The last few years have been tough sledding for shareholders of AT&T (T +0.73%). The telecommunications giant made some blunders last decade, none more impactful than its purchase of Time Warner. The debt-fueled acquisition worth $85 billion was closed in 2018, but was spun off from AT&T last year due to severe underperformance.
So it is no surprise then to see AT&T shares significantly underperforming the broad market in the past three years, posting a total loss of nearly 12% versus gains of 31% in the S&P 500.
However, with shares down in the dumps, AT&T's dividend now yields an attractive 7.5%, with its core business still growing customers. Is this dividend yield sustainable, and should it lead you to buy shares of AT&T? Let's run the numbers and find out.
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Smartly spinning off Time Warner
Back in 2018, AT&T closed its acquisition of Time Warner. This brought it several major media properties such as CNN and HBO, but was clearly bought at too high a price, especially with the streaming transition shaking up the TV industry. It also made AT&T the most indebted company in the world, with a ballooning pile of loans that hit $180 billion in 2021.
With the merger not working out as management hoped, the company made a smart move to spin off the Time Warner assets last year into a stock now known as Warner Brothers Discovery. This helped AT&T reduce its debt burden and focus on its core telecommunication segments. At the end of last quarter, the company had $128 billion in long-term debt on its balance sheet, compared to $153 billion at the end of 2021.
Management hopes to continue lowering its debt load in the coming quarters with interest rates rising around the globe. As the Federal Reserve raises its Federal Funds Rate from zero to 5%, that will make the debt AT&T has to issue come with higher interest expenses, which will be a headwind to free cash flow generation and the ability to pay dividends. In the first six months of this year, AT&T had $3.3 billion in interest expenses, compared to $12.4 billion in operating income.
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Key Data Points
Growing mobile and fiber customers
So how is the core business of AT&T doing? Quite well, actually. Last quarter AT&T passed 70 million phone subscribers to its mobile data/internet service, up from 68 million a year ago. Average revenue per user (ARPU) is also climbing, up to $55.63 last quarter, compared to $54.81 a year ago. These are the two key KPIs for AT&T's mobile business that investors need to follow. Subscribers may not grow that much in future years, but AT&T believes it has plenty of pricing power with its customers as it continues to invest in 5G infrastructure.
A much smaller part of the business -- but one that is growing very quickly -- is AT&T's fiber internet segment. The company hit 7.7 million subscribers last quarter, up from 6.6 million in 2022. Revenue has grown 28% year-over-year in each of the last two years, with the fiber segment now doing $1.5 billion in quarterly revenue.
Rising interest rates could present a headwind for AT&T's profitability, but the company should be able to counteract this with the growth of its mobile and fiber business units, leading to at least stable profit generation over the next few years.
The math works, but is it better than treasuries?
There are a lot of moving parts with AT&T's business, but the math behind its dividend payment is simple. Over the last 12 months AT&T generated around $16.2 billion in free cash flow and paid investors $9.3 billion in dividends. As long as AT&T keeps growing its fiber and mobile businesses, the company should generate at least this much in annual cash flow for the next few years despite rising interest expenses. This will give it enough firepower to both pay its current 7.5% dividend yield and pay down its debts.
But do AT&T shares offer an attractive enough yield to compensate for what you can get with the risk-free rate? That is the yield you can get owning U.S. Treasuries, which are guaranteed by the U.S. government. As of this writing, investors in three-month Treasuries earn a 5.5% annualized yield, which is not that far from AT&T's yield, a business with fierce competition.
Do you really want to own AT&T because it yields two percentage points higher than 3-month treasuries? I think you're better off with the riskless government bonds at the moment, even when you take the dividend yield into account.
