Prepared by Chris, Tara, and Stephanie of BAD BEAT Investing
It needs to be asked. Is there really any more of controversial, yet incredible stock than AT&T (NYSE:T)? Our analysts have talked about how it is a zombie stock, but not dead money. We have told you to remember what you own (a dividend stock). The stock still makes a tremendous long-term buy with its ability to provide compound interest growth in a tax-favored account. The company has some longer-term catalysts with 5G, a new phone cycle, and the future success with Warner Media. The company does have a sizable debt load, but is working to reduce it. Other than periodic acquisitions, big moves regarding bond sales/debt, or broader market swings, the only major stock-moving catalysts are earnings. AT&T will be reporting Q3 earnings in just a few days, and we have to tell you, this is one of the most anticipated events in a long time for the stock. This is because of the recent terrible price action in the stock, driving the stock yield to nearly 8%. We want to highlight our expectations for several of the key metrics that we expect to see for Q2.
Look for the top line to contract
Revenues had begun to flatten for the company until Time Warner’s assets were brought under the AT&T umbrella. With COVID-related pressures noted in Q1-Q2, we expect similar pressure in Q3. Below is the historical revenue for Q3 and our projected result:
Source: SEC Filings, graphics by BAD BEAT Investing
As we look to Q3, we can tell you that the Q2 earnings of $40.9 billion was well slightly below consensus estimates by about $25 million. In fairness, it was really tough to handicap this quarter for many industries, including AT&T’s massive global telecommunications operation. There were declines at WarnerMedia. Declines at WarnerMedia included lower content and advertising revenues partly due to COVID-19. Revenues also declined in domestic video and legacy wireline services, and Latin America was impacted by foreign exchange pressure. It bears repeating that there continues to be a shift from premium linear services to more economically priced video service or to competitors, consistent with the rest of the industry, and this has pressured video revenues. There were 17.7 million premium TV subscribers an 886,000 net loss. In mobility, we saw service revenues down 1.1% due to declines in international roaming while equipment revenues up year-over-year.
With Q3 approaching we will be closely watching WarnerMedia results, which have been hit hard with so few box office releases. We are always watching the DirecTV issue, and the wireline services. We expect more of the same here. Putting it all together, we are looking for revenues to decline around 4-8% from last year, and are looking for about $41-$42 billion.
We expect that Q3 expenses were reined in aggressively, and this will help offset revenue declines. That said, we think based on our revenue range, and expenses that fall in the single digits, EPS will be between $0.78 and $0.83. Below is the historic Q3 data, with the midpoint of our projections displayed:
Source: SEC filings, graphics by BAD BEAT Investing
This EPS range is wider than we would normally forecast, but there are a lot of moving parts on the back of COVID-19 and the slow reopening of the economy. Much like Q1 and Q2, this makes it difficult to handicap. As a reminder, the bottom line saw nice growth in Q1, much of it from solid expense control, offsetting the revenue issue. EPS was up from last year’s Q1. However, we will say that Q2 saw declines, and we expect Q3 sees declines as well. Making the situation more complicated, management has pulled all guidance. With this understanding and our revenue projections, any divergence from these expectations will have a profound impact on cash flows and dividend coverage.
Operational cash results will likely decline
Make no mistake, H2 2020 is seeing pressure but nothing like H1 2020. As you saw we expected revenue declines. It is not all bad news. We are projecting strong cash from operations in 2021, but we do optimistically expect sequential improvement in Q3 and Q4 2020. For Q2, we look to our revenue expectations of $41-$42 billion. Operating cash flow is likely to decline from last year in the single digits. Last year, operational cash was $11.8 billion. Depending on the revenue result, operational cash should come in around $11.1-11.7 billion.
Key to watch is free cash flow
Sometimes we feel like a broken record in that when asked about AT&T, we often advise our members to pay attention to, if not study, free cash flow. That is because free cash flow is really what impacts the ability to cover dividend payments. Assuming we were operating under normal circumstances, it was quite likely that free cash flow would have approached $25 billion on the back of the addition of WarnerMedia, but then COVID hit.
Given that free cash flow is so far down the line of results, it is quite difficult to project where free cash flow will end up. All starts on that top-line figure. What we can say with confidence is that H2 2020 will be much better than H1 2020, especially as economies have started opening back up. With expectations for revenue declines and operational cash declines, we think if free cash flow comes in down $1 billion from our past expectations in the next two quarters, it means you should be looking for free cash flow of $5-6 billion in Q2 and Q3. If this plays out, then free cash flow could still be a strong $32-24 billion this year. We are looking for $5.75-$6.0 billion in free cash flow.
Dividend is covered
So, if AT&T is really not going to offer any growth, then it needs to keep that dividend going. Yielding 7.8%, the compound interest builds over the years. A boring name to slowly build wealth.
That said, wherever free cash flow lands will quite obviously impact the dividend payout ratio. We continue to see a $0.04 annual dividend payment per share increase, so free cash flow needs to remain high or show some growth as well to keep the payout ratio safe in the future.
There will be about $3.8 billion in dividends paid in Q3. If our expectations for free cash flow of $5.75-$6.0 billion comes to pass, then running the numbers, we will see a payout ratio in the 63-66% range. As we mentioned, management pulled its guidance; however, it has kept at least one projection on the table. Management continues to see the payout ratio in the 60% range as it stated recently. So we will see if we are underestimating cash flow. But even after our conservative estimates, we will see a tremendous payout ratio. If free cash flow comes in higher, we will see an even better ratio. 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. That means AT&T’s dividend is safe. Let us repeat. The dividend is definitely safe.
Take home and final thoughts
The short- and long-term impacts of the coronavirus pandemic remain unclear. We simply have limited visibility on the pandemic’s impact on the overall economy and how long the effects will continue to be seen. When AT&T reports, hopefully we get some hints of clarity on this front. We should also be looking for plans to continue to address debt, arguably the most bearish aspect of an investment in the company.
Another metric will be HBO Max subscriber updates. It is going to be another difficult quarter overall. This fact, along with the lack of capital appreciation over the years, makes an investment unattractive to many. But this is an income name, so know what you are buying. You are buying a safe, near-8% dividend yield for income. With dividend growth and adequate coverage, this makes for a strong, long-term addition to a tax-favored account. If there were ever a clear example of buy and hold, AT&T in the mid- to high-$20 range is it.
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Disclosure: I am/we are long T. 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.