U.S. telecommunications giant AT&T (T -1.21%) recently reported its earnings for the second quarter of this year. Among some solid results was a notable drop in the company's cash profits compared to the prior year.
The decline was so steep that AT&T couldn't cover its dividend payment for the quarter and had to pull from its balance sheet instead. Is this a fluke or a sign of danger on the horizon? Here is what investors need to know.
Customers are struggling with inflation
AT&T's cash profits (free cash flow) totaled $1.4 billion in the second quarter, down from $5.2 billion in the prior-year period. The company spent $2 billion on its dividend in the quarter, meaning there was roughly a $600 million shortfall. Dividends are cash expenses; AT&T must pull from its balance sheet, either from its cash reserves or debt, if cash flow isn't high enough to afford the payment.
Most investors own AT&T for the dividend. Its 6.3% yield makes it a tremendous passive income tool for retirees and others looking to live off their investments. AT&T had already cut its dividend earlier this year to help free up cash to pay down debt. Naturally, shareholders want to know whether this shortfall is a one-off or if they could face another dividend cut.
Management explained the drop in cash flow on its earnings call. Part of the decline was due to higher capital expenditures than last year. Capital expenditures are investments into the business and reduce a company's free cash flow. Management also pointed to economic pressure, as some customers are falling behind on their phone bills. The company reduced its full-year guidance on free cash flow by $2 billion.
Too early to panic
Fortunately, it looks like things will turn out fine by year-end. AT&T is still guiding for $14 billion in free cash flow, assuming a total dividend expense of $8 billion, resulting in a dividend payout ratio of 57%, which is low enough to still free up billions for the company to continue paying down debt.
Management added some color to the situation, commenting that what it's seeing is on par with previous times of economic hardship and that because phones are such a critical part of modern life, they expect customers to pay their bills ultimately. Executives also said expected capital expenditures in the back half of the year by should be lower $2 billion. Further backing up their free cash flow forecast, they cited lower interest on debt now that AT&T has applied the cash proceeds from the Time Warner spinoff to its debt and strong customer growth.
Things don't always go according to plan, and AT&T could, of course, miss these projections over the coming quarters. But because the dividend payout ratio is so low, it's hard to imagine a realistic scenario where AT&T's business craters to the point that it truly can't afford its dividend. Telecom companies are historically very stable; people typically pay their phone bills like they do electric or water.
Customer growth remains strong
AT&T could see an uptick in growth as investors look further beyond the second half of this year. The company's picking up new customers at a solid rate: Net wireless connections grew by more than 800,000 in the second quarter, compared to just 12,000 for rival Verizon. It seems highly likely that AT&T is taking business from Verizon, enough that the former boosted its wireless segment growth forecast from 3% year over year for 2022 to 4.5% to 5%.
The top-line growth could trickle down to the bottom line as customers regain their financial footing and bill payments pick up again. In other words, AT&T's dividend should be fine during these short-term challenges and could become even stronger over the long term.
AT&T's stock is down 15% over the past year, but don't let the negative market sentiment distract you from the company's financials. Declining cash profits aren't ideal, but management gave plenty of color to the situation, and the payout remains affordable despite the setbacks. Investors can continue counting on the company's strong 6.3% dividend yield.
