Summary

  • Even though some investors may disagree, it still seems that the majority agree that AT&T is capable of at least sustaining their current dividends.
  • Following the recent selloff, their share price now appears priced for a dividend reduction that is not even coming thanks to their strong dividend coverage.
  • Regardless of what cost of equity assumptions an investor utilizes, their shares are still pricing a dividend reduction with the average result being 41%.
  • This situation means that investors can expect to generate alpha even if they just keep their current dividend trend going into the future.
  • Since I believe this outcome is more likely than a dividend reduction, I feel that maintaining my very bullish rating is appropriate.

Introduction

There have been few blue-chip companies that have garnered as many competing views as AT&T (T) over the last few years as investors with differing views square off. Thankfully, it generally appears agreed upon that their dividends are at least sustainable even if their future growth is debatable, thereby providing a high yield of around 7.50%. Recently, their shares have been sold down to such an extent that they now appear to be pricing a dividend reduction that is not even coming and thus they offer very desirable value for a contrarian dividend investor.

Source: AT&T.

Background

They have long been a source of a high dividend yield well before Covid-19 was sweeping across the world as investors debated a wide range of topics such as whether their debt load was too high and the cable-cutting trend that threatens older legacy business segments. Following the broad economic and market turmoil brought about from Covid-19, their dividend yield has once again pushed towards the highest points in over the last decade, as the graph included below displays.

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Source: Seeking Alpha.

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The single most important factor that has allowed them to sustain their dividend amidst this recent turmoil is their very strong dividend coverage that averaged 162.71% during 2017-2019 and has held up well at 152.89% during the first half of 2020. Whilst many have worried about their net debt that still sits at a massive $152.023b, during the first half of 2020, they still produce a handy $3.953b of free cash flow to help deleverage.

AT&T cash flows

Source: Author.

Discounted Cash Flow Valuations

Since they are primarily desired by income investors, their intrinsic values were estimated by using a discounted cash flow valuation that simply replaces their free cash flow with their dividend payments. The normal approach would be to calculate the intrinsic value for their shares; however, this time the formula was rearranged to solve for their dividends to illustrate the extent that a negative outcome is already priced into their shares. If interested, all of the details regarding the inputs utilized for these valuations can be found in the subsequent section.

The results range between a massive 75% and 7% from the highest to lowest cost of equity assumption with an average being 41%, as the table included below displays. These results clearly show that even if an investor wishes to disregard the benefit their intrinsic value estimates derive from the current record low interest rates, their shares still appear to be pricing a material double-digit dividend reduction. This creates a very desirable scenario whereby investors can expect to generate alpha even if they just simply keep their current dividend trend going into the future, as this would produce an intrinsic value above their current share price regardless of their cost of equity.

Source: Author.

This valuation scenario assumes that their dividends continue growing at 2% per annum perpetually into the future after being reduced, which sits in line with their historical dividend growth. Given their already very strong dividend coverage, it would not be realistic to assume that they would imminently reduce their dividend and then never grow them again in the future as they have done so for the last decades straight, as the graph included below displays.

Source: Seeking Alpha.

Valuation Inputs

The discounted cash flow valuations utilized a cost of equity as determined by the Capital Asset Pricing Model that utilized a 60M Beta of 0.76 (SA) and expected market returns from 5% to 10% and risk-free rates from 0% to 5%, both of which used 0.5% increments.

Conclusion

They are not a perfect company with a flawless history but this is obviously already reflected in their share price and thus should not deter investors who are seeking a high yielding source of dividend income. Even though their share price could still sink lower in the short term when focusing on the long term, they already appear priced for a material dividend reduction. Since they are a massive company whose dividend coverage has remained strong throughout this Covid-19 economic downturn, I believe that this will not be forthcoming and thus maintaining my very bullish rating seems appropriate.

Author: Daniel Thurecht

Source: Seeking Alpha: AT&T: Priced For A Dividend Cut That Isn’t Even Coming

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