Besides unsurprising fourth-quarter earnings, AT&T's (T 1.30%) management confirmed the giant telecommunications and entertainment conglomerate was still on track to deliver results in line with its three-year plan, which means the dividend should remain safe over the next several years.
Yet, besides a potential recession, the company's free cash flow and dividend depend on operational uncertainties, such as the decline rate of the legacy TV business and the success of the long-awaited video streaming service HBO Max. Thus, AT&T's preferred stock could represent an interesting alternative for investors looking for a safer income stream than the company's dividend.
How safe is the dividend?
After its recent 2% increase, the quarterly dividend of $0.52 per share represents an annual cash outflow of $15.09 billion, which is more than covered by the company's free cash flow that increased from $22.35 billion in 2018 to $29.03 billion in 2019.
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In addition to paying its dividend, AT&T reduced its debt load thanks to about $18 billion of asset divestitures, such as its stake in the video streaming service Hulu (now controlled by Disney) and its operations in Puerto Rico and the U.S. Virgin Islands.
As a result, the company's net debt decreased to 2.5 times its adjusted EBITDA at the end of 2019, compared to 2.8 times a year ago. However, the net debt of $151.02 billion remains massive.
Management aims at increasing the dividend and reducing the debt load over the next couple of years, thanks to at least $30 billion of expected annual free cash flow by 2022. AT&T's mobility segment, which includes its wireless business, should support the company's goals over the next several years thanks to the deployment of 5G.
Given this encouraging outlook, the dividend seems safe, and the current dividend yield above 5.5% remains attractive. But the company is facing some significant challenges that could have a negative impact on its medium-term forecasts.
AT&T must deal with the steep decline in its legacy video offerings because of the secular cord-cutting phenomenon. During the last quarter, the number of subscribers to premium TV, which includes DirecTV, dropped to 19.5 million, down 945,000 year over year.
Obviously, the video streaming service HBO Max, which the company will launch in May, is supposed to offset the decline of its legacy video business. Management expects HBO Max to attract 50 million domestic subscribers by 2025. But given the intensifying competitive landscape with the new streaming services such as Disney's Disney+, Comcast's Peacock, and Apple's Apple TV+, the success of HBO Max remains uncertain.
With this challenging context, AT&T's dividend could become less safe if the company's transition to video streaming delivers disappointing results.
Safer than the dividend
With its strategy of reducing the debt load, management diversified the company's capital structure. Instead of rolling over some debt, it issued $1.2 billion of preferred stock in December in the form of depositary shares -- financial securities -- that trade on the New York Stock Exchange under the symbol T/PA.
The dividend of this type of stock is safer than the common stocks. AT&T would have to cut its common stock's dividend before its preferred stock's in case a prolonged recession or disappointing results lead to diminishing free cash flow. Also, in contrast with the common stock's dividend, the company will have to catch up on any missed preferred stock's dividend payment.
Obviously, there's no free lunch and you should also consider the drawbacks of this safer instrument.
First, AT&T's preferred stock is currently trading above its issue price, which leads to a dividend yield of 4.8% that remains below the common stock's dividend yield of 5.5%. Also, this preferred stock is callable as from December 2024 at its issue price of $25, which means the company will have the option to buy its preferred stock at that price, which would deprive investors of their income stream. And in general, preferred stocks become less attractive if interest rates rise, and their upside potential remains limited because of their fixed dividend.
Thus, AT&T's preferred shares represent an interesting alternative for dividend-oriented investors that prioritize the safety of their income stream over some upside potential.
But given the company's significant debt load in a challenging context, execution remains one of the most important factors investors in the common and preferred stocks should pay attention to over the next several quarters.
