Stocks Investment

AT&T Highlights The Modern Problem With Income Investing

It’s difficult to find a bull case for AT&T (T) stock that doesn’t highlight the dividend yield. The yield does look attractive, at a current 7% while the 10-year Treasury bond offers much less than 1%. But it’s important to remember that the AT&T dividend, like any dividend, is not ‘free’ money.

That’s true in a literal sense, of course. A dividend simply is a transfer of control of a portion of a corporation’s earnings, from the board and management to shareholders. And it’s true in a figurative sense as well. AT&T is one of the most widely-held and widely-covered stocks in the market. The 7% yield isn’t hidden; it’s obvious. And so in that context, the yield itself highlights the risk to earnings, and the T stock price, that the market sees.

Meanwhile, the continued focus on the dividend yield itself highlights the core problem with AT&T stock: there’s simply little else to recommend the name. AT&T no longer seems a particularly attractive business. Execution remains substandard. Management is a long-running concern. There are easier ways to get exposure to the more attractive end markets (notably wireless), while the business elsewhere faces significant secular pressure.

Investors can’t let the headline yield obscure those issues. Buying any stock for a dividend is risky, and T stock is no exception.

Dividend Investing in a Zero-Commission World

It bears repeating: a dividend on its own does not create value. It is not free money that comes on top of expected share price appreciation. Rather, in theory, it should be deducted from the share price, as the payout reduces the company’s assets. This is why stocks generally fall on ex-dividend dates (an effect most notable in the case of large special dividends), even if market factors often obscure those movements.

A dividend, as the old adage goes, is simply a transfer of capital from one pocket (the corporation, where shareholders still have claim) to the other (the shareholders themselves).

And in a zero-commission world, the relative value of that transfer is far less. At a time decades ago when investors had to pay $35-plus in commissions, a zero-cost dividend payment was attractive. Now, with not only zero commissions but fractional shares, the need for a fixed distribution seems far less pressing.

In fact, there’s an argument that dividend payments should be obsolete in this investing world. Why should investors desire payments, fixed in timing and amount by a third party, with no flexibility relative to tax planning or income needs? Yes, if an investor sells a small portion of her stake in a company that doesn’t pay a dividend, her ownership stake is diluted. But presuming that company reinvests its cash flow in projects that drive future growth (instead of returning that cash flow to shareholders), she still has a modestly smaller stake in what should be a more valuable business. A dividend recipient, in contrast, has the same stake in a less valuable business, as the dividend exits the balance sheet.

Income investors can and no doubt will raise a series of objections to these points. Admittedly, they are largely theoretical and ignore practical concerns (like the difficulty of selling tiny portions of multiple stocks on a regular basis). It’s worth noting as well that dividend stocks, over time, have outperformed the market.

Still, the highest-yield names like AT&T have not been the biggest winners. (That honor has gone to the stocks whose yield is in the second quintile: high but not that high.) And it’s likely that at least part of the reason that dividend stocks have outperformed is that they’ve simply been better stocks: stable compounders with established moats, rather than higher-risk, flashier growth names that flame out as often as they soar. (We’ll ignore, for now, the fact that in recent years high-growth stocks have far and away been the biggest winners, and dividend stocks generally have lagged.)

This is not to say that a dividend has no value. There is something to be said for long-term compounding. There likely is some incremental value in control of the cash. But it bears repeating: a dividend alone is not a reason to buy, or to own, a stock. From here, that seems even more true in a zero-commission world.

Struggles in the Wireless Business

The problem with AT&T is that once an investor looks past that headline yield, the investment case gets thin in a hurry. Years of acquisitions, most notably DIRECTV in 2015 and Time Warner in 2018, have built an integrated media and communications company. But those deals, and pressure in certain areas of the legacy business, have left a company facing significant headwinds.

Obviously, the wireless business remains the largest profit center. Per the 10-K (p. 78), the Mobility unit accounted for just shy of half of segment-level EBITDA, and a bit over half of segment contribution (i.e., operating profit). And Mobility isn’t a terrible business, to be sure.

But even with 5G on the way, it’s not likely to post torrid growth. AT&T’s rival Verizon (VZ) trades at less than 12x forward earnings; T-Mobile (TMUS) garners a far higher multiple, but has potential benefits coming from its acquisition of Sprint and doesn’t have the drag of declining wireline revenues. For its part, AT&T’s revenue in the segment has been stagnant in recent years, rising less than 1% in 2019 and 2018.

That weakness has come in part from lower ARPU across the industry, a direct result of intense competition:

T stock price

Source: Cowen & Co. via Light Reading

But AT&T also has steadily lost market share in postpaid users, the industry’s most profitable, in recent years:

T stock quote

Source: Cowen & Co. via Light Reading

And so a bull case based on the Mobility business runs into a couple of problems. An investor optimistic toward the industry ahead of 5G adoption (which admittedly can drive pricing power and a near-/mid-term equipment upgrade cycle) and with a value bent should at least give Verizon stock a long look. VZ stock is more expensive on a forward P/E basis, but it has better share, higher margins, lower churn, and less debt. It’s also a much more focused play on wireless, without the secular pressures faced by AT&T’s ancillary businesses. TMUS admittedly is more expensive (and simply looks expensive), but that has not been a stock to bet against for close to a decade now.

To be fair, there are some pieces of good news in the Mobility business. Profits actually have increased nicely in recent years despite a stagnant top-line, thanks to cost-cutting. EBITDA increased 6.8% in 2018, 1.8% last year, and 3.7% in the first half of 2020. The Cricket prepaid business appears to be doing well, with record-low churn in Q2.

But it’s asking an awful lot to expect a segment still losing market share (including in Q2, based on reports across the industry) to carry declining businesses elsewhere. And that’s exactly what AT&T has.

Declining Businesses Elsewhere

The simple fact is that outside Mobility, AT&T has three significant businesses that already are in decline and/or are facing significant secular headwinds.

The residential-focused Entertainment Group accounted for 16% of EBITDA in 2019, and over 11% of operating profit. EBITDA rose modestly in 2019 (less than 1%) after a decline in 2018, but the first-half performance is highly concerning. According to the 10-Q, EBITDA fell 12%, and segment contribution 21%.

It’s hard to see how that trend reverses. DIRECTV continues to be one of the biggest victims of cord-cutting, which has accelerated during the pandemic. AT&T TV Now (formerly DIRECTV Now) has flopped. And the broadband business has performed poorly. With the exception of fiber broadband, subscriber figures are in freefall across the board:

T stock quoteSource: AT&T 10-Q

Business Wireline too generated ~16% of EBITDA in 2019, and 12% of segment contribution. It’s been in gentle decline before accelerated erosion in the first half of this year, with profit down 8% in Q2 and almost 10% for the full year. Pandemic impacts on small businesses likely are a factor, but rising cloud-based competition from the likes of RingCentral (RNG) and even Zoom Video (ZM) suggests the business is in terminal decline.

And then there’s the Turner networks. Here, too, cord-cutting is an issue. AT&T admittedly has done a nice job so far, as profits for the networks have risen nicely above where they were under Time Warner ownership. But cord-cutting is going to pressure affiliate fees even once the pandemic’s short-term impact on advertising revenue fades. We’ve seen that risk priced into slashed valuations of other cable network stocks:

ChartData by YCharts

Combined, Entertainment Group, Business Wireline, and Turner accounted for 41% of 2019 EBITDA and over 35% of segment contribution. And there is a significant likelihood that those three businesses have peaked for good. Certainly, the market is pricing both peers and the disruptors in those markets (ZM, RNG, Netflix (NFLX), etc.) as such.

What’s The Bull Case for AT&T Stock?

So, yes, AT&T stock has a 7% yield. But it also has the most indebted corporate balance sheet in the world. And over one-third of the earnings underpinning that debt likely are in permanent decline.

Modest growth in Mobility hardly seems to offset that problem. Nor do HBO and Warner Bros. (each a bit over 5% of profit last year) seem to have enough growth potential to drive consolidated earnings growth.

So what’s the bull case for AT&T stock beyond the yield? It has to be a combination of the following: 1) a sum that is greater than the parts; 2) cost-cutting in declining and lower-growth businesses; and 3) better execution, in particular a reversal of market share erosion in Mobility.

AT&T has been able to take out cost, with a $1.5 billion target for 2020. But the case for the value of the integrated portfolio at this point has little evidence. Both major acquisitions were supposed to aid the wireless business. Subscriber figures show that thesis didn’t play out.

As far as execution goes, that requires trust in management. And it’s impossible to see how an investor can trust the management or board. AT&T just spent thirteen years being led by Randall Stephenson, whose disastrous tenure seems surprisingly underappreciated given the visibility of T stock.

The Management Problem Seals the Bear Case

Stephenson wasted $6 billion trying to acquire T-Mobile, despite obvious antitrust worries; the cash (and spectrum) helped that upstart rival become the biggest thorn in AT&T’s side. The DIRECTV acquisition has been “a disaster“, as one well-respected media analyst put it. And Stephenson defended the Time Warner purchase, which increasingly looks like an overpay, by arguing that “content is king” in the new ecosystem. What that saying has to do with a company that generated over half of its operating profit from the content-light, syndication-heavy Turner networks remains a mystery to this day.

Admittedly, Stephenson has moved on from his CEO post. But he remains chairman of a 14-person (!) board of directors, which still largely consists of those who approved the destructive M&A strategy. It’s the same board that pushed through a $4 billion accelerated share repurchase in Q1 at a price over $38 per share, and canceled a second ASR of the same size only because of the pandemic.

And Stephenson’s replacement is long-time lieutenant John Stankey. Stankey was in charge of the Time Warner/AT&T integration, which had a key goal of launching a Warner-backed streaming service.

That goal was not accomplished. On this site in late May, Stefan Redlich made a compelling argument that the launch of HBO Max was, in a disturbingly familiar phrase, “a disaster“. That was three weeks before AT&T had to rebrand the offering after spending millions of dollars on marketing. The service still isn’t available on Roku (ROKU) or Amazon’s (AMZN) Fire platform, and seems lapped by not only Disney (DIS) but Comcast (CMCSA), whose Peacock had strong numbers out of the gate.

This is a company that requires exceptional execution in terms of both operations and capital allocation. AT&T needs to balance debt reduction and shareholder returns. It has to avoid throwing good money after bad in declining businesses. It has to compete with several of the world’s best companies. And it has to find a way to stabilize wireless market share while protecting margins, given the importance of Mobility to earnings growth going forward.

There is close to zero evidence that this management team, and this board, are capable of managing those delicate balancing acts. Yet AT&T shareholders are dependent on those directors and executives to do so. A single metric, no matter how attractive, doesn’t fix that problem. Shareholders in AT&T, as with any company, are buying a business, and this simply doesn’t seem like a very attractive business right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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