AT&T: Inflation And Dividends

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Justin Sullivan

AT&T (NYSE:T) saw its worst intra-day decline in almost two decades after its decision to slash guidance for current year free cash flows, which overshadowed the underlying business’ resilience in the face of a slowing consumer end-market. The stock plunged as much as 11% after AT&T released its second quarter results in mid-July, and has yet to recover.

In addition to external market challenges, the first half of the year has also been full of changes for AT&T’s internal operations. Yet, the company’s strategic shift in returning focus on wireless communications opportunities is expected to further the favorable progress made to date on its expanding 5G mobility and fiber broadband businesses despite the looming economic downturn. In the following analysis, we will discuss two key focus areas for AT&T investors: 1) the company’s outlook under tightening financial conditions, given its significant exposure to the slowing consumer end-market, and 2) whether its dividend pay-out would remain sufficiently attractive to compensate for the near-term macro risks ahead.

It is critical to note that AT&T is not alone in facing current market headwinds. And compared to its telco peers and the broader industry that service the consumer end-market, the company is still faring better with impressive market share gains and margins through prudent cost management measures. Paired with its attractive dividend yield, AT&T remains a safe income investment still.

Resilience Under Inflationary Pressure

AT&T revised its free cash flow guidance for the year from the previous $16 billion to $14 billion during its second quarter earnings call in July, citing impact from a persistent inflationary environment observed across its commercial-focused “Business Wirelines” segment and consumer-centric “Consumer Wireline” segment. Specifically, $1 billion of the downward adjustment to free cash flow projections for the year is attributable to lengthening consumer payment collection cycles and related bad debt expenses. The remainder is associated with margin erosion at its Business Wireline segment due to higher costs of operating its wholesale network business, and fluctuating government spending amid near-term economic uncertainties.

While the downward adjustment looks worrisome, the telco and connectivity industry’s churn rates remain at one of the lowest levels on record, considering the increasingly critical nature of services they provide in today’s digital-first era. Mobile and internet connectivity service cancellations remain at under 1% a month over the past year, with most consumers choosing to tighten the belt in other areas like dining out than to “reduce mobile spending and internet bills”.

The trends are further corroborated by AT&T’s resilience demonstrated in the second quarter. Although its Business Wireline segment has been harder hit by recent inflationary pressures, alongside the ongoing slowdown in its legacy voice and data business, commercial take-rate for AT&T’s business 5G and fiber offerings have continued to demonstrate momentum with related revenues expanding more than 7% y/y. This is consistent with observations of increasing demand from the enterprise sector for improved technology stacks to stay economically and operationally competitive. More than half of the corporate scene have expressed that they would rather “tighten the belt” in other parts of the business than to miss out on digital transformation, which is considered a strategic investment in differentiating themselves from competitors, while also enabling cost efficiencies. Meanwhile, the rapid transition towards cloud-based software to support virtual collaborations in the post-pandemic workplace has also fueled corporate demand for connectivity that enables faster speeds and reduced latency, which continues to provide favorable tailwinds for AT&T’s expanding 5G and fiber broadband businesses.

On AT&T’s Consumer Wireline segment, its mobility business had more than 800,000 net adds in the second quarter, representing the best three months through June in more than 10 years despite recent price increases. It also beat second quarter phone net adds observed across key rivals T-Mobile (TMUS) and Verizon (VZ), which only signed up 723,000 and 12,000 net new customers for the service, respectively. As a result of the resilient demand environment observed across its consumer mobility business, AT&T has raised its guidance for the segment’s full-year revenue growth from the previous 3% to now at least 4.5%. This continues to underscore AT&T’s robust market share gains, as well as pricing gains materialized from the gradual transition of its user base to higher margin unlimited plans. AT&T’s consumer fiber sign-ups were also strong, exceeding 300,000 net adds over the same period, as coverage availability continues to extend to more than 18 million customer locations. AT&T has grown its fiber customer base by more than 50%, or more than 2 million new net adds, over the past two years, which further bolsters the growth prospects of its broader Consumer Wireline segment.

AT&T’s robust demand environment continues to demonstrate resistance against the near-term slowdown in consumption. This accordingly reinforces expectations that the company will deliver on its promise to return to GDP+ growth in coming years as it invests greater focus towards capitalizing on 5G and fiber momentum ahead. With more than 70 million mid-band spectrum PoPs today and further expansion to 100 million mid-band PoPs by the end of 2022 and 200 million by 2023, AT&T is uniquely positioned to enable faster mobile connectivity speeds across a wider field of 5G coverage and drive greater customer adoption accordingly.

Safe Dividends

In addition to a resilient wireless communications business, AT&T’s industry-leading dividend yield also provides some insulation against any potential market valuation decline, while compensating for record-high inflation.

AT&T’s current annualized dividend is at approximately $1.11 per share, which approaches 60% of its anticipated free cash flows of $14 billion for the year. Based on the stock’s share price of about $18 today, AT&T’s annualized dividend yield still tops 6%, which remains on the higher-range compared to other dividend-paying stocks on the broader market while also partially compensating for core inflation of 5.9%.

While management’s recent decision to slash AT&T’s free cash flow guidance for the current year has recently fueled worries over whether its dividends will be cut next, the possibility remains slim. The company is expected to generate $10 billion in free cash flows in the second half of the year, after having frontloaded some of its capex spending in the first half to ensure adequate capitalization of growth opportunities ahead. Continued resilience demonstrated through its growing Consumer Wireline segment, and prudent management of its Business Wireline segment’s gradual transition out of the legacy voice and data services business also bolsters confidence in AT&T’s ability in achieving GDP+ growth and generating robust cash flows over coming years. And even in the unlikely event that AT&T decides to cut dividends to brace for near-term macro headwinds, it likely will not be the only one in the industry to do so – as peers are expected to move in lockstep, we view AT&T’s dividend pay-out to remain within an attractive range compared to peers in the event of an adjustment.

Final Thoughts

With investors being spooked by AT&T’s latest decision to adjust its free cash flow guidance for the year, the stock now trades at one of its lowest values on record at about 7x forward earnings. This is a discount to the peer group median of about 9x, especially considering AT&T’s continued market share gains across the consumer and commercial connectivity markets despite mounting macro uncertainties ahead.

The faster connectivity speeds and competitive economics enabled by 5G and fiber broadband is unleashing one of the biggest upgrade cycles in coming years buoyed by the demands of digital transformation, driving favorable growth trends ahead for AT&T. The company’s recent resilience demonstrated against the mounting macro headwinds, with robust market share and pricing gains still, bolsters prospects for continued delivery of GDP+ growth over the longer-term.

The Fed is already amping up its hawkishness on fighting inflation, which is expected to stay elevated due to amassing economic pressures from protracted COVID disruptions and a worsening geopolitical crisis in Ukraine that shows no sign of abatement. Considering the anticipated continuation of market shocks from mounting macroeconomic challenges that remain unresolved, AT&T remains an attractive investment under the current market climate given its predictable business with robust cash flows and an attractive dividend yield.

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