Image Source: AT&T Inc – IR Presentation
By Callum Turcan
Telecommunications, entertainment and media giant AT&T (T) is a free cash flow cow heavily burdened by a large net debt load, a product of past acquisition activity. As a free cash flow cow, AT&T has been able to steadily increase its dividend over the past three consecutive decades and shares yield 6.4% as of this writing. We like AT&T’s ability to generate a lot of net operating cash flow and respect its ongoing deleveraging efforts, but caution that the company won’t be able to pursue meaningful payout increases until its net debt load comes down further. Divestments are helping AT&T reach its leverage targets.
Monitoring Free Cash Flow and Net Debt
AT&T’s net operating cash flow came in at $38.4 billion, $38.0 billion, and $43.6 billion in 2016, 2017, and 2018, respectively, while its capital expenditures were $22.4 billion, $21.6 billion, and $21.3 billion during this period. This enabled free cash flows (defined as net operating cash flow less capital expenditures) of $16.0 billion in 2016, $16.5 billion in 2017, and $22.4 billion in 2018. We appreciate AT&T’s strong and consistent free cash flow, which easily covered $13.4 billion in dividend payments and $0.6 billion in share buybacks last year.
Last year, AT&T issued ~1.2 billion shares and paid ~$42.5 billion in cash to take over Time Warner in a deal that closed in June 2018. That’s on top of the net debt AT&T took on from Time Warner, which at the time of closing pushed AT&T’s consolidated net debt up to $180.4 billion. Note that AT&T’s diluted shares outstanding rose from 6.2 billion at the end of the first quarter of 2018 to 7.3 billion at the end of the first quarter of 2019 due in large part to the equity issuance side of this transaction.
AT&T expects to generate $26.0 billion in free cash flow this year with a targeted payout ratio in the high-50s% (of free cash flow). Adjusted EPS growth is forecasted in the low single digits. Management is targeting $1.0 billion in revenue-related synergies and $1.5 billion in cost synergies at AT&T, a product of its Time Warner acquisition, by the end of 2021 on a run-rate basis.
Management is committed to deleveraging efforts and aims to bring AT&T’s net adjusted to adjusted EBITDA ratio down from 2.9x at the time of closing to 2.5x by the end of this year. As of the end of its latest quarter, AT&T had a net debt load of $169.0 billion and the company wants to bring that down to $150.0 billion by the end of 2019. Keep in mind that this position weakens when including $3.7 billion in dividends payable at the end of March 2019. Being a free cash flow cow allows for significant deleveraging efforts while still maintaining a relatively high payout ratio.
Image Shown: AT&T is targeting additional divestments to meet its deleveraging targets. Image Source: AT&T – IR Presentation
In 2015, AT&T completed its cash-and-equity purchase of pay-TV provider DIRECTV in a deal worth $67.1 billion when including net debt. Due to the ongoing “cord cutting” phenomenon in American pay-TV markets, the purchase of DIRECTV didn’t stop the ongoing erosion in the pay-TV provider’s subscriber base which is weighing negatively on AT&T. An analyst from UBS Group AG noted that AT&T could spin off or sell DIRECTV, possibly to DISH Network Corporation (DISH), which in theory could provide a significant catalyst for T stock. That analyst went on further to highlight the risk of continued erosion in DIRECTV’s subscriber base with UBS predicting 2.8 million in subscriber losses this year. Early successes at DIRECTV Now have since reverted to major subscriber losses as well with no end in sight.
Reportedly, AT&T and DISH are open to potentially merging DISH's operations with DIRECTV's. Combined, these two pay-TV providers have lost over 2.7 million subscribers over the past year. A merger would seek to change that while also preserving pricing power, but it's not clear if a deal would get approved by federal regulators. While there is far more competition in this realm than there was twenty years ago due to the rise of streaming video services, anti-trust concerns are still very material.
Whether or not spinning off DIRECTV would behoove AT&T comes down to what price the firm might receive for that division (in an outright sale, a spin-off, or merger with DISH), how AT&T envisions itself as a company over the long haul, and what management would do with those proceeds. It isn’t entirely clear if AT&T would get a good deal for DIRECTV considering its current problems. As an aside, AT&T has made some acquisitions of its own in recent past, such as buying Otter Media for an undisclosed price.
AT&T agreed to sell its space at 30 Hudson Yards for $2.2 billion in a transaction that’s slated to close by the end of this quarter, keeping in mind that property is owned through WarnerMedia. This is part of management’s $6.0-8.0 billion asset monetization strategy, with $5.0 billion in deals already announced as of May 2019. Additional divestments are expected this year, and the proceeds from this deal are going towards debt reduction. AT&T has an agreement to lease the 30 Hudson Yards property through WarnerMedia through early 2034. In April 2019, Hulu announced it was buying AT&T’s stake in the streaming service for just over $1.4 billion. Management had this to say during AT&T’s latest quarterly conference call with investors:
“As you remember, I told you that paying down the $40 billion in debt that we took on to acquire Time Warner that that would be our top priority, and we are on target to retire 75% of that by year-end. This quarter, we generated free cash flow of $5.9 billion and brought our net debt down by $2.3 billion. And that puts us well on track for generating at least $26 billion of free cash flow for the full year.
And then already here in the second quarter, we’ve sold our stakes in Hulu and Hudson Yards. That generated an additional $3.6 billion of cash. And then John Stephens’ team is doing their typical great job. They’re driving down working capital and restructuring some collateral arrangements, and this is also adding significant cash flow and it’s giving us very clear line of sight to reaching our target of $6 billion to $8 billion from asset monetizations, so bottom line, we committed to driving our net debt to EBITDA ratio to around 2.5x by year-end, and we are right on track for achieving that.”
Integrating Time Warner into its company-wide operations and realizing expected synergies will go a long way in strengthening AT&T’s financials. AT&T’s dividend isn’t at risk of its large net debt load due to its sizable free cash flow generation, but its dividend growth potential is stymied by the need to pursue deleveraging activities. By 2020, it appears AT&T may consider changing its capital allocation strategies somewhat as you can see in this press release excerpt below:
"To the extent the company over-achieves on cash generation this year, AT&T said it will look at using a portion of its free cash flow after dividends to retire some of the shares it issued in conjunction with acquiring Time Warner, particularly with shares at today’s levels. Looking to 2020, AT&T said it will continue to generate significant cash flow, and it will continue to de-lever — though not at the same pace as in 2019."
Share buybacks may be in the works for 2020, depending on AT&T’s free cash flow trajectory over the next few quarters. We are more supportive of AT&T’s deleveraging efforts as that could lead to a resumption in serious dividend growth. The possibility the US Fed cuts interest rates may also be enticing management to consider slowing deleveraging efforts down in the medium term. As T shares trade at the lower end of our fair value range, derived from our rigorous enterprise free cash flow analysis, a decent argument can be made for share repurchases.
What We Think
Here’s what we think of AT&T, from our 16-page Stock Report:
"AT&T is one of the leading providers of IP-based communications services to businesses. The firm has the nation's largest 4G LTE network, and the largest international coverage of any US wireless carrier. The company's recent acquisitions of DirecTV and Time Warner have created a next-generation media giant, and it has big plans for bundling services in the near future. It is based in Dallas, Texas. AT&T is butting heads with rivals in the 'Race to 5G.' The company completed 5G trials in multiple cities since 2016, and it plans to have 5G technology in 500 markets by mid-2019. The company is starting on the path to a nationwide mobile 5G network.
AT&T acquired Time Warner for $85.4 billion in cash and stock in 2018. The deal has brought even more debt, but AT&T now has an attractive position in three key factors in next-gen media entertainment in premium content, direct-to-consumer distribution, and high-speed networks. $1.5 billion in cost synergies and $1 billion in revenue-related synergies on a run rate basis are expected by the end of 2021. AT&T's acquisitions have left it with $169.0 billion in net debt at the end of the first quarter of 2019.
However, the company generates substantial amounts of free cash flow and is targeting ~$26 billion in 2019 despite rising levels of capex. It is targeting net debt-to-adjusted EBITDA of ~2.5x by the end of 2019 thanks to ~$12 billion in free cash flow expected after dividends in the year. AT&T has raised its quarterly payout for 30+ consecutive years and targets a free cash flow payout ratio in the high-50% range in the near term. Buybacks may be curtailed. Moody's Corporation (MCO) downgraded its credit rating to Baa2 (stable outlook) following the Time Warner deal, which is no longer being pursued by the US DoJ."
We like AT&T’s investment grade credit rating, strong free cash flows, growth prospects outside of the pay-TV market, and its ongoing deleveraging strategy. The roll out of 5G services combined with potential media and entertainment growth offers multiple near- and medium-term catalysts. If the US Fed does cut interest rates, that would likely act as a very powerful tailwind for AT&T as its net debt load would become more manageable a lot faster (aided by easier access to credit as investors search for yield, and lower interest rates due to a better credit profile and lower rates overall). On the downside, AT&T needs to figure out a better strategy for its DIRECTV operations as subscriber losses continue, with DIRECTV Now offering little reprieve. We like AT&T as a high-yield consideration, but we generally prefer other names with smaller net debt loads.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
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AT&T is included in Valuentum's simulated High Yield Dividend Newsletter portfolio.