How bad would the economy need to get for AT&T to consider cutting its dividend? The stock’s annual yield is 7.2% in a zero-interest-rate world, and the payout is no small part of many investors’ reason for owning the Dividend Aristocrat’s shares in the first place.
Phone companies tend to be the types of stable, high-cash-flow businesses that can support generous dividends through good times and bad. But years of diversification initiatives have transformed AT&T (ticker: T) into a much more cyclical and economically sensitive company. That promises greater potential growth in boom times, but also higher risk during busts.
And there is little remaining doubt that the coronavirus pandemic will cause a sharp recession in 2020. In a report on Friday, MoffettNathanson analyst Craig Moffett ran through several recession scenarios, looking at how they would affect AT&T’s business and ability to maintain the payout.
Moffett’s conclusion wasn’t optimistic. He kept his Sell rating on the stock, and lowered his target for the share price to $23, the lowest on the Street, from $30.
The company declined to comment. AT&T shares were down 5% on Friday, to about $27.30, versus a 2% drop for the S&P 500.
In 2019, AT&T produced $29 billion in free cash flow after capital expenditures, which easily covered the company’s roughly $15 billion in dividend obligations. But equity holders aren’t the only ones with claims on the cash generated by the telecom and media conglomerate.
AT&T ended the year with $151 billion in net debt, one of the highest totals for any individual company in the U.S. The debt load is largely a product of two non-telecom acquisitions: The company paid a combined $172 billion, including debt, for DirecTV and Time Warner, in 2015 and last year, respectively.
Those deals changed the profile of the company. AT&T’s wireless phone segment brings in about 40% of sales now, with the rest split between the renamed WarnerMedia, cable and satellite TV, and the business wireline operation.
“Wireless is rightly viewed as a defensive business,” Moffett wrote. “...Their other businesses, which now compose the majority of the company, are all either moderately or highly cyclical.”
The shift within AT&T shows clearly in the stock’s relative performance in 2020. Since the S&P 500 hit its last record high on Feb. 19, the index has lost 25% of its value. AT&T shares have dropped 27%, yet Verizon Communications (VZ)—still predominantly a mobile phone service business—has slipped just 6%. Verizon’s dividend yield is 4.5%, below AT&T’s, signaling investors see the former stock as less risky even though dividends soak up a bigger share of its free cash flow.
Even in his most severe recession scenario, AT&T’s dividend commitments never exceed Moffett’s projection for its free cash flow—assuming some reductions to capital expenditures. But for Moffett, it’s less a question of AT&T’s dividend coverage and more a problem of leverage.
“The issue is not whether their dividend coverage ratio drops below 1x free cash flow—although it certainly might—it’s whether they will become too levered to sustain their credit rating without cutting the dividend,” Moffett wrote.
AT&T’s debt is currently rated Baa2 by Moody’s and BBB by S&P—both two levels above junk status. Maintaining an investment-grade rating is a must for a company with hundreds of billions of dollars of borrowings and at least $10 billion in maturities coming due in each of the next five years.
Moffett pointed to a December credit opinion by Moody’s, in which the company says it could downgrade AT&T’s rating if its free cash flow declines relative to its debt, or if adjusted leverage climbs above 3.5 adjusted earnings before interest, taxes, depreciation, and amortization on a sustained basis. Some of AT&T’s debt covenants also require it to keep net debt below 3.5 times adjusted Ebitda.
Ebitda from AT&T’s more economically sensitive segments will likely decline substantially during a recession. If a downturn continues beyond 2020, Moffett writes, AT&T’s leverage ratio could rise to the point where the company will need to choose between using its cash flow to maintain its dividend, or to preserve its credit rating. AT&T has already suspended planned share buybacks to preserve cash during the coronavirus crisis.
“In a lingering recession, would [the ratings firms] demand a dividend cut to now pay down debt more rapidly?” Moffett wrote. “We simply don’t know. But it is certainly not inconceivable. In our view, AT&T’s dividend can no longer be considered a sure thing.”
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