymore. Factoring in the 2021 run rate in synergies until 2030 would already return realized accumulated synergies of almost $28B, a truly impressive figure which will be a great level to pull down that $190B in debt AT&T owns.

With these massive multi-billion dollar figures, it is easy to lose perspective as only a tiny fraction of the population will ever deal with such amounts or has already dealt with them. For instance, $26B in free cash flow would be enough to service the annual debt obligations of Malaysia ($12.4B) and Thailand ($14.4B) combined which have a total combined debt load of $377B ($228B for Malaysia and $149B for Thailand), almost double AT&T's debt load.

Summary: AT&T will generate even more cash than expected in 2018 which will ensure a safe and slowly growing dividend and leave massive funds available for debt reduction.

2) We will see significant debt reduction

Ever since the DirecTV acquisition in 2015, AT&T's debt load has started to balloon, culminating in a record debt level of $190B in long-term debt. Although I haven't yet become a fan of the DirecTV acquisition, I fully endorse the Time Warner deal as despite the seemingly high price, AT&T acquired a business in very healthy state with a vast library of content, just what it needs to prevail in the new digital age of streaming.

However, the markets have not yet warmed up to that deal at all, as ever since the acquisition was announced, the stock shed almost 1/3 in market cap, and although it is not clear what exactly the market is opposing here, I strongly assume it is the fact that despite AT&T's strong cash flow it has not started paying down debt. This has dragged the stock price to historic high yields and has been a gift for investors scooping up shares at depressed prices. Such an investment, however, is only adequate for those who understand the big business risk AT&T is exposed to amid its giant transformation. And whenever you talk about risk in connection with AT&T, debt immediately takes center stage.

2019 will and has to be the year where AT&T substantially deleverages its balance sheet, showing that its reasoning for acquiring Time Warner is sustainable and affordable. From Q4 2018 to the end of 2023, AT&T will have to pay down debt of $73B of which $8.6B will be due in 2019. Factoring in $26B in 2018 FCF will allow AT&T to pay all its dividends, all its debt maturing in 2019 and still have around $2B left.

Source: Figures used from AT&T's quarterly filings

Let's see how this development will impact AT&T's leverage. At the end of Q3 2018, AT&T's net debt stands at $181.4B and its YTD EBITDA amounted to $41.1B. Extrapolating full-year 2018 EBITDA based on the latest quarterly performance gives us annualized EBITDA of around $57B as a conservative estimate or a net debt to EBITDA ratio 3.18.

For 2019, AT&T expects to grow EPS in the low single digit, i.e., we use 2% as EBITDA growth resulting in full-year EBITDA of around $63B (using the latest quarterly EBITDA from Q3 2018 of $15.8B multiplied by 4). We expect AT&T's cash position to grow by around $2B to $10.8B with debt reduced to $174.4B. This will now result in a net debt to EBITDA ratio of 2.6 and thus very close to AT&T's guidance which calls for "around 2.5x by year-end".

Over the next four years from 2020-2023, AT&T will have to redeem almost 1/3 (~$60B) of its total debt amount which will notably exceed free cash flow after dividends in three out of four years. Although this will slow down debt repayment, AT&T's total debt by end of 2023 will decline further to $136.5B with full-year EBITDA expected to grow to $68B by year-end. Assuming AT&T's 2019 cash balance of $10.8B remains unchanged (i.e., any gaps between FCF after dividends and redeemable debt will be funded with new debt) gives us a net debt to EBITDA ratio of just under 2 and as such represents a deleverage of more than 1/3 from current heights and certainly demonstrates that AT&T in principle is more than capable of managing that debt risk provided that the big elephant in the room, namely its all-decisive bet on streaming and DirecTV will pay off.

3) We will see a new AT&T with an all-new streaming service as it directly fights with Netflix and others in an attempt to compensate for the sharp fall-off in subscribers for its traditional TV segment

In 2019, it is "Game On!" for AT&T as this will be the year which shows whether its strategy of bundling content and entering the streaming wars can and will pay off. AT&T itself expects stable EBITDA from its Entertainment Group for the year, but behind that assessment is a complex and diverse set of "gives" and "takes" that can make or break that guidance.

Source: AT&T Analyst Event November 2018

For me the biggest question marks are behind the first two bars "video subscriber losses" and "linear improvement" which AT&T basically expects to completely cancel out each other. I don't have the insights into AT&T's daily operations to assess that projection, but what I can do is lay out some risk factors AT&T has to cope with.

In the last quarter, AT&T lost almost 300,000 video subscribers as it dropped promotions mostly around DirecTV Now and instead raised prices by $5. This is the latest observation of an alarming trend that has AT&T seen total DirecTV Now subscribers collapse to 49,000 in Q3 2018, down from more than 300,000 in Q2 and roughly the same over the corresponding period during the previous year. If that signals the beginning of an accelerating downward trend, it is certainly a big concern for the company. But I do not want to be too pessimistic here as there are always two sides to a medal.

The customers AT&T is losing could be high-value or low-value customers, and according to information from AT&T's earnings call, it is mostly:

"folks that are just jumping from promotion to promotion and really spinning in the industry between us [AT&T], Hulu Live, YouTube TV".

Source: AT&T Q3 2018 Earnings Call

Although that information is publicly available here on Seeking Alpha, I believe that only a fraction of investors ever gets to know about that, but it is crucial in understanding that. Although the 300,000 loss in video subscribers looks sky-high, it was actually significantly better than what AT&T expected. And as a result...

"That customer base that we burned off, if you will, in the third quarter, and that we may or may not going forward chase in any given quarter, is always available. It's very promotionally-sensitive and price-sensitive, so you can always go get that business when you find the economics to do it so – or advantageous as a result of, for instance, what you can do on ad-supported models."

This implies that the big drop we saw in Q3 is very unlikely to continue in Q4 as you can only lose those "promotionally-sensitive and price-sensitive" customers once while those highly-engaged with the service are much more likely to pay that additional $5 and have a much lower churn. Speaking in terms of churn, though, AT&T cannot afford to let it out of control as too many customers leaving mean declining profits and less cash flow to be channeled towards debt repayment. This will be especially relevant for the current Q4 during which a lot of subscriber additions from late 2016 will come off promotional pricing. Assuming those are not the low-value customers AT&T can just burn off as it could easily attract them back into the system at the right price, AT&T might have to secretly increase its promotional activities in Q4 to manage churn and keep its guidance.

The big elephant in the room for AT&T is whether its transformation into a media company will generate enough sales and attract enough customers to manage the decline in its traditional TV business.

Source: trilovespeaks.com - all image courtesy remains

As such, AT&T will launch its new big streaming service in Q4 2019 that comes with a three-tier pricing setup.

Source: AT&T Analyst Event November 2018

While in theory that setup looks appealing, in the end, it will all come down to three ingredients: pricing, quality and quantity of content, and customer service. As a German living in Germany, I have never used any AT&T product or service, but based on personal consumer spending for Amazon Prime (AMZN) and Netflix (NFLX) and the monthly TV bill, I'd pay €15 for the premium service and I personally believe that this will be most highly sought after tier based on the initial feature set shown above. However, before AT&T goes full-scale with that approach, I sure hope that it will test multiple setups and price points with different customer segments and also run tests mirroring the setup of extremely successful yet unprofitable Netflix. And don't forget, when AT&T goes beta with its service, Disney (DIS) will already go live with its own Disney+ streaming service.

The number of cord-cutters is estimated to have already reached 25M in the U.S. by end of 2017, much worse is expected to happen over the next 5 years. According to eMarketer, the number is expected to more than double as an estimated 20% of the population could have cut the cord.

This is a forecast which is as good as any other forecast, but regardless what exactly the data figures in and what it doesn't, it is impossible to argue against the fact that traditional cable and satellite TV is in decline. The most important reason for people to cut the cord is price which has drawn millions of Americans to cheap monthly packages from Amazon Prime, Hulu and Netflix. The fact that industry leader Netflix is posting multi-billion dollar losses due to high and rising cost for content is reason for concern overall but won't help AT&T in retaining its customers.

In fact, it actually hints at the fact that it will be very tough for AT&T to sell bundled packages at higher prices than its default DTV NOW offering to customers. As long as the price remains cheap, there is no reason to expect cord-cutting from slowing down which in turn means that AT&T faces a big challenge to bundle its content from Time Warner with DTV NOW at prices that offset the decline of its traditional cable business.

Investor Takeaway

I will be following closer than ever how AT&T's 2019 unfolds, as in my view, it will be the decisive year to gauge whether its business transformation and strategy can succeed. That said, 2020 when the all-new streaming service will be fully in place will be big as well. For 2019, though, I have outlined three main topics that will shape AT&T's financial year and thus also how its stock performs.

After a dismal 2018, it seems logical that 2019 will be better but only if AT&T delivers on its cash flow generation, pays down debt substantially and ultimately limits the impact from the erosion of its traditional TV business.

I still believe it can work, but it is "Game on" now for the new AT&T to deliver.

What do you think? Can AT&T rise to the challenge and prevail in a fiercely competitive market or will it have to alter its strategy, whatever this could mean?

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Disclaimer: I am not offering financial advice but only my personal opinion. Investors may take further aspects and their own due diligence into consideration before making a decision

Analyst’s Disclosure: I am/we are long T, AMZN, VZ, DIS. 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.