AT&T Inc. released Q2 2019 and YTD 2019 results July 24, 2019. It has generated ~$29B in free cash flow over the last 12 months and full-year free cash flow guidance is now ~$28B.

In addition to reducing net debt by ~$6.8B in Q2, T has repaid ~$18B of debt subsequent to the June 2018 acquisition of Time Warner.

AT&T sports an attractive dividend yield but the dividend growth rate is only roughly equivalent to the rate of inflation.

Summary

  • On July 24th, AT&T reported Q2 2019 results which included $14.3B of cash from operations and $8.8B of free cash flow.
  • T’s long-term debt rating has deteriorated with Moody’s having lowered the rating 3 notches from A2 to Baa2. S&P Global has also lowered T’s credit ratings.
  • At the end of Q2, adjusted net debt to EBITDA was just under 2.7 times versus ~3 times when the Time Warner deal closed in June 2018.
  • Management has indicated the plan is to reduce net debt to adjusted EBITDA to ~2.5 times by FYE.
  • I view shares as currently being fairly valued.

NOTE: I encourage you to access T’s Investor Profile to get a very high level overview of the company so as to determine whether this is a company that would be remotely of interest to you as an investment.

Introduction

Despite having:

  • initiated a position in AT&T, Inc (T) in September 2011 in an ‘undisclosed’ account;
  • acquired another block of shares in December 2011 for the same account;
  • purchased a further block of T shares in October 2015 (these shares are held in one of the ‘Core’ accounts within the FFJ Portfolio)

I have never previously written an article about T.

The reason I now write this article is that I am currently working on our family’s cashflow forecast for the next several months. In looking at the inflows/outflows I could not help but be impressed with the degree to which T has contributed to our inflows over the years.

For a little over 3 decades I dreamed of being able to take a ‘Well’ day (as in…’Well, I just don’t want to work anymore’) much earlier than the norm. As much as I had far more enjoyable days than unpleasant days during my career, I just could not fathom myself working to my mid-60s and then having a few remaining years in which my health might limit my ability to do the things I want to do and when I want to do them.

As part of my wife’s/my early retirement planning process I focused on getting to a position where we could rely solely on our investment income during retirement. I did not want to be in a predicament where I had to rely on ANY form of pension income nor did I have any intention of continuing to own rental properties much longer.

Given this I realized that it would be prudent not to invest solely in growth companies. As much as Berkshire Hathaway (BRK.b), Visa (V), Mastercard (MA), Church & Dwight (CHD), Broadridge (BR), Brookfield Asset Management (BAM), Becton Dickinson (BDX) et al have dramatically increased our net worth on paper, I need positive cashflow. Generating positive cashflow from the sale of our holdings was certainly not my idea of a prudent game plan.

I am not denying that the sale of assets to cover expenses during retirement does not work for some people. I just merely did not want to be in a position where I would NEED to liquidate assets only to find out that my NEED to liquidate assets coincided with a market downturn. As a result, I decided to invest in income producing equities.

While I could have ploughed money into MLPs and REITs, I abhor those investments. They typically disburse a significant percentage of their cashflow and unit count typically increases over time. As a Canadian resident I did not want to deal with any US MLPs and on the REIT front, the distributions of the vast majority of the Canadian REITs I have reviewed include a return of capital in their monthly distribution.

After having owned shares in another telco (BCE Inc. (BCE)) since the early 1960s (kudos to my parents on this investment decision), I decided to increase my exposure to this industry by acquiring shares in T; subsequent to my T investments I acquired shares in Verizon Communications Inc. (VZ) and Telus Corporation (T).

Much has transpired to T subsequent to me initiating a position including a 3 notch long-term debt downgrade by Moody’s. While this certainly makes one wonder whether T is still an appropriate investment for a retiree I am optimistic the probability is low that I will experience a permanent impairment to my capital.

My Rationale for Investing in T

When you look at the ~2% annual increase in T’s dividend I can fully appreciate how it could be difficult to get excited about T. When you look at the rate of inflation you see that it is comparable to the growth rate of T’s dividend.

I did not invest in T with the expectation that it would perform like some of our other holdings (listed earlier in this article). I invested in T primarily from an income perspective.

In early 2012, the dividend income generated from my T investment held in undisclosed accounts was sufficient to acquire ~20 shares/quarter. Without acquiring any additional T shares other than through the automatic reinvestment of all dividends, the quarterly dividend income is now sufficient to acquire ~40 shares/quarter.

In addition to T shares held in an undisclosed account, T shares are held in the FFJ Portfolio. The automatic reinvestment of this dividend income, after withholding tax, results in the receipt of a further ~8 shares/quarter.

While we do not currently rely on T’s dividend income to service any of our retirement expenses I really don't know what to expect a decade or two down the road. Although the actual rate of growth of T’s dividend is not appealing I am reasonably confident that when we do decide to use T’s dividends to cover some expenses during retirement, the amount we receive should be sufficient to pay some bills without me HAVING to liquidate shares.

Q2 2019 Results and FY2019 Guidance

T’s Q2 Earnings Release, Earnings Presentation, and Financial and Operational Trends released July 24th can be accessed here.

In addition to looking at non-financial metrics when analyzing a company, I look at various financial metrics with Debt and Free Cash Flow being two critical metrics I look at.

Looking at slide 6 of the Q2 Earnings Presentation we see $14.3B of cash from operations and $8.8B of free cash flow. On the July 24th Earnings call, management indicated that the addition of WarnerMedia’s receivables to T’s securitization efforts resulted in a $2.6B positive impact to free cash flow.

Looking over a slightly longer-term we see that T has generated ~$29B in free cash flow over the last 12 months and full-year free cash flow guidance is now ~$28B.

In addition to reducing net debt by ~$6.8B in Q2, T has repaid ~$18B of debt subsequent to the closing of the merger.

At the end of Q2, adjusted net debt to EBITDA was just under 2.7 times versus ~3 times when the Time Warner deal closed in June 2018.

Management has also indicated a further ~$12B net debt reduction in the 2nd half of this year should get net debt to adjusted EBITDA to ~2.5 times by year-end.

Credit Ratings

The following image reflects the credit ratings Moody’s has assigned to T over the years. At one point an A2 rating was assigned which is the middle tier of the upper medium grade range. The current Baa2 rating is 3 notches lower than the A2 rating and is the middle tier of the lower medium grade range.

In June 2018, S&P Global lowered T’s local currency long-term debt rating to BBB. This rating is equivalent to Moody’s Baa2 rating.

Although I don’t like credit rating downgrades I like how T is now aggressively repaying its debt. I am, therefore, prepared to stick with my T investment and will monitor leverage levels going forward.

Valuation

In T you have a company currently trading at $34.15. It generated $1.07 in Diluted EPS and $1.75 in adjusted Diluted EPS for the first half of the year.

When FY2018 results and FY2019 guidance were released, management projected low single-digit adjusted diluted EPS growth. FY2018 adjusted diluted EPS came in at $3.52 so using a 1% - 3% range we can expect T to generate adjusted diluted EPS of ~$3.56 - ~$3.63 in FY2019.

I suspect there might be a wide variance in earnings guidance provided by multiple analysts but I will go with ~$3.58. Using this figure and the current share price we get a forward adjusted PE of ~9.54.

The T of a few years ago is very different from the T of today which makes it a bit more difficult to look at historical valuations to see if the current valuation is reasonable.

In 5 – 10 years I envision debt levels and share count being much lower and I think the valuation will begin to become a bit richer than the current forward adjusted PE of ~9.54.

Dividend, Dividend Yield and Dividend Payout Ratio

Investors who rely heavily on stock screeners and who seek investments primarily based on a company’s dividend yield will likely be attracted to T’s ~6% dividend yield. Delving a bit more into T’s dividend history we see the annual dividend growth rate is ~2%. This is not much different from the inflation rate of recent years.

I do not expect this dividend growth rate to change any time soon. In fact, on the Q2 Earnings call management indicated debt reduction is a top priority with share buybacks being the next priority.

‘Looking at the remainder of the year, we’re confident that we’ll hit our year-end leverage target. To the extent, we can overachieve with that target you can expect will take a hard look at allocating capital to share buybacks in the back half of the year.’

On the dividend payout ratio front, I draw your attention the Q2 2019 Discussion and Reconciliation of Non-GAAP Measures. I appreciate the Free Cash Flow and Free Cash Flow Dividend Payout Ratio analysis on the first page of this document covers a very short timeframe. I am, however, encouraged by the degree to which the Free Cash Flow Dividend Payout Ratio has improved relative to the prior year timeframes. I fully expect T’s future dividend payments to continue to be adequately covered by free cash flow.

Final Thoughts

Some investors will be passionate about T while other investors will deem T to be an inferior investment. We all differ when it comes to priorities, goals and objectives, cashflow, wealth, tolerance for risk, tax brackets, etc. so it is perfectly fine to have a difference of opinion re: T investment.

Despite the low level of dividend growth an investor can realistically expect from a T investment over the next several years, I provided my personal example of how T has been rewarding.

I chose to invest in T because my portfolio already had holdings with much greater growth potential. What I sought from a T investment was something that could throw off income to cover expenses during retirement which would reduce the need to liquidate holdings.

As I have indicated in several previous articles I am of the opinion that a broad market pullback is becoming increasingly likely. I do not expect T to be immune from any such pullback but I think any T pullback will be far less pronounced than many high growth ‘darlings’.

I view T as attractively valued but I will not be acquiring additional shares other than through the automatic reinvestment of dividends since my existing T position already increases by ~200 shares/year without any interference on my part.

I wish you much success on your journey to financial freedom.

Thanks for reading!

Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].

Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.

Disclosure: I am long T.

I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.