Why AT&T Is Still a Buy After the Dividend Cut

After telegraphing the move nearly a year ago, AT&T Inc. recently announced that it would be slashing its annual dividend by close to 90% from the prior year due to an upcoming spinoff of its Time Warner assets. The company had a dividend growth streak of more than 30 years prior to that. AT&T now joins the list of other fallen Dividend Aristocrats whose business decisions didn't work out, costing them the ability to continue to raise distributions to shareholders. While the market has clearly soured on AT&T for the moment, and perhaps rightfully so, the future might not be all that bleak for the company. We try to consider the long-term when it comes to investing and believe that those holding the stock or are interested in the name shouldn't write off the stock just yet. There are several factors working in AT&T's favor that we feel make a compelling investment thesis, especially after the shares have pulled back. Recent Events Up until recently AT&T had been a darling of the dividend growth investment community. And for good reason as the stock had an average annual dividend yield below 4.5% only one time since 2005. The stock's average yield for the last decade was approaching 6%. Dividend growth was never that impressive, just slightly more than 2% on average since 2011 and earnings growth had been anemic, but the amount of income provided was the tradeoff for many investors. But then the unthinkable occurred. On May 17th, 2021, AT&T announced that it would combine its WarnerMedia assets with Discovery Inc (DISCA) to create a new global entertainment company. At the same time, the company announced that it expected its dividend payout ratio to be approximately 40% of free cash flow remaining following the spinoff. The WarnerMedia assets were expected to make AT&T even more of a cash cow than it was at the time of purchase. And this was the case, with free cash flow reaching nearly $30 billion. However, leadership projected free cash flow to be $20 billion in the first year following the mid-2022 separation. Unfortunately, this provides just $8 billion for dividend payments, which equated to roughly $1.15 per share or so based on the share count at that time. This would mean a drastic reduction in the dividend for a stock that was largely held for its income generation. The shares plummeted on the initial announcement. The shares went down nearly 5% again on the announcement that the new annualized dividend would be for $1.11. This will represent an 87% reduction in dividend payments compared to the prior year. Reasons for Optimism In the short-term, there are some issues that remain with the company. The acknowledgement of previous poor acquisitions resulted in the cutting of the company's dividend. Investors relying on AT&T's dividend, which had appeared quite safe, are going to feel the impact of the cut. It is never good when a company known for low growth, but high yield ends up cutting its dividend. That said, there remain some positives working in AT&T's favor that we think long-term investors should consider before selling their positions. First, the spinoff of WarnerMedia will return AT&T more to its roots as a pure-play telecommunications company, with this perhaps the best moment to do so. 5G is going to be a substantial tailwind to the telecommunications sector in general, but AT&T in particular. We are very much in the early innings of 5G, but already there have been clear benefits. In the most recent quarter, AT&T added 1.3 million net additions, including 884,000 phone net additions. This is a massive influx of customers and tops even rival Verizon Communications' total of 1.06 million net additions and 558,000 postpaid phone net adds. Just as important as acquiring new customers is the ability to retain the current customer base. Here, AT&T shows its strength as the churn ratio for the quarter was just 0.85%, up slightly from a record level in the prior year. Customer retention is hugely important as it shows consumers value the service being provided. AT&T also extracts significant revenue from its user base. The most recent quarter saw average revenue per user fell slightly, but remain at a solid level of $54.06. AT&T's Wireless Service segment grew 4.6% in the fourth quarter of 2021, a positive showing for what will likely be an even more important business within the company. While leadership may have mismanaged acquisitions, it appears that they are leveraging its core business to the benefit of the company. AT&T acquired the WarnerMedia assets in 2016, but at a significant cost to the balance sheet. Total debt from this transaction and other acquisitions that haven't worked out as planned, such as DirecTV, saddled AT&T with a burdensome debt amount that was approaching $200 billion. To illustrate how much debt the company took on, AT&T's market capitalization is just $175 billion today. To its credit, AT&T did take pains to reduce its obligations, but often at the cost of having to divest other assets. The good news is that long-term debt was down to just under $153 billion as of the most recent quarter. A sizeable sum to be certain, but still a significant improvement from where the balance sheet was just a few years ago. As part of the spinoff agreement, AT&T will receive $43 billion in a combination of cash, securities, and retention of debt, leaving the company in a much better finance position than it has been in quite some time. This debt repayment will provide assistance in the company achieving its net-debt-to-EBITDA ratio of 2.5x by the end of 2023. Expected Returns With the dividend cut finally occurring, we believe investors should now turn their attention to what potential returns could be for AT&T. We are enthused by the wireless business' performance in the most recent quarter and the added benefit of 5G, but we maintain an expected earnings growth rate of 2% annually through 2027. This is similar to the long-term average. We continue to expect that AT&T will earn $3.10 per share for 2022. With the stock trading around $24.50, this implies a price-to-earnings ratio of 7.9. Our five-year target valuation is 10 times earnings, which is lower than the long-term average. This multiple is appropriate, in our opinion, given the slowdown in earnings growth in the recent term. Reverting to our target valuation would mean that multiple expansion adds 4.8% to annual returns over the next five years. Lastly, the dividend will continue to be important to total returns. Even at the reduced payment, AT&T yields 4.5%, which is more than three times the average yield of the S&P Index. Therefore, our total return projection is 10.4%, stemming from a 2% earnings growth rate, 4.5% dividend yield, and a mid-single-digit contribution from multiple expansion. Final Thoughts AT&T's status as a Dividend Aristocrat has now officially come to an end following a pause and then steep cut to its dividend. The decision to divest its media assets and the need to improve the balance sheet meant that distributions were forced to be lower. While this is painful in the short-term, it was likely needed to put AT&T on a stronger financial footing. The debt obligations should will be lower post-spinoff as well. AT&T will also benefit form the expansion of 5G, something that is already occurring given the strength of its customer additions in the most recent quarter. Even after the dividend cut, we still forecast that AT&T can provide more than 10% annual returns over the next half-decade. For investors willing to see past the dividend cut, AT&T could prove to be a solid investment going forward.

Why AT&T Is Still a Buy After the Dividend Cut

While the market has clearly soured on AT&T for the moment, there are several factors working in its favor.

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