We are now approaching a very critical earnings season, and this is the catalyst we believe could trigger the next major move in markets, and a shift in sentiment. We expect S&P 500 (SP500) earnings for Q2 to be down 6-7% from last year, and be a trough. However, should inflation data remain hot and earnings fall more than this, we could be in store for a sizable correction since markets are pretty expensive as a whole right now. On the flip side, better than expected earnings and cooler inflation data could keep us chopping along around 4400-4550. However, the risk is to the downside in our opinion after a great first half.
The second half is off to a shaky start at best. We believe the odds favor earnings estimates as a whole coming down broadly, and that the market will revalue lower. One stock that we made a bold call to sell over $20 and repurchase in the mid-teens was AT&T Inc. (NYSE:T). That call worked out to perfection, and we have recently been buying in the $14-$16 range, 25% plus lower than when we exited.
While we always trade around a core position this move was made with conviction as we saw downside ahead. Now we see value again, and more broadly, because we suspect market choppiness if not a broader draw down, we are rotating into more defensive and income plays. Each week we are outlining winning trades for income but also focusing on achieving dividend payments and cash preservation the next few months. On top of that, we are selling covered calls on many of these positions.
With that said, our thesis to get long AT&T stock in the mid-teens for stable income will be put to the test in a few short weeks as Q2 earnings will be reported on July 21, 2023. We experienced a nice market pump in the first half, but we see headwinds brewing which may impact consumers. One major impediment to the economy is going to return in a matter two short months. Millions of Americans will see their budget hit because they will need to begin student loan repayment after three years plus without making payments. That is money getting sucked right out of the system, but one thing that consumers will not give up is their phones, internet, and connectivity. Same goes for business.
AT&T will be pretty insulated compared to consumer discretionary type companies at large. We will be closely watching Q2 earnings for any signs that there is stress on revenue drivers and cash flows, and will be closely watching the outlook.
Critical indicator: Q2 cash flow
We are looking for $29.75 billion to $30.15 billion in revenues in Q2, but more importantly we will be watching cash flow. It is just a key indicator that dictates so much of this stock’s trading. Better cash flow translates to better share prices, and vice versa. Now, to bring in cash and chip away at debt the company has engaged in a number of asset sales. However, this strategy only lasts as long as there are assets that can be strategically sold off. We will point out that over the last few years AT&T has monetized many billions in non-strategic assets as well. You should expect continued asset sales moving forward, though on a much smaller scale relative to the past few years.
So, we will watch cash flows, and it all begins with that revenue target. Back in reported earnings from Q1, the view was a consensus of $30.24 billion. With $30.14 billion in revenues, this was an ever-so-slight miss versus consensus, and effectively in line. If the economy does start to roll over, we could see back half risk on phone upgrades and believe people will select cheaper plans as this year persists if this materializes. Even in a strong economy, telecoms have become more promotional to attract customers, and this could lead to churn. We would expect such promos to ramp if budgets are tighter and the sharks are eating the sharks for lack of a better metaphor as the major telecoms battle for customer dollars and contracts/plans. For Q2, consensus is $30.0 billion on the nose, so that is the benchmark from which to gauge performance.
The Q1 revenue grew just 1.4%, but EPS was a slight surprise at $0.60 per share and surpassed consensus by $0.01. As we come into Q2’s report, we expect a quarter-over-quarter seasonal revenue decline, but with potential for a very low single-digit percent gain if it’s a strong quarter, but we also expect earnings of $0.60-$0.65 per share. We still think expenses will remain elevated beyond what we would like, despite measures being taken to preserve cash flow. Cash flow was weak in Q1, fueling a selloff but we know that operating costs are a priority for management to preserve earnings.
The fact is that revenue growth is going to be muted all year. There is not much that is going to change that now or in the future, especially if promotional activity reduces revenue per subscriber. Additionally, any updates to guidance will be key. Back in Q1 operating expenses were $24.1 billion, roughly flat from a year ago, but operating income expanded from last year to $6.0 billion, up $500 million. The economy has not rolled over yet, so we think this is going to be a positive quarter, but it’s all about cash flow in our opinion, because after all this is a key income name for many investors.
Free cash flow is key
Free cash flow was just $1.0 billion. This had missed our expectations for about $2.5 billion and was way below what most saw was possible, as cash from operating activities was $6.7 billion, and capex was $4.3 billion. There was also cash spent for vendor financing of $2.1 billion. With dividends paid of $2.01 billion, after dividends, the free cash flow was a negative $1 billion. Overall, the payout ratio was 200%. However, for the year, the payout ratio is still projected to be in the 60% range, as Q1 is generally a weaker quarter for free cash flow.
For Q2, we think we see a return to positive dividend coverage. Assuming cash from operating activities of $6.5-$7.0 billion, capex of $4.0-4.5 billion, and unknown estimates for additional financing, we are targeting free cash flow of 2.0-3.0 billion conservatively. This would be essentially full coverage of the dividend unless there is disaster.
Revenue drivers in Q2 and earnings results
You will want to watch for wireless postpaid growth and net fiber adds. Wireless postpaid growth saw 0.542 million adds in Q1. Such adds are boosted by 5G availability as well as promotions. AT&T also reported 0.272 million fiber net adds in Q1. For Q2 we are targeting 0.5 million postpaid adds and 0.215 million fiber net adds. The fiber add would result in the 14th straight quarter of 0.2 million adds or more. For 5G, they are now covering over 160 million people, so look for the number to jump 2-5% in our estimation. That is quite impressive. However, the CFO a month ago warned that Q2 subscriber adds will be below estimates, so we may be a touch liberal in our expectations for low percentage gains. This is a potential problem, but temporary if they miss our expectations.
That said, Domestic wireless service revenues were up 5.2% in Q1, and we are targeting a similar increase/ Consumer broadband revenues were up 7.3%in Q1, and we see another 4-6% growth in the cards as likely. However, longer-term, there is a lot of government funding available to expand broadband to more rural communities, so you can expect some positive gains on this front longer-term for the sector. Generally speaking, these drivers keep the slow and minimal revenue growth going. Provided expenses are well-maintained, cash flow will increase nicely from Q1, and will cover the dividend. Since we are buying for income here and (perhaps some capital gains in the medium-term), we will say plainly the dividend is secure.
The dividend is secure and will be covered in Q2 by free cash flow
We see a very high likelihood of the dividend being covered and view it as secure. The company just announced another dividend payment two weeks ago. Folks, the dividend is why many buy, and why we came back in recently. We will say that if for some reason the dividend were to be cut significantly, shareholders the stock could fall as far as the single digits as income investors abandon the stock. Growth investors are long gone. AT&T stock is owned by income-seeking investors, and many income funds. While there are positives to cutting the dividend, we just do not see it happening at a significant level unless performance really falls off. Discussing such impacts are beyond the scope of this article at this late stage of the column but we once again invite you to read this pivotal piece that assesses what could/would happen if the dividend was eliminated:
AT&T’s Dividend: The Impact Of Eliminating It Altogether.
The dividends are a huge source of income for so many investors. Many investors rely on the income to supplement their retirement or other financial goals. Since the payout ratio is projected to still be under 60% this year, there is no reason a cut will be made, unless the company chose to really go after debt. Finally, the massive debt burden will also be key to watch as it is the biggest risk to an investment here.
Final thoughts
We came back to AT&T stock recently with a strong buy conviction. We see it as a solid income name with a 7% yield and a dividend that is secure. Watch for churn, watch the revenue drivers, and especially keep an eye on cash flow. We believe annual 2023 free cash flow will again be more than sufficient to cover the dividend. If the economy rolls over and recession hits, we will be watching for updates to the payout ratio forecast. Medium-term, we see potential for capital appreciation as the stock can easily melt up toward $18-$20 once again.
Your voice matters
What are you doing with AT&T stock? Are you short? Are you generating extra income from your holdings like we do at our service? Are you hedging it? Are you a buy and hold forever type or do you embrace trading around a core position? Is this investment a waste of space in your port? Are you getting defensive or keeping the gas pedal on and buying growth? Let the community know below.
Read the full article here