AT&T (NYSE:T) indicated it would cut its dividend “nearly 50%” last week. This would be the result of the potential merger/spin-off of its TimeWarner division into a new company with Discovery (NASDAQ:DISCA, NASDASQ:DISCK, NASDASQ:DISCB). Barron’s said over the weekend that this makes T stock a buy at today’s price.
I don’t think so. There is a very high probability the stock will fall further if the deal goes through.
The reason I say this is because the effective yield will probably rise to 5%. The dividend yield today is 4% if the deal goes through. Here is how that works out.
AT&T’s Proposed Dividend and Yield
On May 17, the company’s proposed deal with Discovery included the following statement about the dividend:
“After close and subject to AT&T Board approval, AT&T expects an annual dividend payout ratio of 40% to 43% on anticipated free cash flow of $20 billion plus.”
This isn’t going to happen anytime soon. AT&T said that it expects the deal won’t close until mid-2022. I suppose they will continue paying the $2.08 annual dividend (52 cents quarterly) until then.
But let’s look at the numbers they propose. If we use 43% and then project that free cash flow (FCF) will be $20 billion, the dividend payment will be $8.6 billion. That works out to $2.15 billion per quarter.
Today, the dividend payments cost AT&T $3.741 billion each quarter, or $14.964 billion annually. You can see this on the Seeking Alpha page that shows its quarterly cash flow statements.
So the $8.6 billion proposed dividend payments will be 57.47% of today’s $14.964 billion dividend cost. This would lower the dividend payment to $1.195 per year, or possibly $1.20 annually (assuming they round up).
So, at a price of $29.75, this gives T stock a pro format dividend yield of 4% (i.e., $1.20/$29.75). But investors have been used to a 6% dividend yield up until recently.
So, I suspect that once the deal goes through T stock would fall to a 5% dividend yield. This means that the $1.20 prospective yield, divided by 5% equals a target price of $24. That implies a 19.33% drop.
But Not So Fast
But let’s get real here. First, the deal won’t go through for a year. Second, the company will keep paying the present dividend (I assume). Third, this now makes the stock very attractive, since it has a high dividend yield of almost 7%.
So, ironically, that makes T stock a buy right now. And, let’s not forget, even though the proposed deal could result in a lower stock price, shareholders get something to offset this.
They get to own shares in the spun-off company (with no name right now). The potential deal right now looks like AT&T shareholders will get 71% of the company spun off to them. This will show up in your brokerage account one day, tax-free. You can sell these shares, and potentially buy back more of the T stock in order to increase the dollar amount of the dividends that you are not receiving.
There are not enough numbers right now to calculate what the potential yield would be if you did this. However, you would have to also include the capital gains tax on the spun-off shares that you sell.
What To Do With T Stock
So, now we have a conundrum. We like the T stock at this price, since the yield is very high, at least until the Discovery deal goes through, over a year from now. But after that, the stock could fall. But there is a hedge in that you can sell off the Newco shares you receive.
All in all, I suspect most investors will hang on to their T stock if they already own it. Those who don’t may find this an interesting entry point, albeit they may have to average down into the stock later on. That would occur when the deal goes through and, if I am correct, T stock will fall to a 5% dividend yield or $24 per share.
On the date of publication, Mark R. Hake did not hold a long or short position in any of the securities in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.