AT&T (NYSE:T) just released its second-quarter earnings. Not surprisingly, COVID-19 contributed to a drop in adjusted earnings of nearly 7% from year-ago levels. The news that the company has also lit up 5G service nationwide may obscure any bad news coming from the pandemic or the quarterly report.
However, if one looks closely at the earnings report, they may notice that net income has not kept up with dividend payments over the last six months. Fortunately for AT&T investors, the company has addressed this problem, and income investors should not worry about the dividend.
Why the dividend may worry some investors
For the previous six months, AT&T has reported a net income of $6.526 billion. That is down significantly from the $8.322 billion earned in the first six months of 2019. Unfortunately for the company, the dividend expense for the first six months of 2020 amounted to $7.474 billion, nearly $1 billion more than the net income so far this year. This takes the dividend payout ratio, or the percentage of net income going to the dividend, to well over 100%.
At first glance, this is concerning for many reasons. Due to both the expense of the 5G buildout and the cost of acquisitions in recent years, AT&T now holds nearly $153.4 billion in long-term debt. Subtracting liabilities from assets leaves the company with a stockholders' equity of just under $193.5 billion. This adds to an already high debt burden.
Additionally, AT&T is a Dividend Aristocrat due to the payout hikes that have occurred every year since 1985. This has contributed to a long-term trend of rising dividends and stagnant stock price growth. Consequently, the $2.08 per share annual dividend now yields approximately 7%.
While this is attractive to income investors, AT&T also faces tremendous pressure to continue the dividend increases. Numerous funds and investors hold AT&T stock due to the Dividend Aristocrat status. If those stockholders choose to sell, it could take years for AT&T stock to recover.
How AT&T can continue payouts
However, shareholders who only look at net income often forget one factor -- depreciation. This non-cash charge significantly obscures the company's true cash flow. Depreciation alone amounted to more than $14.5 billion in the first half of 2020. This does not include other non-cash charges. Moreover, even after accounting for the considerable capex costs of building the 5G network, AT&T reported free cash flow of $11.493 billion for the first six months of 2020.
This comes in well under the free cash flow for the first half of 2019. Still, it leaves AT&T with more than enough cash to cover the $7.474 billion dividend expense.
Indeed, AT&T made its commitment to the dividend clear in both the Q1 and Q2 conference calls. AT&T CFO John Stephens stated the goal of a dividend payout ratio (measured against free cash flow) in the "60% range" by the end of the year. Earlier in the year, the company also entered a $5.5 billion loan agreement to bolster the company's cash position.
Additionally, even though analysts predict a 10.9% drop in profits for the year, they estimate that earnings will increase by 2.5% in fiscal 2021. While such anemic growth will not make AT&T a "millionaire maker stock," it should generate enough additional cash flow to give dividend investors more breathing room.
The company also faces pressure from Elliott Management, who owns $3.2 billion worth of AT&T stock. Elliott has urged the company to suspend acquisitions and sell some businesses, in large part to protect the dividend. AT&T went so far as to suspend share buybacks in March, going against Elliott's recommendation. However, the pandemic may have driven the decision to halt repurchases.
AT&T faces tremendous challenges. COVID-19 will likely reduce revenue and profits in the near term. Longer-term, the focus for this telecom stock will shift back to the success of 5G and its investments in DirecTV and WarnerMedia should it choose to not divest either of these subsidiaries.
However, those invested in AT&T for income have fewer worries. Instead of turning to the dividend payout ratio as they would for most stocks, shareholders need to watch the company's free cash flow. As long as free cash flow stays well ahead of dividend costs, investors will likely see a payout hike in 2020 and further increases in the years to come.