On Monday, AT&T (T 0.39%) confirmed that it will spin off its WarnerMedia entertainment unit and merge it with Discovery. While this will help AT&T reduce its debt and become a pure-play telecom again, it will also force the company to reduce its dividend significantly.
AT&T unwinds another big mistake
AT&T made two massive acquisitions between 2015 and 2018 in a quixotic quest for growth. In 2015, it bought DIRECTV for a total enterprise value of $67 billion. It followed that up by buying Time Warner (now known as WarnerMedia) in 2018 at a $104 billion enterprise value.
Both acquisitions were strategic blunders. Earlier this year, AT&T agreed to sell a 30% stake in its U.S. video unit (including the bulk of DIRECTV's business) to TPG Capital at an enterprise value of just $16.25 billion. Now, the WarnerMedia spin-off and merger with Discovery values that business at more than $90 billion: a meaningful discount to what AT&T paid three years ago.
The WarnerMedia spin-off will reduce AT&T's net debt by $43 billion, helping it reach its long-term leverage targets much sooner than would be possible otherwise. On the other hand, the company now projects that annual free cash flow will be at least $20 billion after the spin-off, down from an estimated $26 billion in 2021. Even that cash flow target could prove ambitious.
AT&T's current dividend costs $15 billion annually. The reduced cash flow outlook makes that payout unsustainable. In fact, AT&T plans to reduce its free cash flow payout ratio to between 40% and 43%. Assuming free cash flow of $20 billion, AT&T would have to slash its annual dividend payments to between $8 billion and $8.6 billion. That implies a 40%-plus dividend cut.
Lumen is a solid alternative
Shares of Lumen Technologies have surged roughly 50% year to date, but the company still boasts a 7% dividend yield. That is similar to AT&T's current dividend yield and significantly higher than AT&T's yield will be after it cuts the dividend.
Lumen's annual dividend payments of $1.1 billion put its free cash flow payout ratio below 40%. Thus, even after AT&T reduces its dividend, Lumen will have a slightly more conservative payout ratio.
To be fair, Lumen faces its own challenges. Revenue has been eroding steadily in recent years, largely due to declining demand for legacy voice and DSL internet service. The COVID-19 pandemic has aggravated matters, as some customers temporarily paused some IT spending.
However, Lumen has managed to return to earnings growth by cutting costs and repaying or refinancing debt to reduce interest expense. The company will reduce interest expense even further over the next few years by retiring more high-cost debt. Meanwhile, Lumen should be able to stabilize its revenue by capitalizing on growing demand for high-speed, low-latency fiber internet connections. That would support further earnings growth.
AT&T stock could eventually become a good investment opportunity again, once the company finishes its ongoing restructuring and shows that it can meet the financial targets management has laid out. And even with its plans to cut the dividend, AT&T will maintain an above-average yield based on its recent share price.
For now, though, Lumen is a more attractive stock for income-focused investors. Its low payout ratio means that its 7% yield is clearly sustainable. Meanwhile, Lumen has a straightforward opportunity to continue reducing interest expense, driving earnings higher despite the recent pressure on its top line.
This simple formula for near-term earnings growth -- combined with the company's high dividend yield and low payout ratio -- makes Lumen Technologies a great dividend stock. If management's plan to get revenue growing again succeeds, long-term investors could benefit from substantial share price appreciation, too.