AT&T Is At A Critical Crossroad (NYSE:T)

The telecom space is busy and packed right now. There are so many debates and outright arguments on the great analyses for the telecom stocks. We have covered a lot of manes here. The big names of course are AT&T Inc. (NYSE:T), Verizon (VZ), T-Mobile (TMUS), and Lumen (LUMN). We have found trading opportunities in all of these names. T-Mobile offered the best growth in our opinion, Verizon is ok for income, Lumen is now at generational lows and we traded that one for rapid-return gains, and then there is AT&T which continues to be a name we own that we believe offers both solid income and growth.

Folks, AT&T is now at a critical crossroad. Our last big wave of buying came when the stock fell under $15. We believe astute investors can enjoy continued gains in the stock, collect income, and can compound their income through the appropriate use of a put selling and covered call selling approach. When done correctly, you can double the income when combined with earnings. AT&T remains a core holding for our trading team and many of our members and followers. The name is regarded as superior to the top competitor Verizon, recently getting some love from Barclays and Raymond James who both see AT&T as a superior play. T-Mobile is not paying income, and Lumen is in survival mode with all of the moves they have made. We believe AT&T is emerging from the ashes. While debt challenges persist, the company is certainly moving in the appropriate direction. We remain long, and just sold a wave of covered calls this week for income on the huge market rally. We think on the next pullback you might be able to scoop shares again in the $17-$18 range and think put selling on the pullback is a wise strategy. Momentum is on AT&T’s side right now and this has not happened in a long time. Let us discuss.

Momentum strong

Folks the momentum has been strong over the last month for both the entire market, generally speaking, and AT&T has been in rally mode since it reported Q3 earnings. In fact shares are up 32% from their October lows. These are some solid gains. You may be surprised to learn, but we shaved some of our position as well. One thing we teach is how to trade around a core position. Essentially, on massive rallies like we have seen, we embrace waves of selling a few percentage points of holdings, with plans to redeploy those gains on pull backs. We also sold more covered calls following this 32% rally. The momentum has been impressive. But a lot of macro risks persist. While a cooler than expected inflation report was welcomed, inflation remains rampant and the Fed will continue to raise rates. The Fed cannot and should not stop prematurely or we will be in much more dire straits if inflation becomes entrenched.

The action in the stock is promising but is at a key crossroad. What is more, we have been very critical of management here, but it does finally seem that it is understanding that its shareholders have been crushed over the years. The dividend income was nowhere near enough to offset capital losses.

Q3 results sparked a rally

So did the stock rally due to the market rally, or was it earnings? Well both really, but the market rally pales in comparison to AT&T’s 32% really. There were some great successes in the quarter, and even a guidance hike. We continue to believe AT&T is a great income stock. We are long-term bullish, and this comes as the market was nervous about this Q3 earnings season. For the most part, earnings have been stronger than expected. To be clear, we see earnings market-wide coming down in 2023, perhaps at $220 in earnings for the entire S&P 500 in 2023. This will depend on when rate hikes stop, and how deep of a recession is felt. But earnings will come down. AT&T has a beat and raise quarter sparking the big rally in the stock.

Management is making strategic moves, including target pricing adjustments to adapt to the high inflationary pressure. Their pricing strategy will be in flux over the next few months to allow even the most loyal of customers to take advantage of special offers, while attracting new customers. We expect lots of different promotions and pricing points to reduce churn and grow subscribers. The beat and raise was really a surprise because we thought the company would be extremely promotional, and believed it would pressure revenue. We also thought the inflationary pressures in labor costs would hurt the business. We had low expectations. However, management’s actions to address rising inflation worked, thus far. They are seeing benefit on profit trends now, and the balance sheet has improved. Basically, management had already been operating like the economy was in a recession, and those moves led to success.

Analysts covering the company were targeting a consensus of $28.6 billion. With $30.0 billion in revenues, this was a beat of $140 million vs. consensus. There were quite a few metrics that drove this revenue beat.

Improvement on critical metrics has us bullish

Wireless postpaid growth has been impressive. There were 708,000 adds here. Folks, this growth is impressive considering the intense competition. These adds came as 5G availability drove gains.

Now as we mentioned, the company had an impressive set of specific promotional marketing strategies, and these helped AT&T deliver industry leading 338,000 fiber net adds. These fiber adds were the second-best in the company’s history they were so good. This level of customer additions followed reports earlier this year which also showed growth.

A turn around seems to be in the works and that is why for 5G, they are now on track to hit 130 million people. This is 30% ahead of what management had previously expected for 100 million, and nearly double the initial 2022 forecast for 70 million.

These reasons are driving the stock higher after sentiment was so horribly poor for many quarters

AT&T profit growth drives strength and ensures the dividend is secure

The solid key metrics drove a strong top line performance. One concern we had was the inflationary pressures we may have seen with rising labor and other costs. Many companies have been crushed by these rising costs. But because the company was acting like we were already in a recession and playing defense on expenses largely, it helped drive the bottom line to a beat versus consensus. Analysts were looking for $0.61, and this was surpassed by $0.07. This is a wide margin to surpass estimates by. Now the cost reduction efforts are great, but even with the efforts we are not fully comfortable with where things have landed as expenses still remain higher than we would like. Operating expenses were $24.0 billion. While this is down from last year and down from the sequential quarter, we need to see these expenses come down more to maintain earnings as operating income fell from last year to $6.2 billion, even with adjustments for restructuring.

Now all of that said, we are getting more bullish because there is a path to growth again. Still, we like AT&T as a dividend play. This year one of the major concerns was declining free cash flow.

However, with these results, free cash flow will more than cover the dividend, and the all important payout ratio indicates that the dividend will remain safe.

Free cash flow covers dividend

Up until 2022 we had not seen issues with dividend coverage in many years. But it was looking disastrous as in the sequential In Q2, AT&T reported only $1.4 billion in free cash flow. We targeted Q3 free cash flow at $2.0 to $2.5 billion, with cash from operating activities of $9.5-$10.0 billion and capex spending of $5.7-$6.0 billion. Well with the strong top line, cash from operating activities were $10.1 billion, but capex was high again at $5.9 billion, while total capital investment hit $6.8 billion. All of this led to free cash flow being about in line with expectations at $3.8 billion

This means the dividend was covered. Dividends paid were $2.01 billion, leaving around $1.83 billion in excess free cash flow after the dividend. We closely follow the payout ratio metric. The payout ratio was a very safe 52.3%. As an income investor for the long-term this is critical. Now that said, for the year, the payout ratio is 97.6%, largely due to the Q2 2022 shortfall. It is not an easy task to balance as the company is investing massively in itself to grow and to attract customers, but needs to ensure the dividend is covered. A cut to the dividend would destroy shares. Look what happened to Lumen when it eliminated its dividend. As opportunistic traders we took advantage of other’s bad beats, but imagine holding AT&T and seeing the dividend eliminated. The stock would be cut by a third, maybe more. We just do not see it happening as we expect revenue to improve, and cash flow still is expected to be just $14 billion for the year. This means Q4 needs about $5 billion in free cash flow to hit the goal. We see the dividend as being safe despite its safety rating being reduced thanks to H1 2022 performance.

AT&T’s debt is still a risk, but outlook strong

The debt is the biggest risk to the company and investors, especially with rates rising so much. Refinancing debt in the medium-term will come at a much higher price thanks to rising rates. As such, future debt payments could be very high, and you could see the interest expense line explode if principal is not knocked down. It is the largest problem for all of these telecom stocks. They are debt laden.

The debt is one of the biggest risks with holding AT&T stock through this period. Management is improving the balance sheet by selling off assets and paying down its debt. Coming into Q3, net debt was $131.9 billion, and that translated to a net debt-to-adjusted EBITDA of 3.23x. We want to see this ratio come down a lot more.

At the end of Q3, net debt came down $800 million and was $131.1 billion, with net debt-to-adjusted EBITDA of 3.22X. There is still a lot to do here. We want to see the debt ratio under 3X in 2023. Now that said, if cash flow stays strong, more debt can be serviced.

The outlook for the year however looks quite strong. With the outperformance, management updated its outlook. Full year EPS is now expected to be $2.50 or higher. This is up from the $2.42-$2.46 prior view. Free cash flow of $14 billion this year will cover the dividend and the high cash from operations should help the company chip away at more debt. But expenses for spectrum auctions and other strategic investments may counter these efforts. It is something to watch closely as the company is at a crossroad.

Take home

The stock has had a major run over the last month. We trimmed our position this week on the immense strength, and this came after some heavy buying by our traders in September and early October. This is an income name, but capital appreciation is welcomed. We are trading around a core position as well, by selling these pops, as well as writing covered calls for more income against the position. On pullbacks, we will sell puts for income and/or to define our entry points. This is a battleground stock but the outlook is much better than we could have expected following H1 2022’s performance. The debt is still a major issue. Seeing the dividend barely covered for the year is definitely something we have not seen in a long time, but free cash flow should improve in 2023 which keeps the dividend secure and helps tackle debt.

What do you think about AT&T

So what do you think? There are always great conversations in our chat rooms and in the comment sections of our public columns. Do you like the options approach we embrace for more income? Do you think trading around the core position is too much work? Is AT&T a worse investment than VZ? Can its shares grow like TMUS have? Or is it another Lumen? What is your take? Let the community know below.