AT&T: The Big Battle

About: AT&T Inc. (T), Includes: AMZN, DIS, NFLX
by: Stefan Redlich

Stocks rise and fall every day on numerous reasons.

Whenever great dividend stocks plummet, lucrative long-term opportunities can emerge.

Despite the market's rebound not every rising tide lifts all boats.

The markets have rebounded strongly from their Christmas Eve's low following rising optimism surrounding the U.S. - China trade war. Still, despite the markets rallying there are always individual stocks underperforming the markets or even dropping. For long-term dividend investors seeking reliable and rising income every drop represents a potential opportunity.

(Source: AT&T Investor Relations)

One of those stocks is AT&T (T) which is down 20% from its high and yielding almost 7%.

AT&T - Patience is key

AT&T's stock price has been trapped in the $28-$32 area for months and despite some occasional sharp ups and downs the stock never managed to exit that range.

Chart Data by YCharts

While this means zero capital appreciation for investors, it is actually great news for long-term dividend investors as it creates an extended opportunity to accumulate shares at rock-bottom prices.

The investment case for AT&T can be easily described with three simple words: Patience is key! AT&T has three key challenges to tackle:

  • Turn-around declining EBITDA in its legacy Entertainment Group and stabilize earnings
  • Priority in 2019 will be to repay debt. 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
  • Following the final verdict in the AT&T vs. Time Warner case it needs to integrate Time Warner properly and build up new avenues for revenue growth

The Entertainment Group

For Q4/2018 in total, AT&T 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 the company 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.

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)

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.

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.

Debt Repayment

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.

Source: SEC Filings and author's calculations

The Time Warner integration

After almost 2.5 years after AT&T announced the $85B acquisition of Time Warner, AT&T finally got the unrestricted approval. It marked the end of countless months of uncertainty as the Department of Justice appealed the initial verdict. Although there has only been a very, very slim chance that the appeal proves successful it hindered AT&T to fully integrate Time Warner and realize the projected synergies. Now that attempts to unwind a merger have been stopped once and for all, AT&T can focus on what is important.

Shortly after that decision AT&T gave a business update to reiterate the company's plans for 2019. The key points are:

  • Gross capital investment of $23B
  • Free Cash Flow in the $26B range with a dividend payout ratio in the high 50% area
  • $12B of that will be channeled towards debt reduction leaving AT&T with a net debt-to-adjusted EBITDA of around 2.5 times by year-end
  • Develop an all-new streaming service

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.

It's unlikely that even if launched at the end of this year it will take some time for the new service to gain momentum. Hence, already today AT&T has announced to launch a new "slimmer Live TV Packages with HBO included". The key here of course is HBO access, which is the second time AT&T is seeking HBO to leverage its content and excite customers. The new bundles "DirecTV Now Plus" and "DirecTV Now Max" are priced at $50/month or $70/month respectively. That change is actually not a surprise as AT&T already announced months ago that it wants to thin out its offerings, especially at times where its overall streaming subscriber customer base is declining. As its launching these new offerings almost at the end of the quarter the upcoming Q1/2019 earnings are highly unlikely to shed any light on how they are performing and if they can help to offset the declines AT&T is currently confronted with.

Investor Takeaway

In summary, AT&T has to cope with a myriad of challenges in 2019 as it undergoes arguable the biggest business transformation in its history. Investors willing to wait and show patience can currently collect a record 6.7% yield. The company will execute its business plan

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.

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Disclosure: I am/we are long T, 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.

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.