2018 has been the year of change for AT&T (NYSE:T) and, to be honest, I am sure that this company's management team is looking forward to starting a new year. AT&T closed the Time Warner acquisition in 2018 (well, sort of) and its management team has consistently provided a bullish outlook but, at the end of the day, the market is not yet sold on what Mr. Randall Stephenson, CEO, and team are selling.
AT&T's stock has been a consistent underperformer (i.e., the 1-, 3-, and 5-year stock performance is nothing to write home about) but, in my opinion, there are reasons to be optimistic about what 2019 may bring for this large company. There are a few things that need to fall into place - finalize the Time Warner deal, an efficient & effective 5G rollout, and get some "wins" in the streaming space - but I believe that there are two main metrics that have a material impact on the investment thesis. AT&T is (and has been) viewed as an income play, so investors should mostly be concerned about the sustainability of the dividend; therefore, I believe that investors will need to keep a close eye on the two metrics that really matter right now: (1) free cash flow metrics and (2) financial leverage.
To start, I believe that AT&T has the capacity to support its rich [and growing] dividend for the foreseeable future, but that does not mean that it will be smooth sailing over the next 12-18 months. Market sentiment has the real potential to wreak serious havoc if AT&T fails to manage the story - that is, fears/concerns can play a more significant role than the actual fundamentals when it comes to the performance of the stock. The stock performance over the last two years is a good case in point.
For a capital-intensive business like AT&T, I believe that investors should focus more on FCF than earnings when it comes to evaluating the dividend. As such, the following table should come as welcome news.
|$ - in millions||Nine-Month Period|
|Net cash provided by operating activities||$31,522||$28,473||$3,049||11%|
|Less: Capital expenditures||(17,099)||(16,474)||(625)||4%|
|Free Cash Flow||14,423||11,999||2,424||20%|
|Less: dividends paid||(9,775)||(9,030)||(745)||8%|
|Free Cash Flow after dividends||$4,648||$2,969||$1,679||57%|
|Free Cash Flow Dividend Payout Ratio||67.8%||75.3%||-7%||-10%|
Source: Data from Supplemental Q3 2018 Report; table created by author.
Make no mistake about it, AT&T's FCF metrics are improving and not deteriorating like some pundits would have you believe. Moreover, as we look ahead, it is important to note that management is guiding for the FCF metrics to further improve over the next 12 months.
Source: Investor Event, November 2018
The dividend payout ratio has not been in the 50s percent for quite some time, so this is definitely encouraging news. Additionally, FCF is projected to be in the $26B range, which is a significant increase from the $18B that was reported for fiscal 2017. Let's not forget that these results also factor in the ramp in CapEx that is expected for 2019.
In conclusion, AT&T's dividend is not only safe but this company also has the capacity to grow its payout ratio in the years ahead. However, I believe that management should not increase the dividend beyond the token 2% annual raise but, instead, should focus on improving the other metric that matters right now - the company's growing debt balance, i.e., financial leverage.
An investment in AT&T does not come without its risks. This company obviously operates in a highly capital-intensive industry, so AT&T typically carries a very high debt balance, which adds risk to the story. The DirecTV and Time Warner acquisitions greatly increased AT&T's financial leverage, as the company had to take on a significant amount of debt to close both deals.
Source: 2017 10-K
The percentage change in the debt balance says it all.
Debt is up big over the last three years, but as management has reaffirmed on several different occasions, this company has the cash flows to properly manage/service its liabilities.
Plus, there are two important points to consider: (1) the company has plans to retire or refinance a large portion of its debt in the near term and (2) the majority of the debt has fixed rates.
Source: Q3 2018 Earnings Presentation
Lastly, in addition to returning to a historical adjusted EBITDA-to-net debt ratio by 2022, management expects for the ratio to be at a more reasonable level by the end of 2019 (approximately 2.5x).
Simply put, AT&T's financial leverage is a risk factor, but I do not believe that it is a significant concern. I definitely plan to monitor the progress that management makes through 2019 but, in my opinion, the company's financial leverage should not cause investors to jump ship at this point in time.
AT&T's stock is trading at a steep discount when compared to its closest competitor, Verizon (VZ).
Moreover, T shares are trading at an attractive valuation when compared to its own historical metrics.
There are risks to AT&T's story but, in my opinion, the stock is currently oversold - the risks are more than priced into the stock at today's price. For example, AT&T's stock would be at the $35 level if shares were trading at 10x 2019E earnings (based on estimates per Yahoo! Finance). In my opinion, the stock would still be cheap at $35 per share.
The two metrics mentioned above (i.e., cash flows & financial leverage) are the most significant risk factors that need to be considered. If the cash flow metrics fail to impress in 2019, or if the leverage targets are not achieved, AT&T's stock will likely face major downward pressure.
Additionally, investors should closely monitor the progress that is made with incorporating the newly acquired Time Warner assets with the legacy businesses in the quarters ahead. Integration risk could potentially impact the stock in a material way over the next few years if investors are not sold on the long-term business prospects of the newly acquired assets, i.e., similar to the way that the DirecTV acquisition is viewed today.
While there are plenty of concerns when it comes to AT&T business model and management's strategy, I believe that this telecom company has great long-term business prospects - e.g., 5G rollout, international operations, and in the streaming space (including leveraging the newly acquired assets/content). Additionally, the Street is getting more bullish by the day (see here and here for recent upgrades for T shares) and I fully expect for more professionals to jump on the train in 2019.
Today, AT&T should still be viewed as a large defensive telecom company that pays a safe [and growing] dividend but, in my opinion, this narrative could turn on a dime with the changes that are occurring in the wireless and entertainment industries. However, at the end of the day, I believe that AT&T's stock will go as the two metrics - cash flows and financial leverage - go over the next 12-18 months. As such, the improving free cash flow prospects, coupled with the company's manageable financial leverage position, make the stock a long-term buy at today's price.
Author's Note: I hold a sizable AT&T position in the R.I.P. Portfolio and I have no plans to reduce my stake in the near future.
Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.
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Disclosure: I am/we are long T, VZ. 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.