AT&T (T): Is The Highest-Yielding Dividend Aristocrat A Value Trap Or A Bargain?

When it comes to safe and consistent dividend growth, few companies have done it better than the dividend aristocrats, S&P 500 companies with 25+ consecutive years of payout increases under their belt.

 

Of these impressive dividend growers, AT&T (T) stands tall above all the rest with a 5.9% dividend yield. When combined with the company’s 33 straight years of dividend increases, AT&T could deserve consideration as one of the best high dividend stocks.

 

One of the reason’s AT&T’s yield is so high is because the company’s stock price has dropped by more than 15% over the past month. That’s a surprisingly big move for a stock that is held by most investors for its safe income and defensive qualities.

 

With concerns growing over AT&T’s pay-TV subscriber losses, uncertainty over the Time Warner (TWX) merger gaining final regulatory approval, and the company’s massive debt burden, some of the stock’s underperformance seems justified.

 

Let’s take a closer look at the issues affecting Ma Bell to see if the stock’s dividend yield, which sits near its highest level since 2011, appears to be attractive for a diversified income portfolio or is instead a sign that AT&T is becoming a value trap.

 

Business Overview

Founded in 1983 as SBC Communications (the company bought AT&T in 2005 and adopted the more famous moniker), AT&T is a telecom and media conglomerate that operates four business segments:

 

Business Solutions (43% of 2016 sales): offers wireless, fixed strategic, legacy voice and data, wireless equipment, and other services to over 3 million business, governmental, and wholesale customers, as well as individual subscribers.

 

Entertainment (31% of 2016 sales): provides video entertainment and audio programming channels to approximately 25.3 million subscribers; broadband and Internet services to 12.9 million residential subscribers in over 240 markets; local and long-distance voice services to residential customers, as well as DSL Internet access services. This division has connections to over 60 million locations nationwide.

 

Consumer Mobility (20% of 2016 sales): offers wireless services to over 136 million U.S. customers and wireless wholesale and resale subscribers, such as long-distance and roaming services, on a post and pre-paid basis.

 

This segment also sells a variety of handsets, wirelessly enabled computers, and personal computer wireless data cards through company-owned stores, agents, or third-party retail stores, as well as accessories, such as carrying cases, hands-free devices, and other items.

 

International (4% of sales): offers digital television services, including local and international digital-quality video entertainment and audio programming under the DIRECTV and SKY brands throughout Latin America. This segment also provides postpaid and prepaid wireless services to approximately 13.1 million subscribers under the AT&T and Unefon brands; and sells a range of handsets.

 

Business Analysis

The key to AT&T’s ability to generate such high and growing dividends over time is the wide moat created by the extremely capital intensive nature of the industries in which it operates.

 

For example, AT&T spent more than $140 billion between 2012 and 2016 on maintaining, upgrading, and expanding its networks, including over $22 billion in 2016 (13.4% of revenue).

 

Few other companies can afford to compete with AT&T on a national scale. Only Verizon (VZ), T-Mobile, and to a lesser extent Sprint (S) have the resources to operate networks that offer similar levels of connectivity.

 

To make matters even more challenging for new competitors, most of AT&T’s markets are very mature. The number of total subscribers is simply not growing much.

 

In other words, it would be almost impossible for new entrants to accumulate the critical mass of subscribers needed to cover the huge cost of building out a cable, wireless, or satellite network.

 

In addition to covering network costs, AT&T’s scale allows it to invest heavily in marketing and maintain strong purchasing power for equipment and TV content. Smaller players and new entrants are once again at a disadvantage.

 

Barring a major change in technology, it seems very difficult to uproot AT&T. It’s much easier to maintain a large subscriber base in a mature market than it is to build a new base from scratch.

 

While AT&T’s wireless division is its most consumer-facing business, the company’s strong presence in hundreds of broadband internet markets, as well as its expansion into pay-TV, via the $67 billion acquisition of DirectTV in 2015, have helped it continue growing despite a highly saturated U.S. market in both wireless and internet service.

 

Source: AT&T Earnings Presentation

 

In addition, DirectTV has allowed AT&T to bundle many of its offerings to customers, helping it fend off the worst of the cord-cutting trend that has plagued so many of its rivals.

 

In fact, AT&T showed continue improvement in phone churn and has seen satellite churn drop by 50% when bundled with wireless. More of its pay-TV customer base is also using the company’s wireless plans compared to two years ago.

 

 

With plans to acquire Time Warner, the media content juggernaut, in an $109 billion mega-acquisition (including debt), AT&T hopes to better leverage its various platform offerings to remain competitive in the cutthroat wireless industry.

 

For example, thanks to T-Mobile reviving the popularity of unlimited data plans, once price insensitive rivals such as Verizon have been forced to reduce their wireless plan prices to $80 per month for unlimited data (first line).

 

In contrast, AT&T offers a $90 unlimited plan that continues to gain subscribers thanks to the company bundling a $25 pay-TV discount, as well as offering free HBO (a Time Warner company).

 

In fact, thanks to the popularity of these bundled unlimited data plans, AT&T’s postpaid churn rate (what percentage of subscribers leave each month) hit a record low for the third quarter of 0.84%, and the wireless segment’s EBITDA margins have risen to a record high of 42%.

 

In other words, AT&T’s track record of expanding into media and related industries appears to be bearing some fruit, including hitting its synergistic cost saving targets and leveraging its new platforms and properties to strengthen its existing core offerings.

 

That in turn has allowed it to achieve higher-than-average profitability in a massively capital intensive industry not known for its impressive margins or returns on shareholder capital.

 

AT&T Trailing 12-Month Profitability

 

AT&T could also be poised to see very strong growth in free cash flow (what funds and grows the dividend) due to ongoing vertical integration efforts and the economies of scale that go with it.

 

 

If the Time Warner acquisition goes through, AT&T would enjoy a higher-margin business (Time Warner’s operations are relatively much less capital intensive) that is also growing faster, helping fuel a continued rise in AT&T’s free cash flow.

 

That in turn could accelerate AT&T’s long-term dividend growth and total return potential, once AT&T uses the additional free cash flow to pay down the debt it’s taking on to fund the deal.

 

Meanwhile, while still not itself a needle-moving business segment, AT&T’s international divisions are continuing to grow nicely thanks to AT&T successfully gaining new customers in Mexico.

 

That’s a market it entered in 2014 with its $4.4 billion purchases of lusacell and Nextel Mexico to gain access to a fast-growing region; one in which the population is expected to grow 32% between 2010 and 2050 to reach 156 million people.

 

Management has previously stated that they believe AT&T’s Mexican operations could eventually grow to be at least 25% of the size of its U.S. wireless business over the long-term, and subscribers grew 29% year-over-year last quarter.

 

 

In other words, while international may still be a small fraction of sales, AT&T’s strong presence in Latin America means that it also offers long-term double-digit organic growth potential.

 

At the end of the day, AT&T seems to enjoy a strong economic moat due to its ability to provide customers with their video, data, and communication needs anytime, anywhere, and on any device. Few companies have the financial firepower and brand strength to effectively compete.

 

However, the telecom industry and consumer preferences are constantly evolving, making incremental earnings growth more challenging for the large incumbents.

 

Key Risks

While AT&T has historically been a relatively low risk stock, there are nonetheless several major risks to be aware of.

 

Domestically, AT&T’s organic growth has basically stalled because of the saturated nature of the markets it operates in.

 

 

On the wireless side, smartphone saturation and the rise of T-Mobile (TMUS) have intensified competition for existing subscribers. The major players have been forced to offer unlimited data plans to maintain their subscriber bases, losing out on lucrative data overage fees.

 

While there was hope of industry pricing becoming more rational with T-Mobile and Sprint (S) appearing likely to merge, the chances of a deal have taken a hit in recent weeks.

 

There’s also hope that the “internet of things” could bring new wireless data growth opportunities in areas such as smart cars and automated homes, but these categories are much smaller than the total revenue generated from smartphones today.

 

If growth in the wireless market remains weak and there is no further consolidation, the battle for existing subscribers could intensify between carriers, pressuring the industry’s strong margins.

 

Perhaps more concerning, AT&T’s big bet on DirecTV has shown some cracks in recent quarters. You can see that DirecTV satellite subscribers declined during the second quarter and saw an even larger drop during the third quarter.

 

 

Craig Moffett, an industry analyst for Moffett Nathanson LLC, said in a Bloomberg Radio interview that DirecTV is now probably only worth about half what AT&T paid for it ($67 billion)!

 

The rise of over-the-top streaming services could be winning over traditional pay-TV subscribers at an increasing pace. AT&T launched its own streaming service, DirecTV NOW, and has seen it grow to more than 800,000 subscribers in less than a year (compared to company-wide TV subscribers of about 25 million).

 

However, DirecTV NOW is at a much lower price point than satellite TV and is far less profitable. It also risks cannibalizing AT&T’s higher-margin, traditional pay-TV subscribers.

 

Given some of these pressures, the company’s domestic sales, earnings, and free cash flow are almost entirely dependent on continued large-scale acquisitions.

 

For example, while AT&T reported strong double-digit growth in 2015 and 2016, that was entirely due to the DirecTV acquisition. Once those favorable comparison quarters passed, the growth rate basically returned to zero.

 

 

While the Time Warner deal has the potential to once again boost growth, investors need to realize two important risks about that transaction.

 

First, a successful integration of Time Warner is far from assured. After all, due to overpaying and failed synergistic cost savings, approximately 87% of large acquisitions fail to generate shareholder value. These are two companies with very different cultures and lines of business.

 

In addition, The Wall Street Journal recently reported that the U.S. Justice Department is preparing a potential lawsuit challenging AT&T’s planned acquisition of Time Warner if the government and companies cannot agree on a settlement.

 

Should the Department of Justice block the acquisition, then not only would AT&T lose an excellent opportunity to boost its overall profitability and growth prospects, but it would also incur a $1.73 billion breakup fee and face greater strategic uncertainty with plans for its existing businesses.

 

Meanwhile, when it comes to AT&T’s organic growth potential in its international segment, success is similarly uncertain.

 

That’s because while AT&T’s Mexico wireless business is growing strongly, the company is by far the smallest fish in the Mexican wireless sea, facing off against far larger and very well-capitalized rivals such as Telefonica and America Movil.

 

 

Even if AT&T does manage to gain market share in Mexico, keep in mind that it’s far from certain that it will be able to do so while generating the same kinds of impressive 40+% EBITDA margins as its U.S. wireless business does.

 

After all, Mexico is still a developing economy where per capita wealth is far lower than in the U.S., meaning more price-sensitive consumers.

 

AT&T’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

AT&T has a Dividend Safety Score of 78, indicating a highly secure and dependable dividend compared to most other companies’ dividends in the market.

 

While the company’s Dividend Safety Score will likely fall closer to 60 if the merger with Time Warner closes (and more debt is on the balance sheet), there are two keys to AT&T’s impressive track record of secure and growing payouts over the years.

 

First, management has been disciplined to grow the dividend at approximately the same rate as free cash flow, allowing the company to maintain a relatively safe (for its industry) FCF payout ratio.

 

AT&T has generated positive free cash flow each year for more than a decade. Maintaining communications networks is extremely capital intensive, but AT&T’s subscriber base is so large and sticky that it more than covers the company’s capital spending requirements (and dividend) each year.

 

 

This is important because, while AT&T’s business is highly stable (and recession resistant), the amount it spends on capital investment each year to maintain and grow its networks is volatile.

 

By generally sticking to a stable 60% to 70% FCF payout ratio, the dividend is always well covered by cash flow even in years of especially high spending.

 

AT&T also performed well during the last recession, providing greater proof of its ability to reliably generate enough cash throughout all types of conditions. The company’s sales edged down just 1% in fiscal year 2009, and AT&T’s free cash flow per share actually grew from $2.35 in 2008 to $3.01 in 2009.

 

Consumers and businesses continued to rely on AT&T’s internet, voice, video, and data services during the economic downturn. The rise of smartphones during the last recession didn’t hurt either.

 

The other important dividend safety factor is AT&T’s balance sheet. The company’s balance sheet was already looking a little stretched following its acquisition of DirecTV in 2015 and its purchases of additional spectrum. If the Time Warner merger goes through, AT&T’s debt load will substantially increase (more on that later).

 

 

Of course, because it operates in several highly capital intensive industries that generate predictable cash flow, AT&T can be expected to have a large amount of debt, which it does.

 

 

To get a better sense of just how manageable this debt load is, we need to compare these metrics to its industry peers.

 

While AT&T has a slightly higher than average leverage ratio (Debt/EBITDA), it’s overall debt-to-capital ratio is actually about average. Meanwhile, the current ratio (short-term assets/short-term liabilities) is much better than average, and the high interest coverage ratio means the company’s cash flow can easily service its debt payments.

 

 

This is why, despite one of the largest total debt loads in corporate America, AT&T still enjoys a strong investment grade credit rating, which allows it to borrow cheaply at an average interest rate of just 3.6%.

 

However, an important caveat is that after the Time Warner merger closes at the end of 2017 (assuming final regulatory approval), the company’s debt burden will increase substantially.

 

 

AT&T management has stated they expect to repay debt with free cash flow and return the company’s leverage to historical levels within four years of the Time Warner deal closing, according to The Dallas Morning News.

 

Adding more debt raises AT&T’s annual interest expense, could result in a credit rating downgrade (raising its cost of capital), increases refinancing risk, and leaves less margin for error if industry conditions change faster than expected.

 

Here’s what Moody’s noted:

 

“The deal’s financing costs will consume the majority of acquired free cash flow due to an incremental $2.3 billion in annual dividends and $1.3 billion in additional after-tax annual interest expense.

 

Moody’s believes that given AT&T’s limited excess cash after dividends and modest EBITDA growth potential, that organic leverage reduction is limited to around 0.1x to 0.2x annually…

 

AT&T’s funded debt balance could exceed $170 billion following the transaction close and average annual maturities will be greater than $9 billion starting in 2018…This may cause AT&T’s cost of debt to rise, especially in times of market stress. Rising benchmark rates, combined with wider credit spreads would put pressure on AT&T’s free cash flow.”

 

While this much higher debt load seems likely to remain manageable, courtesy of the combined company’s substantial free cash flow stream, investors need to realize that paying down debt is going to be the primary use of Time Warner’s additional earnings.

 

As a result, the Time Warner acquisition isn’t likely to boost dividend growth anytime soon. Investors worrying about the deal compromising AT&T’s ability to pay dividends may find some comfort in management’s recent commentary.

 

“We continue to have strong cash flows, and we view that very positively, particularly as we have great coverage on our dividend. And as we go to that time of year, we want to make sure that we continue and we will be able to continue to provide our board the opportunity to continue raising our dividend if they so choose for the 34th consecutive year.”

 

Furthermore, AT&T’s free cash flow generation remains robust. The company’s free cash flow grew by more than 13% year-over-year to reach $5.9 billion in the third quarter, which compares to approximately $3 billion of dividends paid during that period.

 

On a year-to-date basis, AT&T has generated $12.8 billion of free cash flow compared to $9 billion of dividends paid (i.e. 70% free cash flow payout ratio).

 

Time Warner has generated $3.6 billion of free cash flow year-to-date, up 8%. If we annualize and combine each company’s free cash flow amounts and account for higher interest expenses from the merger, we get a ballpark figure free cash flow figure of around $18 billion to $20 billion (before any merger integration costs).

 

With AT&T’s annual dividend commitment expected to rise to $14.5 billion following a successful merger with Time Warner, the combined company’s free cash flow payout ratio would likely sit around 70% to 80%.

 

That would leave only around $5 billion of excess free cash flow (after paying dividends) each year that can be used to gradually reduce AT&T’s estimated total debt burden of approximately $190 billion.

 

Management has also stated they plan to divest some assets over the next two years to raise cash that can be used to further assist with debt reduction.

 

The stakes are clearly high, and it’s not out of the question that AT&T’s dividend could become at risk within several years if some markets shift faster-than-expected in unfavorable directions (e.g. wireless commoditization, pay-TV declines accelerate).

 

The company also becomes more dependent on favorable credit market conditions and potentially has less wiggle room to invest as heavily in future initiatives (e.g. 5G infrastructure, spectrum) or acquisitions.

 

AT&T not only needs to deliver on its expected cost synergies, but it needs to hope that its big bets on bundling, pay-TV, and content are the right ones to keep it relevant in a fast-changing technology world.

 

As Bloomberg noted, there are no other companies offering TV distribution, mobile distribution plus content. This is a bold strategy that could differentiate the firm for the better, or it could ultimately have costly consequences.

 

AT&T’s Dividend Growth

AT&T’s very slow payout growth is likely to continue for the foreseeable future. This shouldn’t come as a surprise to investors given that the dividend growth rate has never been all that quick and has decelerated over the past decade.

 

 

While the company’s free cash flow will be substantially larger (and presumably faster growing) if the Time Warner merger closes, AT&T’s high debt level (in addition to increased capital spending on new 5G telecom infrastructure) will likely mean that investors will have to settle for 1% to 3% annual dividend increases over the next decade, assuming everything goes as planned.

 

Valuation

Over the past year, AT&T has underperformed the S&P 500 by more than 25%, resulting in an interesting valuation case for contrarian investors.

 

That’s because AT&T’s forward P/E ratio of 11.3 is not only lower than the telecom sector’s 11.9, but also the stock’s historical norm of 17.6.

 

More importantly for income investors, T’s yield of 5.9% is significantly higher than its five-year average and about the highest it has been since 2011.

 

 

Assuming AT&T’s dividend remains secure over the coming years, which seems more likely than not, the company does not have to do much for investors to achieve a decent total return.

 

Due to its slow growth profile, AT&T has potential to generate long-term annual total returns of about 7.9% to 8.9% (5.9% dividend yield plus 2% to 3% annual earnings growth).

 

While that’s not the most impressive return profile, it’s not bad considering the stock’s relatively low volatility (over the past five years, AT&T has been about 50% less volatile than the S&P 500) and defensive qualities.

 

Conclusion

AT&T has taken a number of bold steps in recent years to proactively take on changing industry conditions across wireless, video, and media markets.

 

It will probably take at least several years to determine just how savvy these massive capital allocation bets actually are. For now, AT&T remains a mature cash cow that is a reliable source of income over at least the short to medium term.

 

However, any dividend investor considering AT&T must understand and accept the risks that come with the company’s ballooning debt load and evolving business strategy, assuming the Time Warner deal gains approval (which seems more likely than not).

 

Between AT&T’s sluggish growth in wireless postpaid subscribers and recent DirecTV satellite subscriber losses, there are certainly a few signs that the company’s bundling strategy and large-scale expansion into pay-TV may not be living up to expectations.

 

Investors must not forget that AT&T’s acquisitions of DirecTV and (likely) Time Warner give it meaningful exposure to two companies that are facing their own unique sets of disruptive challenges. These are far from sure bets.

 

If industry conditions take an unexpected turn for the worse or management becomes distracted (very different cultures and businesses would be combining), the company’s debt burden, refinancing risk, and elevated payout ratio could become a big deal within the next five years.

 

With that said, there appears to be a lot of pessimism in the company’s share price today. Investors hate uncertainty, and AT&T is providing plenty of it thanks to larger-than-expected satellite TV subscriber losses and a longer-than-anticipated wait on regulatory approval for the Time Warner deal.

 

This certainly isn’t the predictable AT&T of old, but as part of a well-diversified income portfolio, the company’s stock looks interesting for investors who are comfortable with the risks.

 

As Warren Buffett likes to say, be greedy when others are fearful (see Buffett’s dividend portfolio here).