Where Are We Now?
I don't think anyone is surprised about AT&T (NYSE:T) right now. What I mean is that there is no love, no momentum and no cheer. The market is clearly against T right now and the price shows it:
T is down well over 40% in five years. Even worse, the dividend has not even allowed investors to tread water. Buying at $38 back in late 2016 wouldn't have worked out very well. Here's the simple math.
- $38 buy price - $23 today's price = $15 "loss"
- Five years of dividends = $8 "profit"
Therefore, even with a hefty dividend, investors are still down $7. So, with all dividends added up, that's a loss of about 18%. The dividend dripping and related compounding isn't good enough here. If all dividends were reinvested investors are still looking at a loss 12-15% over the last five years, depending on the exact buy prices, tax implications and so forth.
Now, the main point here isn't to pour salt in an open wound. Trust me, I feel the pain. I've been in T for about six years. I'm getting at the fact that T's dividend has not provided any protection, or true upside whatsoever.
That said, during my recent analysis, something quite interesting popped up. It's very directly related T's dividend. In this article we'll take a fresh look a T's dividend in light of debt, and the spinoff coming in 2022. And, I won't delay the real punchline. T's management sees the WarnerMedia-Discovery transaction as being equivalent to a special, large, tax free dividend.
How Did AT&T Implode?
I won't spend much time on T's implosion since I've already covered this topic. Here's what I wrote:
AT&T's new standalone company can be explained by a single word: debt.
AT&T has been buying and merging with other companies for a long time. Everything gets more complicated, from brands, to value proposition, to leadership. Of course, all of this activity confuses the market too. But worst of all, the debt just keeps going up and up.
And then this:
Clearly, debt has been increasing faster than equity. Therefore, the company is being financed by creditors rather than by internal positive cash flows.
Third, here's how AT&T's debt is starting to wash up on the beach. That is, wave after wave of debt is coming due quite soon.
I bring this up because if the new T doesn't change how it manages debt then I suspect the culture of debt will likely eat away at T over time. That is, if debt piles up again, then we'll just end up back where we started. Sure, it might take many years but it's still a path of destruction if leadership doesn't adjust.
We'll get to the debt load in a minute. First, I want to point out that leadership is pounding the table on cash flows.
And that's we've either closed or announced 55 billion in asset transactions. In the last 12 months, this business has delivered over $26 billion of free cash flow. And we've got the capital structure now in place that will support the investments that we need to make in the communications company in our wireless network with the deployment of C-band as you're well aware of, and our 5G expansion as well as our fiber investments as we announced our goal to drive more than 30 million passings by 2025 as we restart the second major investment wave on our fiber portfolio.
Don't get me wrong here. I love the cash flow! However, that doesn't change the fact that debt is still a problem. And, future growth is highly dependent on capital investments, and almost certainly debt. Some things never change.
The flip side is that after the WarnerMedia transaction, T expects:
Significant debt reduction with Net Debt to Adjusted EBITDA2 in the 2.6x range after close, moving to less than 2.5x by year end 2023
Furthermore, they'll consider share buybacks once Net Debt to Adjusted EBITDA is less than 2.5x. They think they'll be below 2.5x by the end of 2023. We'll see. There are still many moving parts.
So, the balanced view is that T's handling of debt hasn't been the best, but they are using the WarnerMedia transaction to clear the deck. They'll use cash flows and better debt management to make things right. I shall remain bearish and skeptical until I see it clearly, going far into 2023.
Quick Thoughts On Future Debt Management
It's obvious that T is a capital intensive business and once T is smaller, debt will be easier to manage. Nevertheless, it'll still soak up cash flow and will require more debt to carry on. Here's a quick summary of the bull versus bear case on debt versus cash flow:
"Bulls see the telco pure-play, lower debt leverage and a healthier dividend payout cushion using the management team's $20 billion free-cash-flow (FCF) guidance," said Credit Suisse analyst Douglas Mitchelson in a recent client note. "Bears see profitless growth (stronger revenue/subscriber growth offset by capital investments), risks to the 2023+ FCF guidance, significant infrastructure and spectrum investment needs, and further shareholder rotation when the lower dividend kicks in, requiring a substantial yield premium."
My entire point is that it sounds like leadership isn't really going to do anything different in the future. If T's debt worried you before - and it should - then T's future debt management should also worry you. After all, leadership is singing the same tune going forward. This is a culture of debt.
And, lastly, once T is a smaller company, then it could look "lean and mean" for many quarters, even many years. It's unlikely that debt will be an immediate problem. However, we know where this road leads. If T doesn't significantly change how to they approach the business then my faith in T's dividend growth for the long haul will be greatly diminished.
I'll wrap this section in a simple way. T has plans to handle the debt. Cash flows in the smaller T will be certainly robust. However, it'll take years of proof to convince me that things have really changed with T's debt management. And now, as part of this debt management, T's leadership is setting up investors for something rather extraordinary. Let's pivot.
The 22% To 36% "Secret Yield"
T management pitched the idea that new WarnerMedia-Discovery company itself is almost like a big fat special dividend. Previously, I had missed this, which means that many other investors probably didn't catch it either:
The expected value of those shares based on the capitalization as of May 14, 2021, is in the $7-$8 range per share of AT&T stock, or the equivalent of 4+ years of AT&T's current annual dividend, tax free.
This comes straight from management. That said, we don't really know how the new company will actually be priced. Promises, promises. Right now, we're looking at guesses and estimates. Nevertheless, from a yield perspective, at today's prices, this is a mind boggling 31% yield at $7 and 36% at $8, if T keeps their word.
Even with the recent share price drop, whereby T investors only enjoy let's say $5-6 per share for the new company, that's still a yield on today's prices of somewhere between 22% and 27%.
Please realize that I'm not trying to be tricky or hyperbolic here. Instead, I'm emphasizing the news as presented by T management. And, even with a culture of debt, the truth is that if the WarnerMedia-Discovery company does roll out at a price of $7-8 (or, even $5-6) then investors are getting a huge tax free "yield" on T shares that are owned today.
The counterargument is that T's share price will drop even more, so that's not extra money. Hey, I understand. But, given the extreme decline in T's price since late May, it's looking like it might already be priced into T's shares:
In late May, T was right around $30. Today, we're looking at $22-23. Therefore, perhaps the "special dividend" has already been taken out by the market. It's hard to know for sure but it sure does look like we are right at a floor price for T, no matter how you slice it.
AT&T's Current & Future Dividend
With the "secret yield" idea out of the way, here's some more good news. T doesn't expect any dividend changes between now and the middle of 2022. That's when WarnerMedia-Discovery transaction takes place.
Therefore, current T investors can expect to grab at least another $1+ from T between now and then. Therefore, given the $22+ price right now, that's a real yield of almost 5% over the next half year or so. Not too shabby.
Furthermore, as you probably already know, here's what T management has said about how the dividend will look in the future:
Attractive dividend, subject to AT&T Board approval, with an annual dividend payout ratio3 of 40% to 43% on anticipated free cash flow of $20 billion plus
That was back in late May of 2021. Fast forward to late November of 2021 and we hear this:
- The wireline business is doing great.
- Fiber expansion is in a transition but doing fine.
...as I look out at our ability to hit our guidance over the next 2 to 3 years, I'm pretty confident that it's modest in what we can accomplish.
So, if we believe management, then debt will be managed well enough to keep their dividend promises. Again, per management, EBITDA moved down toward 2.5x and (of course) they expect a brighter future.
Regarding the dividend, the bigger picture is that we should see probably $8.2 billion to $8.6 billion in cash flow for this new business. Boiling that down, we're likely to see T stock in the future, after chopping off WarnerMedia, worth somewhere between $15 and $18. That'll likely translate to a future yield somewhere between 4% and 7%. If T wants to be conservative it'll likely be down closer to 4%, especially if T management really does plan to reduce debt and set things up for buybacks in late 2023.
Almost all of this is back-of-the-napkin because we have to guess at what happens between now and when the spinoff takes place. Adding more rigor won't change the big picture ideas:
- The new T will likely remain a debt driven company with hefty cash flows.
- The new T will give investors a reasonable dividend yield going forward.
- The current T set up and spinoff could generate a special 22-36% yield.
And, to emphasize again, the special dividend is likely to be $5-8 per the guidance of T management. While market conditions might push the exact price around, it's still significant. T management has functionally "translated" the WarnerMedia-Discovery shares into a special dividend, tax free. It's possible that once the veil of uncertainty is lifted, T price will rise. Often, it's uncertainty that kills stock prices, not business results.
All of this is to say that I'm sad about T's price action. While I have sold T a bit this year, I also still hold quite a bit. In light of this new perspective, I'm going to be less aggressive about selling out, unless I see highly beneficial tax loss harvesting. I do not love T's cult of debt, but I do like the dividend and I'm not totally against the WarnerMedia-Discovery business, which could do well. T is definitely a mixed bag. Therefore, I'm not going to do much. AT&T is a hold.
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