Singapore Markets closed

Should You Buy AT&T After its Recent Dip?

Leo Sun, The Motley Fool

Shares of AT&T (NYSE: T) have fallen 16% this year due to ongoing concerns about the sluggish growth of its wireless business, high debt levels, natural disasters, declines in video subscribers, and uncertainties about its planned acquisition of Time Warner (NYSE: TWX).

These issues make it tough to get a clear view of AT&T's future, and investors might be wondering if the telco can still be considered a safe income investment. Let's take a closer look at AT&T's business to find out.

An AT&T retail store.

Image source: AT&T.

Understanding AT&T's future

As America's second largest wireless carrier, top wireline services provider, and biggest pay TV provider (thanks to its purchase of DirecTV), AT&T has a very wide moat. After it closes its acquisition of Time Warner, it will also become one of the world's biggest media companies. This massive portfolio enables AT&T to bundle various services together -- like data-free "sponsored" video with wireless plans, or unlimited wireless data with DirecTV -- to lock in customers.

That's why investors were rattled by AT&T's recent warning that its third quarter US video subscribers would drop by 90,000 for the quarter, despite the addition of 300,000 subscribers for its streaming platform DirecTV Now. AT&T warned that drop would "negatively" impact its Entertainment Group revenues and margins, causing its adjusted consolidated operating income margin to remain flat year-over-year.

As for its wireless business, AT&T expects handset upgrades to fall by 900,000 annually due to longer upgrade cycles in the smartphone market. However, it still expects its total postpaid wireless smartphone base to grow as existing users remain, new users sign up, and it links up more devices like connected cars and wearables.

AT&T also expects the recent hurricanes and earthquakes to reduce its third quarter revenues by nearly $90 million and its reported pre-tax earnings by $210 million, or $0.02 per share, with further reductions spilling into the fourth quarter. Analysts expect AT&T's revenue to fall 2% this year and for its earnings to grow 3% (fueled by divestments and buybacks), but those figures might need to readjusted after it reports its third quarter earnings on Oct. 24.

Divestments and debt

AT&T is aggressively divesting its slower-growth businesses (data centers, wireline operations, and cell towers) to extinguish the debt it accumulated from its acquisitions of DirecTV ($49 billion), AWS-3 Spectrum licenses ($18 billion), and Time Warner ($85 billion). It's also considering spinning off or selling its Latin American pay TV assets (excluding Mexico) for over $8 billion, and might divest its Digital Life security business for another $1 billion.

AT&T finished last quarter with $132.8 billion in long-term debt, but just $10.8 billion of that total matures within the year -- which can be managed with the proper cost-cutting measures or divestments. However, its total long term debt will rise above $180 billion after the Time Warner deal closes. That jump is troubling, since AT&T's capex has gradually risen over the past few years but its free cash flow growth hasn't kept pace.

T Free Cash Flow (TTM) Chart

Source: YCharts

On the bright side, AT&T expects to report "capital expenditures in the $22 billion range, and free cash flow at the low end of the $18 billion range" for the third quarter. Those figures would represent a gradual reduction of its capex with an increase in cash flows.

But what about the dividend?

Some bears (and credit rating agencies) believe that AT&T's rising debt levels and anemic earnings growth could lead to a dividend cut. But I believe that AT&T -- a dividend aristocrat which hiked its payout annually for over three decades and three major market crashes -- would only cut its dividend as a last resort.

Granted, AT&T's earnings-based payout ratio often surged over 100% in the past, and its current payout ratio of 91% doesn't look ideal with the Time Warner deal still unresolved. But if we look at AT&T's dividend as a percentage of its free cash flow (the cash dividend payout ratio), it looks sustainable.

T Cash Dividend Payout Ratio (TTM) Chart

Source: YCharts

AT&T also expects the Time Warner purchase to become accretive to its EPS and free cash flow within the first year, then generate $1 billion in cost saving synergies within the first three years. Therefore, the purchase will initially cause AT&T's debt levels to jump, but its dividend looks well protected.

Should you buy AT&T ahead of earnings?

AT&T trades at 17 times earnings, which is well below the average P/E of 21 for telecom companies. Its forward P/E of 12 looks even cheaper. Those low multiples -- along with its high forward dividend yield of 5.4% -- should limit AT&T's downside potential at these prices, even if the stock remains stagnant.

Therefore, AT&T is still a good buy for income investors, but investors looking for a better blend of growth and income should probably look elsewhere.

More From The Motley Fool

 

Leo Sun owns shares of AT&T.; The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.