Anyone who bought AT&T (NYSE:T) stock at the end of December must have been licking their chops; the dividend yield of AT&T stock was well above 7%. Although the yield has dropped slightly since then (due to the appreciation of T stock price), the yield of AT&T stock is still above 7%.
That’s not bad for a company that’s increased its dividend for 35 straight years, putting it in a select group of stocks that’s come to be known as the “Dividend Aristocrats.”
One of just 53 “dividend aristocrats” in the S&P 500, AT&T stock’s lovely payout makes dividend-income investors swoon. “Where can you find a company of AT&T’s stature that pays anywhere near this yield?,” they ask.
Unfortunately, there’s one big reason why AT&T’s current yield isn’t worth the trouble. I’ll explain the reason below.
Free Cash Flow
Typically, a company pays out its dividends from its free cash flow, i.e. excess funds it doesn’t need to operate its business. More free cash flow is better, especially when companies are growing.
In the third quarter, AT&T had $6.6 billion of free cash flow, 8.2% higher than a year earlier. On a trailing 12-month basis, its free cash flow was a whopping $20.6 billion.
It devoted 62%, or $12.8 billion, of that amount to dividends in the trailing 12 months, leaving $7.8 billion for a number of its other priorities, such as repurchases of AT&T stock, acquisitions, debt repayment, and reinvesting in its business.
That’s not a whole lot of money when you consider that it generated $164 billion of revenue over those 12 months.
Then, consider that the company also repurchased $577 million of AT&T stock in the first nine months of fiscal 2018 and $20 million of T stock in the final quarter of 2017, reducing its free cash flow over the past 12 months to $7.2 billion.
That leaves just over $7 billion for debt repayment, acquisitions and reinvesting in its business.
On the other hand, its free cash flow is going to grow once it’s had Time-Warner in the fold for an entire 12-month period. That anniversary will come at the end of June.
AT&T expects to generate $26 billion of free cash flow in fiscal 2019, finishing the year with a net-debt-to-adjusted-EBITDA ratio of 2.5.
How Does Debt Affect the Outlook of AT&T Stock?
AT&T finished the third quarter with net debt of $174.7 billion — $183.4 billion in short- and long-term debt less $8.7 billion in cash. Its debt rose 53% versus the same period a year earlier, due to the Time Warner deal.
In its 2019 guidance, AT&T said it expects to repay as much as $20 billion of its debt this year with $12 billion from free cash flow and the remaining $8 billion from the sale of non-core assets, etc.
Assuming it repaid $5 billion in debt in the fourth quarter and its cash remains the same, it will finish 2018 with $169.7 billion of net debt. The company expects this year’s net debt to be 2.8 times its adjusted EBITDA, which means its adjusted EBITDA will be approximately $60.6 billion.
Taking that one step further, if its cash remains the same in 2019 and it repays $20 billion of debt, it will finish this year with $149.7 billion of debt. In that scenario, its adjusted EBITDA would be unchanged, again coming in at about $60.6 billion.
The implication is that until the synergies from the Time Warner deal kick in in 2020 and 2021, the company’s net-debt-to-adjusted-EBITDA ratio is not going to get much lower than 2.5.
The Bottom Line on AT&T Stock
Assuming AT&T follows through on its statements regarding debt repayment — and the company’s market cap doesn’t change meaningfully — its total debt should be around 70% of its market cap by the end of 2019.
I’m sure that’s not the worst percentage among S&P 500 stocks, but it’s pretty darn high. That’s especially true if there’s a recession in 2020, when the company expects significant savings from synergies to take effect.
I’ve been skeptical of AT&T’s purchase of Time Warner for many reasons. In July, I wrote about seven of them.
Chasing yield is a dangerous game. In my opinion, AT&Ts 7%+ yield isn’t worth it. You’re better off finding something with half the yield and twice the potential.
As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.