Investors often turn to telecom stocks for reliable sources of high-yield dividends. A big wireless network operator isn't going to grow very fast, and neither will its dividend payment, but that dividend is backed by tens of millions of paying subscribers. Even in a tough economy, wireless service is essential.
When a telecom giant gains an ambition to branch out beyond its core business, the dividend can start to look fragile. AT&T (T -1.36%) put its dividend at risk starting in 2014 as it embarked on a series of mega-acquisitions in the media industry. The company loaded up its balance sheet with debt bringing DirecTV and Time Warner under its umbrella, with grand plans to benefit from the bundling of wireless services and entertainment.
AT&T's strategy was a value-destroying failure, and the pandemic certainly didn't help. The company has now largely rid itself of its media assets, selling a stake in DirecTV and spinning off Time Warner into a new company, Warner Bros. Discovery. While longtime AT&T investors were harmed by all this dealmaking, the silver lining is that the dividend is far more secure now that AT&T is back to being a telecom company.
Cutting the debt
AT&T's core wireless business throws off a lot of cash. It has to, because the company must continually pour billions into maintaining and expanding its network. Telecom companies tend to carry a lot of debt to support their asset-heavy business model, which is fine as long as returns on investment are attractive. There also must be enough cash flow left over for an attractive dividend, which is one of the main reasons investors are drawn to slow-growing telecom stocks.
With the DirecTV and Time Warner acquisitions, AT&T piled on even more debt to buy businesses that don't have the same stability as wireless networks. At the end of 2014, before AT&T closed any of its misguided media acquisitions, the company's total debt stood at $82 billion. By the end of 2020, before AT&T had sold off any of its acquired media businesses, total debt had nearly doubled to $157.3 billion.
AT&T shelled out nearly $8 billion for interest payments in 2020, up from $3.6 billion in 2014. This huge debt load made AT&T highly sensitive to changes in interest rates. In a rising interest rate environment, AT&T would pay more in interest over time as it refinances its debt. This additional interest would eat up cash flow, leaving less for the dividend, opportunistic share buybacks, and investments.
With the spinoffs of DirecTV and Time Warner now complete, AT&T has taken the proceeds and used them the improve its balance sheet. Total debt stood at $136 billion at the end of the second quarter, and the company plans to continue to pay down its debt over time.
A smaller, safer dividend
AT&T cut its dividend after completing the Time Warner spinoff. While this move was no doubt disappointing for some investors, it was the right thing to do for the long-term health of the company.
Had AT&T kept its overly generous dividend, that dividend would have gotten in the way of the investments AT&T needs to make to compete, as well as further debt reductions. Growing its 5G and fiber networks is capital intensive, and being forced to underinvest to afford a big dividend would weaken the company in the long run.
AT&T now pays $1.11 per share in dividends on an annualized basis, still good for a 5.9% dividend yield. The dividend will eat up around $8.5 billion annually based on the current share count, which is 60% of the company's 2022 free cash flow guidance.
Free cash flow will be depressed this year for a variety of reason; the company has previously said that free cash flow should rebound to around $20 billion in 2023, although that outlook may end up being lowered as the economic environment worsens. If AT&T does hit its 2023 target, the dividend will eat up just over 40% of the free cash flow.
An improving balance sheet lowers the risk that the interest expense becomes a problem, and a smaller dividend leaves more cash for debt reduction and investments while creating some breathing room for tougher times. All of this ultimately makes AT&T's dividend safer.