AT&T Has Been Obliterated (NYSE:T)

After giving all but giving up on the stock, we started buying AT&T (NYSE:T) in a big way as the stock dipped into the $16s, but we said we would really be buying heavy at $15 and below. Well we are there, and have ramped up to build a position for income here. We are adding in equal lots ever 25 cents lower from 15.00. We have been trading very defensively. We have maintained a high single-digit percentage of our portfolio in hedges, which because the market is horrible, has helped preserve capital. We also are looking for income names that should see revenues hold up relatively well in a recession. We want to own companies that are necessary in consumer and businesses’ lives. We all know that the raising of rates this rapidly is being done to slow the economy. With today’s jobs number, there is little sign we are slowing, at least not yet. The impact will start to be felt. So far, in our opinion, we have seen normalization in many commodities, and in housing, so the effects are beginning. But the bond yields are still very high. This has made equities less attractive as bonds carry far less risk. The strong US dollar is going to hurt revenues of companies that do business overseas. This does impact AT&T to a degree, as well as countless others. We are sticking to our guns and putting our money where our mouth is. Or where the pen and paper have been. Or the keyboard and on Seeking Alpha. You get the idea. The price action is devastating. The stock has been obliterated. It has been an awful year, and a tough month. But the dividend, while seeing some near-term coverage issues, will be maintained in our opinion. As the stock declines, the yield gets higher, and higher. We think you buy this stock for income, and eventual appreciation as the market rebounds. But with the VIX being so high, even with a low beta stock like AT&T, you can sell slightly out of the money puts a few months out for added income. It works because of how high option premiums are with the volatility in the market.

The dividend is why we own the stock, but pressure mounts on cash flows

We started our buying in the $16s, as the yield is solid and the payout metrics look sound longer-term. Look, with the current payout, if it never gets raised our cut, you could make all of your money back in 13-14 years here. That is great. Assuming the company does not go belly up, if you are playing the compounding game, the 7.3% yield, if you own this for decades and continue to add, could generate exponential wealth. Easier said than done, and it takes a long time, and relies on a lot of assumptions, but if you play with the math, you can see how a high-yield stock like this, if invested in consistently and the dividends are reinvested, can generate long-term returns. In the near-term, it is an income name, and for income investors, the dividend is not getting cut, even if there are cash flow concerns.

After the Q2 report, the stock resumed a decline. The top line revenues were $29.60 billion. It was driven by a strong quarter for postpaid subs, one of the best in many years. They saw wireless postpaid growth saw 0.813 million adds and another 316,000 Fiber net adds. Earnings were a strong $0.65 per share, even with high expenses. While the bottom line was strong in Q2 we need to be mindful that we have a weakening macro situation, whilst operating expenses were $24.7 billion and projected to get worse. Operating income fell to $5 billion, though adjusting for one-time and special items the operating income was $5.9 billion up from $5.7 billion, but free cash flow and the outlook for future free cash flow in the near-term is weak. In the medium-term the market is betting on continued weakness. To be clear, we do not see the market as pricing in cuts. Rather, it is pricing in more pain on revenue and earnings, along with the entire market. The rising costs, while management is trying to control them and sees the issues, have crimped free cash flow.

The free cash flow generation of any high-yielding dividend paying company is key. One of the reasons that free cash flow and the expectations for less of it in the future. Free cash flow is really how the dividends that are paid are covered. So we need to focus on this. When Q3 is reported soon, this will be the metric we watch more than any other. This is because if AT&T pays more than it brings in, the balance sheet worsens. Make no mistake AT&T’s dividend had been comfortably covered by free cash flow for so long. What is weigh is CAPEX, which was $6.7 billion in Q2. It hurt free cash flow when we consider the cash from operations brought in. Free cash flow was just $1.4 billion. The stock has fallen for weeks because cash flow was guided by management to be just $14 billion for the year. This is why when Q3 is reported we will be watching this indicator more than any other. This should still cover the dividends to be paid of about $4.2 billion for H2 2022, considering free cash flow through the start of Q3 was $4.2 billion. So look for another $9.8 billion in free cash flow this year. The dividend will be covered for the year, and that is the key message, but the margin of safety has come down.

A reminder on risk for AT&T

We are buyers but there are risks. One of the biggest risks with holding AT&T has continued to be the debt on the balance sheet. Management has been trying to improve this situation by selling off assets and paying down some of its debt.

The spinoff of WarnerMedia assets helped with debt but it is high. Coming into Q3, net debt was $131.9 billion good for a net debt-to-adjusted EBITDA of 3.23x. We really would like to see this debt ratio under 3.0.

The government is a prevalent risk. They can legislate new rules that could hurt AT&T’s ability to generate revenue. Privacy concerns are an issue. Taxes are an issue. Costly litigation can be a risk. Investors should keep an eye on proposed legislation and that legislation that is in committee that could hurt telecoms.

And rising rates are a risk to every business really, but especially those that rely on debt. Borrowing costs are now much higher. AT&T does hedge by entering into and designating interest rate locks to partially hedge the risk of changes in interest payments during a borrowing period.

If cash flows are crushed by any of the above risks, or failure to compete, or anything else that puts the dividend in jeopardy, the stock will not just be obliterated like it has now, it will be an apocalypse for investors here. We are in it for the dividend, and for selling covered calls for more income.

Covered call strategy

We are getting a beautiful 7.3% yield to own the stock. But what if you rent it? By this we mean you can collect dividends, but also sell some upside covered calls a few months out. If the stock rallies and you get called away then cool, you saw some capital gains. If the stock is range bound, you can increase your yield. The stock pays $1.11 a year. So that is just under $0.28 every 3 months per share, right. Well, at $15 a share, you can sell $17 calls going three months out to January 2023, for $0.30. By doing so, you now can more than DOUBLE your income yield on the stock, assuming the stock hovers around $15. Even if it rallies to $17 and you get called away, then you made $2 per share, plus the call income and a dividend. You can repeat this process every three months or on a rolling month to month basis. You get the picture. This is how you use your position to trade options for income. Cash flow is the key, and we believe the downturn is short-term. We will be paid to wait. And generate our own cash flow.

Selling puts if you really want to trade like a pro

Want to get even fancier? How about selling puts for income and/or to define your entry point. Let us say you would like to buy shares at $15. Cool. Well you can sell $15.00 puts that expire next Friday for $0.24 at the time of this writing. If assigned, you are actually buying the shares for $14.76, the same shares you were going to buy today at $15, but you had the $0.24 credit. If not assigned, you pocketed the $24 for your time, less any commission. Here is the kicker. If they do get assigned, you can then turnaround on the following Monday and sell covered calls as discussed above.

All of that is not without risk, the stock could crater more, for sure. But, this is a pretty solid approach for an income name, especially once the market starts to stabilize.

What is your take?

What do you think? Is AT&T just a loser? Is the options strategy here junk? What income stocks are better? Do you see the situation worsening? Let the community know below.