It has been quite a while since we covered AT&T (NYSE:T) despite having long owned the stock. We have long held this as a dividend paying name, and of course as we all know WarnerMedia was spun off months ago. The company is now once again operating as a broadband telecom, and still pays a handsome dividend. That entire deal to spin off Warner was controversial, but be that as it may, here we have a new leaner AT&T. We have never seen anything like what we just saw today when it reported earnings. There were some very critical successes, and some blatant downside surprises. It was a borderline disaster in some respects when you look at the action, and seemed to be an absolute homerun when we first saw the news hit the wire. The war between bulls and bears has hit epic proportions now. We continue to believe this is a great income stock, but timing your entry into the stock matters, or else it could take many quarters to recoup on paper capital losses. That said, we are bearish short-term, but long-term bullish. Let us discuss.
Results in context
For the most part corporate earnings have been strong this earnings season. But AT&T left something to be desired overall. Some of the issues we noted we just never saw coming, which we will discuss. Surely management is taking proactive measures, such as selective pricing adjustments, to address as much of the very real inflationary pressures that are out there. It may not be enough yet, and we could see an evolving pricing strategy to allow even the most loyal of customers to take advantage of special offers, while attracting new customers. At the same time, the company is experiencing massive cost pressures in its business. The inflationary pressures are weighing. In the conference call the CEO noted that such pressures are:
“costing more than $1 billion above the elevated cost expectations embedded into our outlook. We’re clearly operating in different times, and the macroeconomic backdrop is evolving in a dynamic manner. “
While this new legacy oriented AT&T has indeed improved its financial position, the fact is that they need to push cost savings programs, or else you can expect ongoing earnings pressure. The fact is that the services they provide are not really discretionary, they are more of a necessity so that helps, but there is so much competition. Getting promotional to attract customers only partially offsets these impacts. We have never seen anything like this. One particular comment in regards to the performance by the CEO really sums up the pain:
“….the current environment is not easy to predict. We’re seeing more pressure on Business Wireline than expected. And on the consumer side of our business, we’re seeing an increase in bad debt to slightly higher than pre-pandemic levels as well as extended cash collection cycles.”
Allow us to translate. In short, the company is implying that it is operating like in a recession. That has been a major fear of many investors. The big bad “R” word, recession. This statement suggests pain. It is not all bad. There are some positive signs that were noted.
A big top-line surprise
Overall our revenue expectations for Q2 2022 were slightly more conservative relative to consensus. Analysts covering the company were targeting a consensus of $29.47 billion. We expected revenue to be closer to $29.75-29.80 billion range on the belief that the company was still seeing robust demand from businesses and consumers, given that unemployment remained so low during the quarter while businesses can’t find enough workers. In short, things seemed strong, despite inflationary pressures. To our surprise the top line hit $29.60 billion, much better than expected vs. consensus but a touch like compared to our over bullish take. This was a beat of nearly $130 million vs. consensus. Let us look a little deeper.
Top line drivers
Wireless postpaid growth saw 0.813 million adds, boosted by 5G availability and marketing strategies. AT&T also reported 316,000 Fiber net adds. Both of these numbers are stellar. The company noted the company has penetrated more and more available markets. We have never seen anything like the level of customer additions. It is epic. Historic levels of adds, and the best Q2 for postpaid adds in over ten years. For 5G, they are now on track to hit 100 million people. That is eye popping when the goal for year-end was 70 million. Wow. The Fiber adds were very close to a record Q2 level as well.
The top line performance helped drive the bottom line to a beat versus consensus. Analysts were looking for $0.62, and this was surpassed by $0.03 solid. Expenses still remain higher than we would like, offsetting the revenue somewhat. Operating expenses were $24.7 billion. While this is down from last year, recall the major divestitures that have taken place. Operating income fell to $5 billion, though if you make (a lot of) adjustments, operating income expanded slightly to $5.9 billion from $5.7 billion, accounting also for the divestitures.
As of now, this is still a dividend play. And that said, free cash flow will again be more than sufficient to cover the dividend, and the critical payout ratio will remain safe, but cash flow is now a major concern. This caught us by surprise in a major way.
Free cash flow was eye-popping
We still own this stock because it is an income name for us. That said, free cash flow is key to covering the dividend payment. We have not seen issues with coverage in years frankly. We thought Q2 free cash flow would be $2.0 to 2.5 billion, considering cash from operating activities of $7.0-$7.5 billion and capex spending of $4.5 billion. We were off slightly on our expectations as cash from operating activities were $7.9 billion, and capex was way up to $4.9 billion, while total capital investment from operations was an obscene $6.7 billion.
Folks, this was the disaster that caused the stock to sell off. Because of massive capital investment now, and projected for the year, free cash flow is going to be way less than expected. That is a problem. Free cash flow was below our expectations hitting $1.4 billion. Ouch. This means the dividend was not covered. That is a major problem, folks. Major problem. It is not good. We have not seen the company fail to cover its dividend in years before this year. Ouch.
Dividends paid were $2.09 billion, so there was about a $700 million shortfall. The payout ratio was a stomach churning 150.7%. As an income investor for the long-term this is a major problem.
But why? Why is this happening. The company is investing massively in itself to grow and to attract customers. We expect revenue to improve, but cash flow was guided to just $14 billion for the year. This should still cover the dividends to be paid of about $4.2 billion for H2 2022, considering free cash flow thus far was $4.2 billion. That means we can expect another $9.8 billion in free cash flow if the forecast is correct, meaning the dividend is covered. But it is no longer a very safe payout ratio for now.
Folks, this has us bearish short-term, but bullish long-term. We believe the investments will pay off and that you will see margins expand, and capital investment normalize in 2023, but for now expect pressure on the stock. This is the only reason we have a bearish rating right now. Frankly, if the market chaos knocks this back to $15, we would buy hand over fist. But when you combine this news with the debt, short-term, we are bearish. Expect traders to walk this down.
Lot of debt still
One of the biggest risks with holding AT&T has continued to be the debt. The company had been chipping away at the debt and improving the balance sheet by selling off assets and paying down its debt. Last year it got into some spectrum access bidding issues, that added back some debt. Now they spun off Warner Media, so debt has come down, but it is ugly still. At the end of the second quarter, net debt was $131.9 billion, and this translates to a net debt-to-adjusted EBITDA of 3.23x.* We want to see this ratio come down a lot more.
This is an income name but a battleground stock. We think the stock pulls back sharply from the $20s and then can be bought. $15 we would be heavy buyers. The risk is that all of the investment being made does not pay off. Seeing the dividend barely covered for the year is definitely something we have not seen in a long time. This all comes despite operational excellence on the headline results. But the issue is that management has been paying up for this growth.
Final take? Short-term bearish, long-term bullish for this income name. Let it come down heavily toward 52-week lows, then hold your nose and buy. For now, expect selling pressure.
Your opinion matters
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