Without Question, AT&T’s Future Is At Stake (NYSE:T)

AT&T (NYSE:T) remains one of our core long-term holdings, and we have been both bullish and bearish. We have not loved the stock recently and even recommended coming back to it lower recently. Over the last week, there was a nice little rally for the stock along with the broader market and some hope for a fiber joint venture. We still believe you will get a retracement, so we would still caution new money to wait for $17-$18. Now despite that being said, every portfolio review we do with our members at BAD BEAT Investing generally comes with a recommendation to bring in more yield, and AT&T was long a go-to name. But it has been a painful stock. That said, the divestment of the WarnerMedia assets has helped focus AT&T largely on the legacy business, and we think this will allow it to tackle debt, and continue to enjoy strong cash flow to fund a still strong dividend. We believe any talk of a dividend cut is futile right now. The financials do not justify it, yet. We would have a different tone if it looked like cash flow would fall off a cliff and stay there, but we do not see that happening.

It is our belief that this stock can still be held for income (several of our analysts hold it), but we like waiting for a pullback to consider buying and we think you might get another one. So, we remain short-term bearish, but longer-term bullish. With that said, AT&T is coming into a key earnings report in a few weeks. The whole DirecTV issue has been a distraction and we think AT&T would be better off without it. The key is that earnings season as a whole is about to begin and it will set the tone for the entire market trajectory over the next few months. We think that we will see a report that first shows the dividend is more than safe. In this column, we highlight some of our expectations for the future performance of AT&T, as well as early thoughts on 2023. Like it or not, the tone of the Q4 report will dictate AT&T’s future.

We remain short-term bearish but long-term bullish

We are bearish short-term for a few reasons that we have previously discussed but it is more so we can get a better price. With income stocks, your cost basis is of paramount importance. That said, the Q4 results are due out this month. This is a near-term catalyst, and we will update our thoughts on 2023 after the report, but regardless of whatever is reported then, we want to say that we are still bullish long-term. That has not changed, and the Q4 report will not change that, unless they indicate that they are going out of business or into a bankruptcy (this is sarcasm). We think you get a chance to buy this stock again a few points lower, especially if we get the kind of earnings season we expect large scale, which is one that shows downward revisions and downbeat conference calls. That remains to be seen. Let us discuss what we are looking for in the report.

Management knows the company best, but the future is at stake

It is not dramatic, the future is really at stake here. The stock has been horrific and operations have been poor. That said, we see management has finally starting to “get it.” It may sound kind of silly, but management knows its business best, and we have to consider strongly their outlook for the business. Go back and pull all of the earnings reports you want. You will find that management’s own projections of performance are generally close to actual performance reported, while analysts, frankly, are largely reactionary. Sure, they offer a wide range of guesses, and we suppose we are doing something similar, as we also regularly cover the company at our fund and invest in it, but the fact remains, management knows best. Even if management at AT&T has been questionable at best for years, especially for shareholders, they know operations. We see no reason why this would change, though as the saying goes, past performance is no guarantee of future success. Still, in the most recent quarterly call, CEO John Stankey stated:

Our results demonstrate that the strategy we put forward more than 2 years ago is the right strategy for not only the future of our business, but for the future of the communications industry. We’re focused on creating sustainable and scalable businesses that drive a free cash flow flywheel for many years.

We continue to hold ourselves accountable for earnings growth against our historic levels of investment, which you’ll see through improved cash conversion moving forward. We’re confident that the investments and choices we’re making will benefit our customers and shareholders now and in the future, while also setting the stage for our next act as America’s best broadband provider.

With this statement, we are looking for the Q4 report to solidify that the strategy is paying off, specifically as it relates to covering the $8 billion in dividends being paid this year by cash flow. In that regards, Pascal Desroches, CFO, stated on that call:

Our results today have only further solidified our confidence that we will exit 2022 stronger than we entered the year. In fact, we continue to expect EBITDA growth and higher free cash flows in 2023. We also plan to continue to use excess cash after dividends to reduce debt with a goal of reaching a net debt to adjusted EBITDA range of 2.5x.

With this assertion, we feel decent about the longer-term prospects for the company. Near-term, there is much work to be done. We expect the fiscal 2022 to be down 25% to about $124.5 billion, but this is of course due to the divestments. Going forward with the existing legacy business lines, we expect revenue growth of 1-3% annually.

Why we see cash flow increasing

While we expect this fiscal year to end with pressure on revenues and earnings, we think it improves in 2023. The CEO specifically discussed cash flow:

We hope this healthy free cash flow for the [third] quarter gives you confidence in our ability to achieve our target for free cash flow in the $14 billion range for the year, a level that is more than ample to support our $8 billion dividend commitment

As such, this is a confident outlook for the remainder of the year, and so, we expect $13.8-$14.2 billion, depending on how Q4 turns out. We also expect about the same level in 2023. Pascal Desroches, CFO, added that the cash flow looked great and the company is on pace to meet all targets:

Overall, we remain on track to achieve or surpass all of our previously shared financial targets for the year… we are very comfortable with our cash levels after paying our dividend commitment, and this should only increase in the future years as we expect cash conversion to improve from here.

So, in order for cash flow to ramp up, we are going to need to see a boost in revenue. We believe we see an average of low-single digit increases over the next few years, including 2023. But to see a meaningful boost to the cash flow figures, we need to see a boost to revenue in the future. So, what is our firm looking for in the AT&T Q4 report? Well, we are looking for $30.7 billion to $31.4 billion in revenues. But what about cash flow?

One way to bring in direct cash flow is with further asset sales. AT&T has monetized many billions in non-strategic assets over the last few years. You should expect continued sales moving forward of even more assets, even though major divestments have occurred. The company has many more assets it can put up on the block.

How do we see cash flows improving further? Well, it looks like performance has started to improve as we did see in Q3 2022. Analysts covering the company were targeting a consensus of $28.6 billion. We expected revenue to be closer to $29.5.0-29.80 billion range on the belief that the company would face declines of 4.5%-5.5% on revenue with a result of the pressure from being promotional. With $30.0 billion in revenues, this was a beat of $140 million vs. consensus, and a beat vs. our expectations.

With Q4, we think that earnings will be a bit closer to the consensus. The holiday quarter however is very volatile. But there were NOT major releases of new phone tech, so new wireless plans and promotions likely will not be as strong as in the past. Let’s dig in some more to the numbers.

Revenue drivers in Q4 and earnings results

In Q3, Wireless postpaid growth saw 0.708 million adds, and these were once again boosted by 5G availability and the specific promotional marketing strategies employed by AT&T. AT&T also reported 338,000 Fiber net adds. Both of these numbers are strong, with the former expected to be industry leading. The fiber adds were the second-best in company history. For Q4 we are looking for another 600,000 net adds, along with 250,000 Fiber net adds, based on year to date performance, past holiday trends as a guide, and what management has indicated, we see continued strength as likely, but perhaps slowing the pace of growth. For 5G, they are now on track to hit 130 million people this year and we think this happens in Q4. This is 30% ahead of what management had previously expected for 100 million, and nearly double the initial 2022 forecast for 70 million.

Earnings are strong coming into Q4. While we applaud the cost reduction efforts of the company that led to $0.68 in EPS, we still think expenses remain higher than we would like. Operating expenses were $24.0 billion in Q3 and we comparable expenses in Q4. 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. Operating income fell from last year to $6.2 billion, even with adjustments for restructuring. Overall, we are moving in the right direction, and we see operating income approaching $7 billion in Q4 provided revenue comes in toward the high end of the range and expenses are well controlled. We see annual EPS hitting $2.62-$2.69, so our Q4 EPS estimate is for $0.52-$0.59.

The dividend is safe

We have to tell you, all this talk of the dividend being cut again that has recently cropped up seems very premature as management is telegraphing that they are going to make more than enough free cash flow to cover the dividend for the year. Folks, we like AT&T as a dividend play. One concern was declining free cash flow. But free cash flow will again be more than sufficient to cover the dividend, and the all important payout ratio will remain safe. This is an income name for us. Taking that into account, free cash flow is key to covering the dividend payment. We see free cash flow coming in at around $5 billion, more than enough to cover the just over $2 billion being paid in Q4. Frankly, any talk of them cutting the dividend could only come with a massive debt reduction scheme. It is not impossible, and we did see competitor Lumen (LUMN) eliminate theirs, but the income is why people own AT&T. Elimination of the dividend would cut shares by a third, and we just do not see this management team making such a move after the heat they have taken from their operational blunders.

Early thoughts on 2023

Well, the wildcard in 2023 will be how any recession impacts the company. That is the unknown here. We think revenue growth tracks higher at 1-3% in 2023 from 2022, while if expenditures are controlled, and overall EBITDA margins remain about comparable to where they are now, and there are no surprises on the tax end, we are looking for earnings per share in the $2.70-$2.90 range for 2023. As alluded to above, we still see free cash flow strong and we think it can average $3.9 billion a quarter, so we are looking for around $15.6 billion on this front in 2023. Considering share count and an increased dividend, the payout ratio will remain comfortably low, likely under 55%.

Take home

We will offer updated thoughts after earnings, but these are the key things our firm will be looking for. We still think there is reason to be short-term bearish, despite a recent bounce on the fiber joint venture. We think shares are likely to come down in the next month or so to the $17 range which is a much better buy level than the near $20 right now. That said, if the dividend is well-covered, and if raised, shares will rally. Guidance will be key, and we think guidance comes in around some of the numbers we have cited, but the future is at stake here. A poor outlook could really crush the stock. The cash flow guidance will be the key to focus on.