Prepared by Tara, senior analyst at BAD BEAT Investing
Stocks are going back on sale, as they have taken back a lot of gains from the last two weeks. This consolidation is supremely healthy. Friday's (May 1st) stumble turned what would have been a winning week into a losing one, which was a disappointment to be sure, but it is giving investors a chance to scoop up opportunities. Although we turned bullish at the end of March and issued a series of buying recommendations, our bullishness has waned a bit in the last week. We have said repeatedly that it is not necessary to chase gains. That is usually a loser's strategy, and we aren't having it. The selloff to end last week is not a reason to panic yet. A little weakness now may ultimately be a good thing, letting stocks catch up with what's been relatively indiscriminate optimism. There's room for a little more selling, in fact, before stocks suffer too much of a blow to reasonably recover. That idea certainly blows the whole "Sell in May and go away thing" out of the water this year.
This is one of those years, however, where expecting history to steer stocks might be a bad strategy, because we are in unprecedented times. But one name is committed to its dividend. One name is still covering its dividend even in these unprecedented times. That name is AT&T (NYSE:T). There are some possible revenue catalysts coming in the way of HBO Max, a management change, and some insider buying. If we set the COVID-19 impact aside for a moment, the first quarter was pretty much what we had expected and was decent. All things considered, we still love buying the stock in the $20's with a safe dividend that is now yielding over 7%. Now is exactly the time to be buying, when the yield is this high and the dividend is safe. Buy shares in the high $20's. Let us discuss.
Revenue pressure in Q1
Those who closely follow the company are likely aware that revenues had begun to flatten for the company until Time Warner's assets were brought under the AT&T umbrella. We had seen the positive impact in 2019, but revenues in Q1 2020 were hit hard mostly because of a bad March, and they showed slight contraction from a year ago:
Source: SEC Filings, graphics by BAD BEAT Investing
The thing is that analysts covering the company were targeting a consensus of $44.15 billion, while were perhaps too liberal in our $44.35-44.75 billion expectation for this metric. Although we expected pressure in Q1, handicapping the actual impact was quite difficult. We felt the impacts from the loss of video subscribers from struggling DirecTV and ongoing promotions in the wireless business would continue, and so our expectations, if met, would have meant revenues were essentially down about 1% from a year ago. However, the posted result of $42.78 billion was well below all of these estimates. There were declines at WarnerMedia reflecting strong theatrical carryover revenues in the first quarter of 2019, continued declines in video subscriptions and legacy services, lower wireless equipment sales resulting from the store closures and declines at Vrio from foreign exchange impacts. There were near-universal revenue declines across the operations, though Xandr saw increases, as did wireless revenues in Mexico. It is also worth noting that there was growth in wireless service revenues and strategic and managed business services. Still, the top line saw pain.
Earnings matter, but the dividend is key
Even though there was a lower-than-expected top line, the bottom line saw nice growth, stemming from solid expense control. We saw EPS up from last year's Q1, but it came up just short of expectations. We were looking for low-single digit growth to $0.86-0.87, and this figure was missed by $0.02 on the low end:
Source: SEC filings, graphics by BAD BEAT Investing
Our thought process to arrive at our estimate of $0.86-0.87 per share stemmed from changes in share count and the well-managed expenses we saw, while factoring in our slightly more liberal revenue expectations versus the Street's. Earnings per share were expected to be around $0.85 by analysts. Performance was decent here. As we look ahead, bear in mind that the company pulled most of its guidance - and we agree with this move - but it gave us some clues in its commentary that lead us to believe the dividend is secure. Considering share count and an increased dividend, the payout ratio will still remain comfortably low, likely still in the 60-70% range for the year, unless there is real disaster. With this understanding, we urge investors to keep a close watch on the impact to cash flows and dividend coverage moving forward. We believe the growing dividend is more than secure for years to come. If you want to gauge the safety of the dividend, there are a few key metrics to look at. We think keeping up on operational cash, free cash flow, and the dividend payout ratio is of paramount performance.
Operational cash
For Q1, we were projecting strong cash from operations, expecting this to be around $10.5-11.0 billion, but with lower-than-expected revenues, the operating cash metric came in well below this estimate. We were not surprised at these results this quarter once we saw the revenue figure. Operational cash that was generated was $8.9 billion. We presume that cash from operations will decline in the high single digits moving forward for the next few quarters, and this realization impacts free cash flow expectations. Free cash flow is a vital metric for the dividend.
Make sure you watch free cash flow
Let us be very clear. Free cash flow is a key metric, and it is vital to the dividend payment being considered secure. We were eyeing $28 billion for the year 2020 in free cash flow, thanks to the boost from WarnerMedia as we entered the new decade back in January. My, how things change quickly! We expected free cash flows to exceed last year's pace significantly, and we were eyeballing around $5.5-6 billion considering capex spending of $4.5-5.5 billion and operational cash of $10.5-11.0 billion. Well, when we saw revenues, and then operational cash, it was pretty clear free cash flow would take it hit, but we suspect H2 2020 will be much better than H1 2020, especially if economies start opening back up by mid-summer.
With COVID-19 playing an obvious role, as well as the launch of HBO Max and ongoing wireless initiatives, we think if free cash flow comes in $1-$2 billion lower versus our past expectations in the next two quarters. Even with this huge hit to free cash flow, the metric could still register a strong $24 billion this year. Overall, increasing free cash flow has been a priority for the company, but in these unprecedented times, it is just not reality, and that has implications for the most critical metric of dividend safety, which is the dividend payout ratio.
Even after all the drama, still a fine payout ratio
As we mentioned, free cash flow impacts the dividend payout ratio. No dividend cut is on the table - it is just not. The cash flows are too strong (even with a quarter or two of real pain ahead). So strong that we continue to see a $0.04 annual dividend payment per share increase. The payout ratio was still favorable in Q1, as dividends paid were $3.8 billion and free cash flow nearly $4 billion. It is very close to 100%, but keep in mind, please, not even counting COVID-19, the first quarter is typically the lowest free cash flow quarter for AT&T due to the timing of employee incentive compensation and vendor payments for holiday equipment sales. Management said the dividend is safe, so don't just take our word for it! On the conference call, management stated that it sees the 2020 payout ratio in the 60% range. That is stellar, all things considered. That is not even remotely concerning as far as dividend safety is concerned.
Even with a prolonged and more severe hit to revenues and cash flows, it really seems hard for the payout ratio for 2020 to be anywhere near a risk to the dividend. Sure, actual results could be worse. But we believe operations will be back to normal by this time next year. As such, we want to be scaling in under $30 a share now. If free cash flow comes in at $23-25 billion for the year, we project the payout ratio will remain be 60-65% for the year. At approximately $15 billion in dividends paid out this year, divided by the projected $23-25 billion in 2020 free cash flow, we arrive at the estimated payout ratio. This is very safe and leaves a lot of wiggle room for the market to deteriorate further.
Take home
There really is not a better time to be buying shares of AT&T. Let the market give you a price in the $20's, then come in and buy. You have to take advantage of these selloffs and buy this dividend yield. A safe 7% is an attractive buy, and by all accounts, there is no cause for concern as far as the dividend goes.
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