We have recently rated AT&T Inc. (NYSE:T) as a strong buy. We believe that the stock is undervalued and remains a solid investment for income. However, there remain concerns about the company’s debt burden and, more importantly, the free cash flow generation being at risk. To remind you, we were long-time owners, then became bearish and shorted the stock a few quarters ago, only to return to the stock when it hit the mid-teens. We continue to believe the stock has found its bottom in the $13-$14 range. And there have been some critical changes that impact our assertion that we seek to update our readers on.
First, with the recent spike in shares, we have been encouraging the sale of covered calls to ramp up your income while holding the stock. Are you afraid of being called away near expiration? Simply roll it out and keep the money train running. We have reason to believe that the stock is going to continue to rally. Even today the stock is running on a volatile triple witching day which has sent markets down rather sharply, at least, on a relative basis given the market has not seen too many strong down days, even in this seasonally weak period.
So, what is going on? Well, we want to point out that AT&T, as well as its main competitor Verizon Communications (VZ), caught some upgrades. Note, we have a buy rating on Verizon as well for similar reasons as AT&T. You can read more about that here. With that said, Citi recently upgraded these income names to Buy/High-Risk ratings. While Citi analysts did cite several concerns that have weighed on the sector and the stocks, the analysts now have a more positive outlook on the stocks and upgraded them.
As we have noted previously, Citi took note that there are signs of stabilization, which should help operating performance. The analysts also cited free cash flow, something we have been hammering our readers and investing group members on. We have specifically shown why the dividend is safe, and the debt can be paid down out of cash flow. Citi noted forward free cash flow will reduce net debt leverage and support dividend payouts. One added risk they addressed was the lead issues and possible cleanup costs. Citi suggested that valuations could be discounting far more than possible remediation cost scenarios. So you need to be aware of this. But just today we are now seeing the impacts of a key update from the company.
Folks, we have pounded the table on AT&T, losing readers and members over reiterating strong buys on the stock at $13.50. Now shares are getting some love. Management provided a critical update. At an investor conference, management backed up its forecasts and indicated that a back-end loaded year in free cash flow is still on target for $16 billion, or more. We have been adamant that the company would hit this target, if not very close, which means the dividend payout ratio would mean the dividend is easily covered. Chief Financial Officer Pascal Desroches was asked if the target was in sight. He stated:
“Yes, yes, yes! ….you can really get a sense for why we are so confident about the back part of the year. We said at the very start of the year, first quarter was going to be the lowest followed by second quarter, followed by third quarter, and fourth quarter. It is playing out exactly as we thought.”
And now we have a target in sight for Q3, which will be reported in October. In referencing device spend and other factors, the CFO indicated that he is seeing $4.5 billion to $5 billion of free cash flow for Q3.
Folks, this is huge. This is why we assert the dividend is not at risk. Management has been improving the balance sheet, as it has sold off assets and paid down its debt. Over $20 billion in debt has been knocked down in the last few years. The net debt was $134.2 billion to start Q2, and they ended with $132.0 billion of net debt, considering cash. The net debt-to-adjusted EBITDA was 3.2X, which is high, but management anticipates in the next two years it will reduce this ratio down to 2.5x. In Q2, free cash flow was $4.2 billion with cash from operating activities being $9.9 billion. With dividends paid of $2.01 billion, the payout ratio was less than 50%.
And now we have a figure for Q3, of $4.5 billion to $5 billion. In no way is this a dividend at risk. Folks, if we have $2.01 dividends paid again in Q3, then the payout ratio will be 44.4% on the high end, to 40.2% on the low end. That is fantastic. But moving forward, is the payout ratio projected to rise to unsafe levels? No, it is not. Sure, the seasonally weak Q1 is likely to see reduced cash flow, but after this Q3, we can expect likely another $4 billion or more in Q4. As such, for the year, the payout ratio is still projected to be in the 60% range, if not lower if free cash flow comes in on the higher end.
Bottom line, this will cover the dividend easily all year. No dividend cut is coming. In fact, a small raise is not out of the question. This reality should continue to generate buzz from income-thirsty investors. As we look ahead to the rest of 2023, we continue to forecast revenue growing 3%-4% on better pricing and more customer adds/volumes. We further see EPS in the range of $2.40-$2.55 for the year. That is less than 6.5X FWD EPS, which is incredibly attractive, since the yield is higher.
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