AT&T (T 0.89%) stock is an alluring option for income investors thanks to its robust dividend, which at current share prices yields nearly 7%. Despite this -- and the company's position as one of the biggest U.S. telecoms -- AT&T is not a straightforward investment to evaluate.
A series of costly entertainment-industry acquisitions a few years ago saddled it with massive debt. On top of this, AT&T is making "historically high levels of investments in 5G and fiber" to expand its networks, according to Chief Financial Officer Pascal Desroches.
This mix of high debt and unusually large capital outlays might put AT&T on precarious financial footing. However, the results from the first quarter of 2023 showed some positive trends. Yet they revealed one warning sign as well.
Green flag: AT&T's customer growth
Beyond its high dividend yield, AT&T is a compelling stock to buy because of its strong customer growth under CEO John Stankey, who took over in 2020. AT&T exited the first quarter of 2023 with 424,000 postpaid phone net additions. Postpaid mobile phone subscribers are the telecom industry's most valuable customer type.
It was the company's 11th consecutive quarter with more than 400,000 postpaid phone net adds. Contrast this with 2019, before Stankey took the reins, when AT&T tallied an average of 121,000 postpaid phone net adds per quarter.
That customer growth is particularly impressive considering the competitive nature of the U.S. telecom market. Since 97% of American adults own a mobile phone, for AT&T to grow its customer base, it largely has to lure people away from rivals. Its multi-year pattern of postpaid phone growth illustrates that it is successfully doing that, and its first-quarter results show this trend is continuing into 2023.
Revenue from AT&T's mobile division rose 2.5% year over year in Q1 to $20.6 billion. This contributed to a 1.4% rise in total revenue to $30.1 billion.
Red flag: AT&T's free cash flow
While AT&T has done a commendable job of acquiring customers and growing revenue, its free cash flow (FCF) in the first quarter came in at $1 billion, substantially lower than its figures of $2.8 billion in Q1 2022 and $4 billion in Q1 2021. This drop is concerning because the FCF metric is an indicator of a company's ability to fund its dividend.
Moreover, AT&T cut its full-year FCF target in Q2 2022 from $16 billion to $14 billion. It could need to make a similar guidance cut in 2023. That's one reason why its shares are near their 52-week low.
Also, the cost of building out 5G and fiber optic networks is substantial, and the projects are time-consuming. To address these factors, AT&T entered into a joint venture with BlackRock on May 11 to help fund and accelerate its fiber buildout in more U.S. cities. Despite all the investment, fiber still accounts for only a modest portion of AT&T's overall sales, contributing $1.5 billion of the company's $30.1 billion in Q1 revenue.
Which flag to focus on for AT&T
Despite the lower free-cash-flow total in Q1, AT&T management reiterated that it would hit its 2023 FCF target of $16 billion. Stankey noted that the company's capital investments had increased over the prior year in Q1, which resulted in FCF coming in lower. But those investments, he said, would moderate for the remainder of 2023, helping to keep the $16 billion FCF target achievable.
Moreover, in its 2023 outlook, the company forecast that wireless service revenue would grow by at least 4%. AT&T achieved a 5.2% year-over-year increase in Q1 thanks to its customer growth, so it's off to a strong start.
However, AT&T management noted that macroeconomic circumstances are impacting customer spending -- for example, causing some people to postpone upgrading their older smartphones. As a result, said Stankey, the company is seeing "a drop-off relative to some of the traditional upgrade rates and the shopping rates."
Depending on how macroeconomic conditions develop throughout 2023, AT&T could be forced to cut its free-cash-flow forecast as it did in 2022. This holds implications for AT&T's ability to reduce its debt, a key 2023 priority for the company, and to maintain its dividend.
Therefore, at this time, the free-cash-flow red flag is too important to ignore. So it would be best for investors to hold off buying AT&T shares until its Q2 results reveal whether the company is trending toward achieving its 2023 FCF goal. Or better yet, consider other high-yield dividend stocks instead.
