AT&T: Even More Patience Required

About: AT&T Inc. (T)
by: Stefan Redlich

AT&T has been yielding 7% for quite some time now, and the post-Christmas rebound couldn't be supported by the most recent earnings.

While the dividend yield itself is a dream for long-term dividend investors, the current state of the business requires even more patience on the part of investors.

2019 is a very crucial year, as the company has to cope with plummeting video subscribers, debt repayment and the launch of a new streaming service.

Will patience be rewarded?

AT&T (T) and the general market have rebounded nicely from their Christmas Eve lows, but the most recent earnings for Q4/2018 have not ignited any sort of excitement among investors.

(Source: AT&T Investor Relations)

It's a familiar story for AT&T investors to see the stock drop following earnings, and this time was no different. While EPS was in line with expectations, a big half-billion revenue miss and a dramatic decline in subscribers resulted in a 5% post-earnings decline, and the stock itself remains trapped in no-man's land.

More patience is required for investors to see any kind of stock appreciation as the company focuses on several major key priorities this year. Can it pay off?

What is going on at AT&T?

Another earnings release for AT&T, and again, investors were not impressed. Earnings rose 10% and revenues by 15%, as the completed but somehow still pending Time Warner merger has been accretive from day one.

Although T only missed revenue by 1%, the real story was its whopping loss of subscribers in the Entertainment Group. In total, it lost around 650,000 video subscribers - 267,0000 from DirectTV Now and 391,0000 traditional video subscribers - driven by expiring discounted introductory offers.

This is very similar to what had already happened in Q3/2018, when AT&T lost almost 300,000 video subscribers as promotions phased out. Now that we have seen two quarters of record subscriber losses, it's time to shed light on how that is impacting the bottom line.

Compared to a year ago, the Entertainment Group saw revenue decline by $0.4 billion in Q4/2018 and by $0.7 billion in Q3/2018. Adjusted EBITDA margin, meanwhile, fell by 2.5pp in Q4 and by 2.7pp in Q3. We can at least read a slight improvement on the EBITDA impact from these numbers, but the much better thing to consider is that by the end of Q4/2018, there are no more subscribers remaining on discounted promotional price offerings. DirectTV Now got slightly more profitable in Q4 overall, but excluding those "low-value, high-churn customers" from the data, DirectTV Now was able to improve its ARPU by almost $10 sequentially.

In my previous article, I wrote that "the customers AT&T is losing could be high-value or low-value customers," and now we most definitely know the answer to this. AT&T clearly burned through its customer base in the fourth quarter, but the customers dropping out were mostly those the company could always re-chase if it chooses to offer promotional promotional pricing.

With less subscribers left in the pool that are much more profitable, AT&T remains confident that it can hit its goal of stabilizing EBITDA for the segment in 2019 and is eyeing "real improvement in year-over-year EBITDA results starting in the first quarter."

(Source: AT&T Investor Relations - Q4/2018 Earnings Presentation)

This goal is very crucial for the long-term story as the Entertainment Group is still responsible for 15% of AT&T's earnings. And as long as the new streaming service has not been launched and proved successful there is always the risk of further dilution of the customer base as rivals like Netflix (NFLX) are drawing in new subscribers in large numbers.

Analysts on the call and investors on the market were certainly not impressed by these results and the explanations and color given by management also provided no real support. Investors need to be patient and give it more time. Admittedly, these issues are not new and so far the only development we have seen is a negative one and so it will be Game On for AT&T in 2019. I am still patient despite being underwater with the stock but management remarks like this sound very reasonable to me even though in the short-term they do not help the investment case:

And so we told you in November, there were 500,000 of those customers on the promotional pricing and we started allowing those customers to attrit out. That obviously has a significant impact on dilution. The product has been dilutive in 2018.

This is one of the main drivers of the dilution and this is also one of the primary triggers as we move into 2019 to getting us to EBITDA stability, as we begin to get the promotional subscribers out and now we have a customer base that's left on the streaming that's growing. Remaining customer base is growing and is a highly engaged customer base and has good churn characteristics.

And so we actually like where we are in terms of how we're positioning the streaming product, and as I said, it's a major driver to how we get to EBITDA stability next year

Source: AT&T 2018/Q4 Earnings Call

For short-term oriented investors, it is easy to claim that T is dead money and management incompetent, but if AT&T finally delivers on these statements in a way that we can see in the officially reported numbers, patience will finally pay off.

Although the Entertainment Group was the main culprit for the results and the main focus during the call, there is much more going on in 2019 for AT&T, as shown on the "Key 2019 initiatives slide" above.

For me as a dividend investor, the main focus is on a sustainable dividend, sufficient free cash flow and substantial debt reduction, as I have not invested into AT&T to see huge stock gains. Admittedly, I have also not invested to witness capital destruction of 20% or more, but as long as I am confident in the long-term investment case, this has little meaning for me apart from seeing a big red number in the portfolio.

For full-year 2018, which includes 6 months with Time Warner, the dividend payout ratio was 60% despite a seemingly weak first quarter with a dividend payout ratio of 109%. In contrast, Q4, despite featuring a higher dividend, sported by far the lowest payout ratio in 2018 and helped bring down the yearly payout ratio to its lowest level since 2012.

Source: Author's visuals supplied with data from AT&T's earnings releases

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

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 6.9% dividend is in danger.

AT&T has always been a cash flow king, and substantial synergies from the Time Warner merger are expected to hit $700 million in 2019 and significantly more in 2020 ($2 billion) and 2021 ($2.5 billion). Although this is a far cry away from the giant $85 billion 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 $28 billion, a truly impressive figure which will be a great lever to further pull down that $171 billion in debt that AT&T owns.

For 2019, management is aiming to reduce that mountain of debt by as much as $20 billion, with $12 billion contributed by FCF after dividends and the remaining up to $8 billion stemming from asset sales. In the ideal case, that will bring down the net debt-to-EBITDA ratio from a current 2.8x to 2.5x-2.6x and leave the company with $150 billion in debt remaining.

That is still a big number, but for a company that is generating over $20 billion in FCF in a year, it is certainly possible to service these debt obligations, while at the same time continue to pay juicy dividends and substantially invest into its business. For 2019, gross capital investment is expected to be in the $23 billion range, which just shows that AT&T is a cash flow monster that is able to retain more than half of its operating cash flow as free cash flow.

Over the next four years, from 2020-2023, the company will have to redeem almost 1/3rd (~$60 billion) of its total current 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 $136.5 billion with full-year EBITDA expected to grow to $68 billion by year end. Assuming its 2019 cash balance of $10.8 billion 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 1/3rd from current heights and certainly demonstrates that AT&T is, in principle, more than capable of managing that debt risk.

Investor Takeaway

We can easily see that the reasons why AT&T is trading at such a high yield are nothing the company can quickly fix given a series of disappointing earnings. It remains a "Show Me" story.

If AT&T really shows us that its key initiatives in 2019 will respectively be accomplished and pay off, the markets will reward that. So, long-term investors will need even more patience. If an investor does not have that, AT&T is certainly the wrong stock to choose.

With a current cost basis of $35.50 (excluding dividends and FX), I am certainly in the red, but by averaging down over the last year, I was able to substantially lower my cost basis while receiving big dividend checks. Admittedly, even a 7% dividend pales in comparison to a 30% drop in the stock when it hit its low of $26.80, but unless you need the capital you have invested and thus are forced to sell, you have not lost a penny.

I'm patient, and I remain patient as I am playing the long game, but I can also understand those who have lost patience and consider AT&T a big empire in its final, yet not glorious, stages.

Disclosure: I am/we are long T. 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.

Additional disclosure: 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.