Justin Sullivan
In our most recent post-earnings coverage on the AT&T (NYSE:T) stock, we had discussed how the company’s third quarter earnings beat and raise, despite an earlier decision to slash free cash flow expectations for the year, continued to corroborate robust market share gains amid increasing competition and growing consumer weakness in the economy. But macro conditions have only deteriorated rapidly since, drawing questions to whether the company’s outperforming resilience could sustain and weather through the looming downturn.
On one hand, the stock currently pays a 6% dividend yield, beating Treasuries with high quality fundamentals that have continued to surprise investors this year. Meanwhile, on the other hand, looming recession risks are bringing back concerns on whether AT&T’s consumer-centric business can withstand stiffening headwinds and sustain the impressive dividend pay-out that has long sustained its appeal to investors. The following analysis will dive into the anticipated risks of tightening financial conditions on AT&T’s near-term fundamental prospects, and the ensuing impact on its dividend pay-out as market sentiment shifts from “inflation angst” to “recession fear” in the upcoming year.
Although inflationary pressures experienced over the past year have likely already peaked, with structural evidence from the most recent readings showing moderation in energy prices and a slowdown in demand for discretionary goods coupled with easing supply chain bottlenecks, price increases remain far above the Fed’s 2% target. Policymakers have also doubled down on their stance to keep rates “higher for longer” as a result, especially as the labor market remains resilient with unemployment remaining at all-time lows. There is also a growing drumbeat that energy prices – a main driving force of 40-year high inflation experienced this year – will rebound, as China’s reopening from COVID Zero and the looming winter season risk exacerbating already-tight supplies.
Given the expectation for further tightening of financial conditions and weakening demand in the coming months, market aversion from investing in risky assets remains a key theme heading into the new year. Yet, AT&T remains an attractive investment given its impressive yield and high-quality earnings. Having demonstrated resilience through the first wave of macro headwinds that is inflation, the company has largely showed it is well prepared with fundamental strength to brave through the second wave of challenges that is the impending recession. Although the stock remains vulnerable to volatility in tandem with broader market weakness in anticipation of tightening financial conditions in the near-term, AT&T’s growing leadership in the recession-prone consumer-centric, yet mission critical, communications business continues to corroborate resilient fundamentals supportive of its attractive dividend yield. This accordingly draws a favorable risk-reward proposition on the stock, especially as broader market risk-off sentiment creates compelling entry opportunities in upcoming months.
The Macro Overview
With the Fed reaffirming its stance that persistent price increases are still far from target levels, and continued monetary policy tightening expected to hit the labor market – which has been largely resilient this year – next, demand is inevitably going to slow further, tipping the market theme from inflation to recession heading into 2023. This is further corroborated by the market’s recent return to a risk-off sentiment, with key benchmarks including the S&P 500 and Nasdaq 100 taking a steep U-turn from the November rally in anticipation of a downturn in corporate earnings that could push valuations toward new lows.
While the recent streak of cooling prices is supportive of continued deceleration in the pace of rate hikes, which is consistent with the Fed’s latest dot plot forecast, the higher for longer narrative aimed at bringing down inflation that is still running 3x too hot points to a further downturn in financial conditions within the near-term. This is already corroborated by the latest streak of relevant data, including a decrease in household savings and net worth, increasing credit card debt, recurring unemployment claims, and broad-based weakening in consumer purchasing power, which points to an increasingly challenging operating environment for AT&T’s consumer-centric business in the near-term:
Decreasing household savings and net worth: The U.S. personal savings rate has declined to 2.3% in October, the lowest since 2005. The latest data underscores the increasing burden of rising borrowing costs and surging inflation on consumer budgets and overall purchase power. U.S. household net worth has also fallen for the third consecutive quarter as a result of battered valuations across asset classes this year.
Increasing credit card debt: While an increase in household debt is inevitable following one of the most aggressive rate hike cycles in American history, data shows consumers are starting to reach for their credit cards more in recent months. Credit card balances increased 15% y/y in the third quarter, returning to record levels last seen at the eve of the pandemic…the anticipated continuation of deteriorating macroeconomic conditions draw concerns on how much longer “borrowers will be able to continue to make payments on their credit cards”, especially with the average American savings rate having come down drastically in the past year.
Recurring unemployment claims: The U.S. saw the highest level of recurring unemployment benefit claims since early February, showing “tentative signs” of a cooling labour market. Continuing claims increased by 62,000 to 1.7 million in late November, while initial claims increased by 4,000 to 230,000 as of early December. Yet, the labour market remains tight, with the unemployment rate of 3.7% still being one of the lowest in decades, pointing to potential wage inflation still that could derail the Fed’s inflation-taming campaign.
Consumer weakness: As discussed in some of our recent coverages, previously deteriorating consumer sentiment has now materialized into real consumer weakness, which is observed through the rapid deceleration in spending in the past several months…The results are corroborated by rising price sensitivity demonstrated across American consumers – more than three-quarters of shoppers have recently indicated they have been searching the web for the best deals and discounts to “maximize their spending power”.
Source: “Amazon: The Rout could Get Worse”
For now, AT&T has largely remained in a relatively safe zone compared to peers like Verizon (VZ). Specifically, AT&T has navigated swiftly through this year’s inflationary headwinds, with massive market share gains within the increasingly price sensitive wireless communications landscape. The company’s latest earnings beat and raise also corroborates prudent management on the deployment of aggressive discounts and promotions that have appealed to consumers’ tightening budgets without compromising on its margins. Despite increasing plan prices earlier in the year, AT&T’s robust net adds have also demonstrated consumers’ recognition of its competitive value proposition compared to peers that have fared worse after deploying the same undertaking.
Fundamental Implications
But with one challenge down comes another – this time being the looming recession. Although wireless communications has become a mission critical service in today’s connectivity-driven world, which would reduce recession-driven churn, the looming downturn portrayed by deteriorating macro fundamentals as discussed in the earlier section could increase AT&T’s susceptibility to other adjacent adverse impacts.
These include lengthened connection cycles and deceleration in the pace of new net adds. The company is also likely to face tough comps next year as a result of the anticipated slowdown in net adds, which could potentially cause further deterioration in already-weak investor sentiment in the risk-off environment. Competition within the industry could also bring about a pricing war, which would pressure near-term margins that are key to supporting the stock’s attractive dividend yield. These are all very possible bear case scenarios to acknowledge, as no corner of the market is really recession-proof.
Although the company’s low level of churn and robust net adds observed this year are unlikely to continue into the next due to broad-based weakness in financial conditions, we view AT&T’s frontloaded market share gains observed in the current year as a competitive advantage. Specifically, on the mobility front, the robust net adds have contributed to higher mobility postpaid phone ARPU for AT&T over the past year, which suggests that more users have been graduating to “higher-priced unlimited plans” that are also more profitable for the company.
The robust take-rates observed on free phone promotions that have been prudently deployed by AT&T over the past year without compromising its profit margins also imply an increased volume of long-term contracts. The advantage of said multi-year plan contracts is that not only do they provide greater visibility into the company’s longer-term growth and profitability prospects, but they also reduce risks of recession-driven churn and protect the quality of the company’s fundamentals from near-term macroeconomic headwinds. This essentially puts AT&T a step ahead of peers like T-Mobile (TMUS) and Verizon, which have either failed to surpass AT&T’s pace of share gains or struggled with retaining share in general over the past year.
Dividend Implications
The higher margins locked in today would play a crucial role in ensuring sufficient margins in AT&T’s bottom-line to absorb anticipated risks of heightened price competition in the coming year as the pool of available consumer dollars dwindle, while also protecting the quality of its cash flows needed to satisfy both its near-term deleveraging goals and dividend requirements. Specifically, the stock currently yields a 6% dividend pay-out, which has fallen from about 7% earlier in the year after AT&T’s market value soared on better-than-expected fundamental performance following the third quarter earnings beat and raise, yet remains one of the higher rates currently available in the market.
The 6% dividend yield also outpaces current returns on both the front- and long-end yield on Treasuries, without exposure to significant fundamental risks as discussed in the earlier section. This is further corroborated by AT&T’s rate of free cash flow generation, which is currently guided at $14 billion for the year and implies more than $6 billion in the current quarter alone, and is indicative of sufficient liquidity to satisfy both its upcoming debt obligations as well as near-term dividend payments at the current rate of $0.2775 per quarter ($1.11 annualized):
Achieving $14 billion in free cash flows by the end of the year is likely already in the bag for AT&T given its demonstration of continued resilience in 3Q22 with a double beat, and expectations for sustained demand through 4Q22 based on robust take-rates observed in recent weeks ahead of an anticipated seasonality-driven surge in end-of-year sign-ups. This largely safeguards AT&T’s ability to fulfil its ~$8 billion annualized dividend pay-out, with excess to further reduce leverage, which is consistent with management’s “focus on paying down debt”. AT&T’s robust 3Q22 performance also reinforces its credibility as a safe long-term investment with industry-leading dividend yield backed by strong fundamentals and a resilient business.
Source: “AT&T: Q3 Beat and Raise Saves the Day”
And based on the foregoing analysis on fundamental implications for AT&T ahead of the 2023 downturn considering its current year market share gains, the company is likely to, at the very minimum, sustain this level of free cash flow generation. There is also potential for further growth even if net adds stall given the anticipated full-year benefit of higher ARPU stemming from mid-2022 plan price increases on 2023 margins. Even with debt obligations pushing $9.6 billion over the next 12 months, AT&T’s balance sheet remains in a healthy position to sustain is dividend pay-out.
Final Thoughts
With surging borrowing costs and growing signs of weakness in corporate fundamentals as the macroeconomic environment heads toward a downturn, investors are building a growing aversion to growth that is not accompanied by profitability. Considering the robust market share gains observed over the past year, and sustained profitability validated by a recent earnings beat and raise, AT&T checks all the boxes for an attractive investment at current levels despite a general risk-off sentiment in equities. The expectation for a continuation of market volatility over coming months as valuations adjust to impending weakness in corporate fundamentals potentially provides for more attractive opportunities to lock-in on the high dividend yield offered by AT&T, with longer-term upside potential backed by the underlying business’s high-quality earnings in the mission-critical wireless communications industry.
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