Can AT&T Carry the Weight?

Sometimes I feel like the generation gap between Gen Xers and Millennials is even greater than the one between Baby Boomers and the Greatest Generation.

While all four generations have seen radical changes during their lifetimes, none may prove more radical than how the digital age is completely reordering society.

I was born at the tail end of Generation X, so I’m a member of a cohort that spent most of its childhood in the pre-Internet era, unless bulletin board systems count.

Rising generations of consumers, however, are thoroughly steeped in the Internet and enjoy easy access to networked media on demand as soon as they’re old enough to tap on an iPad.

This will have absolutely revolutionary consequences for how they consume media as they grow older. In turn, that will determine what they’re willing to pay for such media, if anything at all.

And that will have consequences for the services and advertising that underwrite the content for which they may or may not be willing to pay.

This extraordinary upheaval explains, in part, why AT&T Inc. (NYSE: T) has pursued two blockbuster deals over the past two years—the first, its $66.7 billion acquisition of DirecTV, which gives it greater distribution, and the second, its $85.4 billion cash-and-stock deal to acquire Time Warner Inc. (NYSE: TWX), which gives it a slice of the high-margin content it distributes.

Of course, most investors aren’t holding AT&T to see how it will navigate these changes. They just want to get paid.

And with shares that often yield north of 5%, AT&T comes in at the low end of the high-yield range, making it an enticing stock for income-hungry investors.

But as various equity analysts opined on the relative merits of the telecom giant’s latest deal, one raised the question of dividend sustainability.

He wondered whether the additional debt burden AT&T will take on to close the deal might require management to acknowledge that it’s a different company now, and that the dividend is no longer sacrosanct.

To be sure, this was the speculation of just one analyst. At the very least, we can probably expect dividend growth to slow even further—AT&T grew its payout by just 2.2% annually over the past five years. And, of course, dividend safety will be temporarily undermined until debt is paid down.

The telecom already carries $125.2 billion in total debt on its balance sheet, and it will be borrowing another $40 billion via a bridge loan to finance the deal, while assuming $24.5 billion in Time Warner debt. The bridge loan will later be repaid with a mix of longer-term bond issuances and term loans.

At the end of the third quarter, the $225 billion company had a net debt to EBITDA (earnings before interest, taxation, depreciation and amortization) ratio of 2.2x, while total debt to equity stood at 100.5%.

Though equity analysts’ opinions can temporarily move the market, it’s the credit raters who wield real power in this scenario, especially when it comes to the dividend.

To that end, all three of the major rating agencies—Moody’s, Standard & Poor’s and Fitch—have placed AT&T’s ratings on review for possible downgrade.

However, the debt-laden telecom will more than likely retain its investment-grade status. The odds are that that ratings will be lowered by just one level and certainly no more than two–its ratings are currently two to three notches above junk.

Interestingly, on the company’s conference call, AT&T’s CFO said he didn’t expect a downgrade. But that certainly wouldn’t be the first time we’ve seen a disconnect between a company’s senior executives and credit raters.

Moody’s calculates that the deal will boost AT&T’s leverage to 3.5x, a level which includes a proprietary adjustment that GAAP figures may not show.

The credit rater would like to see AT&T take steps to reduce leverage back below 3.0x. But it believes that strains placed on cash flow by dividends and interest obligations limit the telecom’s ability to reduce leverage by just 0.1x to 0.2x annually, though asset sales could speed this process.

Although rating agencies aren’t quite sounding the alarm just yet, they have indicated that over the long term AT&T can’t have its debt and offer a high dividend too.

The Time Warner acquisition would effectively put AT&T in a new peer group, one that has more stringent criteria for leverage than the ones the company enjoys presently.

Therefore, shareholders must now monitor management’s debt-reduction efforts much more closely. Lip service about lowering debt is no longer enough.

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