Prepared by Chris, CEO Quad 7 Capital, and Team Leader at BAD BEAT Investing
I have to tell you, I interact with hundreds of investors a week, through our writing activities, our paid services, and our investment work. There is sometimes a misconception about our team that we only focus on trading. That could not be further from the truth. While we do indeed do a lot of trading, and BAD BEAT Investing does a bit of everything, what many people fail to realize is that short-term trading is only a small fraction of our investing activity. I personally, along with my team all have massive long-term oriented portfolios. Our trading activities are less than 10% of our overall market exposure. We use our trading activities to boost short-term returns which then feed our long-term holdings. Although we are best known for spotting short-term, fast-moving trades in addition to deep value investing, our longer-term investment recommendations focus most often on dividend growth investment. In considering the latter, we have encouraged our readers to accumulate shares of AT&T (T), especially when shares are $30. You do not often get the opportunity.
Let me be clear. AT&T is boring. It offers little growth (though from here there is upside risk), is not flashy, and yet, is somehow so controversial. The only thing that is controversial in our opinion are some of the long-term investments the company has made (we think DirecTV is a prime example). As a company, it is going to see ups and downs. But this is a survivor. It is a scrapper. It is a true long-term investment with staying power. This is because we believe the dividend is compelling, even though it offers what many consider slow growth. But when they are yielding 7%, and growing the dividend, you have to buy shares. And if you are young, you can retire rich with this stock if the lack of share price growth persists. Yes, I said it. You can retire rich with it. We believe here at $29 a share, the stock is a strong buy, but much prefer you add at a better price. That said, at $34 a share, the yield is exactly 7.172% at these levels. We believe this is still highly attractive for income, and from an operational standpoint, we believe the stock could be offering share appreciation potential.
From the long-term perspective, there has rarely been a better time to consider a large position with an outlook that spans decades in the telecommunications and media giant. In this column, we want to highlight the power of the dividend itself and talk about several metrics which you need to be aware of as it relates to this great source of income. With a yield of 7.2% here, we discuss the dividend history and projected raises and illustrate the power of the dividend on a forward-looking basis. We further discuss why we see the dividend as being covered, at least in the near future, an issue every AT&T investor should monitor. It is our opinion that every investor who needs a stock like AT&T, but young investors stand to gain the most. Let us discuss.
Say what you want but the facts are the facts: the company raises the dividend like clockwork
One of the reasons I love boring ole AT&T is that it raises its dividend like clockwork. Year after year, despite anything happening in the broader market, or with acquisitions, or with debt, it all comes back to how great of a dividend machine this stock truly is. Even here in the COVID-19 pandemic, which is causing short-term disruptions, the company is doing fine, despite some bumps, and the dividend will be fine. Now, we will point out that those perennial bears on the name point out that dividend payments aren’t enough to offset the lack of share price appreciation or to offset those who have capital losses in the stock currently. But those losses aren’t realized, they are on paper. Yes, if you bought at $35 or above recently you are down on paper. Awful to see it, but time is on your side.
The dividend is powerful. Now, older investors may opt to be paid the dividend and pocket the cash. Nothing wrong with that at all, use it to pay bills, living expenses, or for golf. I don’t care. But we strongly argue that, for younger investors with a multi-decade outlook, the best play is to reinvest your dividends to acquire more and more shares.
What are we talking about? We are talking about the power of compound growth. By reinvesting the dividends, your position will grow increasingly larger. With this reality, moves higher in shares will help recoup those on paper losses, while at the same time, the total dividends paid increase every single year. And let me remind you. The dividend has been raised every single year in recent history. Given the growth that AT&T is displaying through its acquisitions, while also working to grow its legacy businesses organically, we project that the quarterly dividend being raised by a penny each year for at least the next 10 years. As such, we expect a significant increase in the dividend. But what does this mean for a new investor?
The dividend has immense power long-term
One of the most popular questions we are asked is “if I have X amount of dollars where would you invest it long-term?” People are often surprised when the answer is T stock. But then we walk them through why. The problem is most people are impatient (we see it all the time in our trading service) and are quick to “try to get it back” or “try to recoup paper losses,” and if you are a seasoned daytrader, it is fine, our team works with them, but a lot of time we find people’s idea of “long-term” isn’t long at all. A year is not long-term, neither is two really, and frankly, although pushing it, five years isn’t long-term either, at least for T. With T, we think in decades.
Let us say someone buys the stock today. Right now, the current share price is $29 at the time of this writing. Let us assume this hypothetical buyer buys just once, and the dividend is raised every year by 4 cents (or one penny quarterly). Let us also assume the investor holds for 15 years. In in this case, the total annual dividends paid to this investor will be:
- 2020: $2.08
- 2021: $2.12
- 2022: $2.16
- 2023: $2.20
- 2024: $2.24
- 2025: $2.28
- 2026: $2.32
- 2027: $2.36
- 2028: $2.40
- 2029: $2.44
- 2030: $2.48
- 2031: $2.52
- 2032: $2.56
- 2033: $2.60
An investment at $29 that does not move in this time frame and instead relies on just the dividend would generate returns of $32.76. Thus, in a 15-year period, the investor has seen a return of 113%. That is a strong return, though compared to what the general markets would likely return in the same period, is maybe average, if not below average. But it is still quite positive.
A simple example, though unrealistic
Of course, this is a touch robotic, and frankly largely unrealistic. We assumed dividend growth will continue at four cents a year. That is possible, but we might get years where the hike is less, or possibly more. Second, we assumed that the share price did not appreciate at all, or decline, at any point in time allowing the investor to buy more on big declines. Further, the simple analysis also does not account for the likelihood that the share price would be higher in 15 years, allowing for capital gains, on top of the dividends. An older investor might opt to simply take the dividend payments and spend them. Collecting for income is a strong strategy but may be more appropriate for investors who need the income say during retirement. Younger investors need to recognize the power of compound interest.
So, you can really retire rich with AT&T?
Yes, well, sort of. AT&T is an example candidate, though, we think it remains. Truthfully the real secret is long-term, routine investing, in dividend paying blue chips, with some growth in between. The overnight biotechs, the penny stock madness gamblers, they almost always lose. In the long-term the secret to an investment in a name like this is compounding. We are going to make some assumptions again, but understanding the math is important. Here is the formula for compounding interest:
A = P(1+r/n)^nt
P = The principal amount (the initial amount invested)
r = The annual rate of interest, or the yield (as a decimal)
t = The number of years the amount is invested
n = The number of times the interest is compounded per year
So, we now have our parameters. What does this mean? Well, let us present another hypothetical case. Let us assume our investor buys $35,000 of AT&T at a 7.172% yield. Let us also assume like we did above that this investor neither adds nor sells shares during this time, and that the share price stays the same. Let us also assume that we were wrong about dividend growth, and AT&T keeps its dividend at $2.08 per share annually.
If these assumptions held, then:
P = $35,000, principal amount (the initial amount invested)
r = 0.07172, annual rate of interest, or the yield (as a decimal)
t = 15, number of years the amount is invested
n = 4, number of times the interest is compounded per year (in this case 4 since paid quarterly)
A = $101,658.30
As you can see, the new value of the investment is now $101,658.3, which is a return of 290.5%. This is substantially higher than simply collecting income. This is also where time is on your side.
Time is on your side
Using the above mathematics, let’s simply change the time frame, and assume a 20-year-old investor makes this same investment, with all of the same other assumptions, but holds until age 70. This is 50 years, a truly long-term investment for retirement
Plugging into the equation these parameters:
Well, that $35,000 investment is now $1,222,430.50. That may not be rich, but it is pretty solid, even if inflation makes 1.2 million not as powerful as it is today. The beautiful thing is that the money just say there, growing. Alright, most kids probably do not have that laying around fresh out of college, but you can repeat the same math for $5,000 or $10,000 which is a bit more reasonable. If you do not have that, our advice is to save until you do before investing. But wait, there is more!
But isn’t the dividend growing?
This is where things get interesting and why we love the predictable dividend increases out of AT&T. Let us factor in our assumption that the dividend keeps getting raised by around a penny per quarter for the next 50 years. Right now, that is dividend growth of 2%. By year 50, this growth would be down to a little over 1%. We will also assume that we get anemic share price growth each year of 1% a year. Using any number of online calculators, you can play with these numbers.
Note, we are not showing the formula or the extensive chart given the length of the calculations.
Using these assumptions, after 50 years, with dividend growth 2%, and annual share price growth of 1%, that original $35,000 investment would grow to over $2.3 million after 50 years.
If the dividend did not increase, and share prices held firm, but the investor was able to save an extra $300 a month into AT&T, we get even better results. If we factor this into the calculator linked above using the same initial investment, 50-year horizon, and growth assumptions, a new result emerges, one that we believe any retiree could live on.
The estimated value of this investment is now worth just over $3.0 million.
Make no mistake, this is riddled with assumptions. But you can try playing with the numbers yourself, especially on the dividend increase side and the percent of annual growth. Obviously, over near a 50-year period, so many things can happen, and the price will be up and down.
Perhaps, a very realistic approach is for a kid who is 18 and gets their first job. Let’s assume they have a family member who really pushes them to save $150 a week from every paycheck, and this kid does this his entire life. He will start at zero, but buy AT&T stock at a 7.172% yield every month. Obviously, we do not have the capability to model the share price movements, so let’s assume again it remains a 7.172% yield the entire time. The 18-year old wants to retire at 72 years old.
Well, if this new investor sticks to this path of $100 a week, and we will call it $600 a month, or $7,200 a year, the wealth creation from nothing is quite impressive.
After nearly 54 years, the retiree will look back to the very first day he bought the stock, as a teen and see his savings have grown to over $4.6 million, and that is without any dividend or share price growth.
If we assume that between dividend growth and share price appreciation, that a total annual return is 8% each year, with these parameters of savings, the initial $150 investment will growth to $6.1 million. If the total return per year is 9%, the investor will have over $9 million to retire on.
Some of our assumptions limit the model
Look, we made a lot of assumptions, especially at the end when we talk about a total return of 8 or 9% each year between dividends and share price growth. If AT&T does 4 cents a year increases, then we are in some trouble because the actual dividend growth yield would drop. But playing with the numbers, as long as the dividend growth is expected and the share price remains within a range, the overall assumption is that continued investment generates millions to retire on. No matter how you slice the assumptions it will not be perfect. It is safe to say that you cannot go wrong though so long as the dividend is secure. Even if it was NOT raised like in our first examples, things would be strong. We believe this exercise really illustrates the power of buying a company that pays a growing dividend with an established track record of dividend coverage. So is the dividend secure?
Let us discuss revenue growth
So we walk you through all of these examples, but we need to know if the dividend is secure. While anything can happen in the future, we see 2020 as a year where the company is truly being tested by a global slowdown induced by COVID-19. We know revenues had begun to flatten for the company until Time Warner’s assets were brought under the AT&T umbrella. We are seeing the positive impact, but revenues in Q1, which really got hit in March, showed slight contraction from a year ago:
Source: SEC Filings, graphics by BAD BEAT Investing
Looking at these Q1 results here, all in all, our revenue expectations were slightly more liberal relative to the pack. Analysts covering the company were targeting a consensus of $44.15 billion. We were targeting $44.35-$44.75 billion for this metric as we felt the impacts from the loss of video subscribers from struggling DirecTV and ongoing promotions in the wireless business would continue, and so this would have been essentially down about 1% from a year ago. However, the posted result of $42.78 billion was well below all of these estimates. In fairness, it was really tough to handicap this quarter for many industries, including AT&T’s massive global telecommunications operation.
Over a period of a multi-decade investment, there are going to be ups and downs. This COVID-19 induced pain is one of these times. And in Q1, there were declines at WarnerMedia reflecting strong theatrical carryover revenues in the first quarter of 2019, continued declines in video subscriptions and legacy services, lower wireless equipment sales resulting from the store closures and declines at Vrio from foreign exchange impacts. Partially offsetting these declines was growth in wireless service revenues and strategic and managed business services.
It bears repeating that there continues to be a shift from premium linear services to more economically priced video service or to competitors, consistent with the rest of the industry, and this has pressured video revenues. There were near universal revenue declines across the operations, though Xandr saw increases as did wireless revenues in Mexico. Still, the top line saw pain, and it led to earnings taking a bit of a lump versus if there was not a slowdown.
Despite a lower than expected top line, the bottom line saw nice growth, much of it from solid expense control, offsetting the revenue miss. EPS was up from last year’s Q1 but came up just short of expectations. We were looking for low single-digit growth to $0.86-$0.87, and this figure was missed by $.02 on the low end:
Source: SEC filings, graphics by BAD BEAT Investing
Projecting out decades from now is impossible, but for 2020 the company pulled guidance and we agree with this move. Again, handicapping performance with all of the unknowns on economic impacts from people losing jobs, businesses closing, cloudiness on reopening timelines, and inability to really foresee when theaters. But here is the thing. We want to know if the dividend is secure.
Considering share count and an increased dividend, the payout ratio will still remain comfortably low, likely still in the 60-70% range for the year, and that factors in H1 2020 being pretty weak. With this understanding, we urge investors to keep a close watch on the impact to cash flows and dividend coverage moving forward. We believe the growing dividend is more than secure for years to come.
A look at operational cash and free cash flow
So for Q1, we were projecting strong cash from operations, and we are expecting them to be around $10.5-11.0 billion, stemming from our revenue expectation of ~$44.35-$44.75 billion. Operating cash flow came in well below this estimate.
Operating cash flows had been flat-to-declining before Time Warner was brought in, then spiked. However, with the big revenue miss, every other line down the report suffered.
Operational cash that was generated was $8.9 billion. We presume that cash from operations will decline in the high single digits moving forward the next few quarters. Of course, with this measure coming in like this, it impacts free cash flows which is a key metric for the dividend. We were eyeing $28 billion for the year in free cash flow thanks to the boost from WarnerMedia. We expected free cash flows to exceed last year’s pace significantly, and we were eyeballing around $5.5-$6 billion considering capex spending of $4.5-5.5 billion and operational cash of $10.5-11.0 billion. Well when we saw revenues, and then operational cash, we knew free cash flow would be horrendous.
Looking ahead, it is tough to handicap where free cash flow will end up, but we suspect H2 2020 will be much better than H1 2020, especially if economies start opening back up by mid-summer.
With some rough estimates, we still see the dividend being more than secure here. We think if free cash flow comes in down $1-$2 billion from our past expectations the next 2 quarters, then free cash flow could still be a strong $23-24 billion this year.
The payout ratio is comfortable
Free cash flow impacts the dividend payout ratio. We continue to see a $0.04 annual dividend payment per share increase, each year, so free cash flow needs to remain high or show some growth as well to keep the payout ratio safe in the future. For this quarter, we were eyeballing a comfortable payout ratio under 50%, which we ratcheted higher as things deteriorated in March. The payout ratio was still favorable, as dividends paid were $3.8 billion and free cash flow nearly $4 billion. It is very close to 100%, but keep in mind, please, not even counting COVID-19, the first quarter is typically the lowest free cash flow quarter for AT&T due to the timing of employee incentive compensation and vendor payments for holiday equipment sales.
On the conference call, management stated that it sees the 2020 payout ratio in the 60’s. That is very secure. Even with a prolonged and more severe hit to revenues and cash flows, it really seems hard for the payout ratio for 2020 to be anywhere near a risk to the dividend. As such, we think buying under $30 is very wise.
Although the dividend has been hiked again and we do fully expect that the dividend will be hiked again in December 2020, it’s more than covered by free cash flow, even with the pain from COVID-19.
While dividend hikes have a negative impact to the payout ratio in and of itself, if free cash flow comes in at $23-$25 billion for the year, then we project the payout ratio will remain be 60-65% for the year. This is a massive improvement from years past. The dividend has been raised like clockwork every year and we see this as continuing.
So, even though many confuse our work as being short-term only, it could not be further from the truth. Trading is done with about 10% of overall investing dollars. We like to use short-term gains to pad long-term investments. And with AT&T, it really is a get rich slowly name. Every investor needs to consider a stock like AT&T. It is great for income. It is great for a supremely long-term holding in which you reinvest dividends in a tax favored account. AT&T is still at a compelling entry point based on its dividend yield of 7.172% here. The dividend is well covered. Debt is being paid off. Utilizing several simple calculations, we have demonstrated the power a dividend growth paying name like AT&T over the course of an investing lifetime.
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Disclosure: I am/we are long T. 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.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.