AT&T's Outlook Amid The Market Chaos

Markets have quietly been chaotic. A slow decline over the last two months has brought your average stock to being down on the year. The broader averages have really only held up on the back of a few of the largest names in the market, notably the magnificent seven. Certainly, most investors have some exposure to the bulk of those names. Should they really falter, the averages will see another hit. We are looking to challenge the 200-day moving average on the S&P 500 (SP500), a key test for direction, but we also have a potential catalyst in earnings. While markets do not always move with earnings historically, they can impact sentiment.

One stock that we have been buying at these levels is AT&T Inc. (), and we have updated you along the way of why we like telecoms at these levels. This is not to say there is no risk. The high debt in this environment is the clearest risk, but cash flow remains strong, and the two telecoms we have recently bought this year, T, and Verizon Communications Inc. (VZ), are covering the dividend. We own them for the income, but do see future capital appreciation. While the stocks have been shellacked, we do not see these companies going bankrupt as some of our readers have asserted in the comments section.

We are in market chaos, and earnings season is approaching. AT&T, as well as hundreds of other S&P 500 companies, will report earnings for Q3 later this month (T expected pre-market October 19th). In this column, we provide our projections for AT&T's Q3 performance and highlight what we are watching.

AT&T is a telecom but also has hints of a utility and consumer discretionary type name too. Share prices have largely held stable the last few months, which is ideal for an income stock. We will be looking at Q3 earnings for any signs that there is stress on revenue drivers and cash flows, and will be closely watching the outlook for any changes

AT&T Q3 key indicator: cash flow

We are looking for $29.95 billion to $30.30 billion in revenues in Q3. Keep in mind that any boost from the new iPhone will have started to hit at the end of Q3, so there could be some small boost there, but investors should largely expect a seasonal Q4 bump from those sales. While revenue sets the one, we will more importantly we will be watching cash flows.

The cash flow metric is simply the most important indicator we watch for with the telecoms, and frankly, most companies. The cash flow metric can impact so much of this stock's trading behavior. In short, better cash flow translates to better share prices, and vice versa. While the correlation is moderate overall, we did see a precipitous decline in shares of T when cash flow numbers were poor several quarters ago. When cash flow numbers are strong, confidence in the dividend is renewed. It is as simple as that.

The other key piece of high cash flow, and, of course, the aforementioned revenue figure, is that it means more resources to take in cash and apply it to the staggering debt. The company has sold off a lot of assets, and will continue to do so. For example, the company is looking to make moves with its sizable DIRECTV stake, which it lost so much money on. But if it can sell its stake (70%), it could apply these directly to debt. However, this strategy only lasts as long as there are assets that can be strategically sold off.

When Q3 is reported, we will watch cash flows, and it all starts with that revenue target. Back in Q2, analysts covering the company were targeting a consensus of $29.95 billion, and this was a miss of $30 million with revenue of $29.92 billion were right at the midpoint. For Q3, consensus is $30.25 billion on the nose, so that is the benchmark from which to gauge performance.

In Q2 we saw wireless postpaid growth saw 0.464 million adds, and these continue to be boosted by 5G availability as well as promotions put into place during the quarter. We are looking for 0.450 million adds in Q3. AT&T also reported 0.272 million fiber net adds, in Q2 and we are looking for 0.260 million in Q3. Consumer wireless service revenues should be up 1-3% while business wireline revenues, likely dip 2-3%. Overall, expect mixed results. As we come into Q3's report, we expect the quarter-over-quarter to be flat to mild gains from last year. Assuming operational expenses similar to Q2, we also expect earnings of $0.62-$0.66 per share. Cash flow was strong in Q2, and we recently were reinforced by the CEO that Q3 cash flow will indeed be strong.

Free cash flow

So, cash flow, and more specifically, free cash flow ("FCF"), will be watched closely, as it is of course critical to covering the dividend payment. In Q2, free cash flow hit $4.2 billion stemming from cash from operating activities of $9.9 billion, CAPEX of $4.3 billion, while cash for vendor financing was $1.6 billion. With dividends paid of $2.01 billion, the payout ratio was less than 50%.

For Q3, we think we see very positive dividend coverage. Assuming cash from operating activities of $8.75-9$.0 billion, capex of $4.0-4.5 billion, and unknown estimates for additional financing, we are targeting free cash flow of $4.6-$4.9 billion conservatively. This would be essentially full coverage of the dividend payments of $2.1 billion, which would be a 44% payout ratio. For the year, the payout ratio is still projected to be in the 60% range, so free cash flow will cover the dividend easily all year. The dividend is safe.

The company just announced another dividend payment. Folks, the dividend is why many buy, and why we came back in recently. AT&T stock is owned by income-seeking investors, and many income funds. While there are positives to arguing that management should cut the dividend, we just do not see it happening. But here is what we see happening if the dividend was cut, or even eliminated:

With a sub 50% payout ratio this quarter likely, and a 60% or so payout ratio for the year, the AT&T Inc. dividend is not getting cut. It is just not reality here. Now, the other item we will watch, of course, is the massive debt burden. Over $20 billion in debt has been reduced in the last few years by the company. We started Q3 with $132.0 billion of net debt considering cash. The net debt-to-adjusted EBITDA was 3.2X. We expect debt to dip to $130 billion in Q3, and keep in mind that the company anticipates in the next two years it will reduce this ratio down to 2.5x. As such, we should watch for incremental declines in the debt going forward.

Final thoughts

In the spring, we came back to AT&T stock with a strong buy conviction. We see it as a solid income name with an over 7% yield and a dividend that is secure. We also see capital appreciation as likely, especially if the company delivers on debt reduction. Watch for cash flows, they are the key.

Your voice matters

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