If you read all the way through AT&T's (T 0.66%) press release announcing the merger between WarnerMedia and Discovery Communications (DISC.A) (DISCK), you'll eventually come to an outlook for AT&T's financial profile following the spinoff. The long and short of it is that AT&T's dividend, which has climbed for 34 consecutive years, may get a haircut.
Dropping the dividend payout
AT&T said it expects to make annual dividend payments totaling 40% to 43% of free cash flow following the close of the WarnerMedia-Discovery deal. It expects annual free cash flow of about $20 billion immediately following the spinoff, which would put its total payments around $8 billion to $8.6 billion.
That's a significant cut from the $15 billion it'll pay out in 2021. What's more, it's less than the $9.6 billion or so it was paying out annually before management decided to start taking on boatloads of debt to buy DirecTV and Time Warner.
The 40% to 43% payout ratio is also less than the high-50% range AT&T is targeting for 2021.
Indeed, the sustainability of AT&T's dividend has been called into question after the company shackled itself with more debt than any other non-financial company with the DirecTV and Time Warner acquisitions in 2015 and 2018, respectively. Additionally, AT&T has had to spend billions on wireless spectrum licenses recently, and it'll have to spend billions more to deploy that spectrum and build out its 5G network. With a goal of also deleveraging the company, something had to give.
Setting itself up for sustainability
AT&T CEO John Stankey deserves some credit for working toward unwinding the megamergers of his predecessor, which put the company's balance sheet in the situation it's currently in.
Aside from the deal to spin off WarnerMedia, he also struck a deal to spin off DirecTV and sell 30% of the business to private investing group TPG. That deal will only provide about $8 billion for AT&T to pay down its debt, though, and it still has a 70% stake in a business with a dim outlook.
The WarnerMedia spinoff will provide greater debt relief. AT&T will receive $43 billion in a combination of cash, debt securities, and WarnerMedia's retention of certain debt. That can go a long way toward paying down the $160 billion of long-term debt on AT&T's balance sheet as of the end of the first quarter. AT&T expects to immediately lower its debt-to-EBITDA ratio to 2.6x from 3.1x as of the end of the first quarter. It'll move that number below 2.5x by the end of 2023.
Those moves are likely more valuable for AT&T bondholders than stockholders. For shareholders, the reduction in debt should free up more cash flow that isn't going toward interest payments. Combined with a reduction in the payout ratio, that should make the dividend more sustainable going forward.
AT&T investors who have been holding onto their shares because it provided a steadily increasing dividend are likely disappointed at management's decision to reduce payments. The market responded appropriately after digesting the news, sending AT&T shares lower, as much of the value of the stock is based on its dividend yield.
Investors who believe AT&T has the potential to unlock new growth as we enter the 5G era may see an opportunity to buy shares here, after a bit of a sell-off considering AT&T's strengthening balance sheet. It's worth pointing out, however, that management has modest expectations for growth following the spinoff. It expects annual revenue growth in the low single digits and EPS growth in the mid-single digits.