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We are now approaching earnings season and this is the catalyst we believe will trigger the next leg lower in the market, and frankly, the end of the bear market. We believe earnings estimates as a whole will be coming down broadly, and the market will revalue lower. Folks at SPX 4150 we are over 18X earnings which is very expensive and will be getting more expensive if earnings estimates fall. One stock which we told you last month we would sell any major pops to raise some cash would be AT&T (NYSE:T). We experienced a nice market pump the last week two weeks of trading and we took the opportunity to shave the position. We go into detail in our investing group on how to trade around a core position but for the purposes of this column, at the most basic level, we sell on pops and rebuy on dips in small amounts, generally 5-10% of the core position. In the linked column above, we also flagged the fact that a major impediment to the economy is going to return this summer: millions of Americans will see their budget hit because they will need to repay student loans each month, something that for three years plus they have not had to do. Where do you think all of that money went that was not going to loan repayment? It went back into the economy. Now that is going to be taken away. This will have no impact on Q1 or really Q2 earnings, but we will see the impact in the back half of the year likely when we are in recession. With that said, we do not think AT&T will be completely safe, but it will be somewhat insulated compared to consumer discretionary type companies at large. The market has been hanging on for dear life it seems at the top end of this trading channel we have been stuck in. We think the market is going lower and our opinion is that you sell big pops in stocks and raise some cash so you can do some buying at better prices, then add back to positions on big drops. The macro situation is a mess, and interest rates continue to rise. With that said, since we shaved profits in (NYSE:T), we will be closely watching Q1 earnings for any signs that there is stress on earnings and more importantly the outlook.
We are looking for $29.8 billion to $30.4 billion in revenues in Q1, but more importantly we will be watching cash flow. One way to bring in extra cash is with further asset sales and over the last few years AT&T has monetized many billions in non-strategic assets. You should expect continued asset sales moving forward although major divestments have occurred. There are still many assets AT&T can see. Cash flow is critical. And it starts with that revenue target. Back in reported earnings from Q4 the view was a consensus of $31.4 billion. With $31.3 billion in revenues, this was a miss versus consensus. We believe later this year that there will be pain for discretionary spending on phone upgrades and believe people will select cheaper plans as this year persists. Telecoms may have to become more promotional to attract customers and this could lead to churn. For Q1 consensus is $30.2 billion, so that is the benchmark.
The Q4 revenue grew just 0.7%, but EPS was a surprise $0.57 per share and surpassed consensus by $0.04. As we come into Q1, we expect the quarter-over-quarter seasonal revenue decline, but we also expect earnings of $0.56-$0.60 per share. We think expenses will remain elevated, despite measures being taken to preserve cash flow. Operating costs are top of the list for management to preserve earnings. The fact is that revenue growth is going to be muted all year. Any updates to guidance will be key. Back in Q4 operating expenses were an adjusted $25.6 billion. Operating income grew from last year to $5.7 billion, up $700 million. Yet, this can easily be reversed if we see economic activity slow. It would seem from latest job numbers and inflation data that the pace of growth is at least coming down in hiring and price increases, but still increasing. The economy has not rolled over yet.
So it’s all about cash flow in our opinion because after all this is a key income name for many investors. Free cash flow was $6.1 billion in Q4 and dividends paid were $2.01 billion, so there was about $4.1 billion in excess free cash flow after the dividend was paid. The payout ratio was a pretty safe 33.0%. For all of 2022 the payout ratio for the year was 69.7%. The funny thing is if the macro situation was not getting so ugly, there was room for a dividend hike, and with management forecasting about a 59% payout ratio in 2023, it looks safe, but Q1 will be the key. Depending on the expense line, free cash flow in Q1 should be between $3.7 and $4.3 billion, assuming revenues hold and factoring in the dividends paid, this would be around a 50% payout ratio at the midpoint. The cost structure is really the unknown but about a month ago management noted they are on target for cost reductions.
Some of the drivers to watch for will be wireless postpaid growth and net fiber adds. In Q4, wireless postpaid growth saw 0.656 million adds, helped by 5G availability and wise promotions put into place. In Q1 we are looking for a number in the 0.350-0.400 million adds. In 2022 year postpaid growth was 2.9 million adds, we think that will be a tough number to match in 2023, it would require churn from competitors and low churn out of AT&T. We should also point out that AT&T’s Q4 saw 0.280 million fiber net adds and was the 12th straight quarter of 0.2 million adds or more. Now that their 5G is covering more than 150 million people sustained growth will be difficult and that streak of 12 quarters straight will be challenged in Q1. We are targeting 0.20-0.23 million adds. These drivers keep the slow and minimal revenue growth going, the key line to watch, once again, are expenses. With that said, the dividend is secure.
We have always liked AT&T as a dividend play, though the company could massively chip away at its debt burden if reduced. We are no advocating for that, but it is a reality. We believe Q1 and annual 2023 free cash flow will again be more than sufficient to cover the dividend. If recession hits, we will be watching for updates to the payout ratio forecast which of course relies on free cash flow. AT&T is slowly seeing its financial position improve, while investing in the future. So what to do? We stand by selling pops and adding in drops when we weigh the bearish and bullish points.
To reiterate the bear case, we have growth which is already anemic and now we have real macro problems brewing. As always the debt is a key risk to the company. New debt taken on will be at much higher rates and increase interest expense dramatically, including refinancing any maturing debt. A debt laden income name like AT&T should be sold and bought back much lower, and we have been sellers at $19 and above. The net debt was $132.2 billion to end the quarter, with net debt-to-adjusted EBITDA of 3.19X.
As we look ahead to 2023, we see revenue flat to growing low single-digit percentages at best here. It is meager.
The company enjoyed a lot of customer adds, but to keep it going the company will need to be promotional, and that can hurt margins. Expenses continue to be higher than we would like.
The dividend has been held firm so it is not a good fit for dividend growth investors.
We are heading into a weaker period economically. We believe this will be exacerbated by the hidden risk of student loan repayments starting up again which will take its toll. It may not hit the financial aspects of the company until the end of this year, or early 2024, so there is time for this to play out. Consumers may delay upgrade cycles, and will be competing for the best deals. Lower end consumers may opt for lower level plans to save money. This will in our opinion squeeze margins, and ultimately free cash flow.
Earnings growth is also meager.
The stock is at the top of a trading range, and the broader market is seeing breadth indicators thin out.
Competition is fierce and churn could become an issue in a weakening economic environment.
For the bulls, the cash flow is strong, and for now the dividend is more than secure.
As we mentioned under bearish points the debt is huge, but we have to point out the improving balance sheet as management has been selling off assets and paying down debt.
The debt-to-adjusted EBITDA ratio is coming down regularly, and the free cash flow has improved.
The stock is stuck in a trading range and that is just fine if you are holding a name for income.
The company is actively reducing costs, and has cut 30,000 jobs and counting thus far.
Competition is facing the same macro pressures as AT&T, but wireless connectivity is a necessity these days, so the broader sector impact may be limited from a recession.
The valuation is attractive at about 8X FWD EPS, and on a price-to-cash flow basis.
The broader market has been incredibly resilient despite a swath of mixed news that normally would be considered reasons to sell.
The market is pricing in rate cuts, which would mean refinancing of debt could be at lower than current rates. Higher for longer rates are a disaster for AT&T because of their immense debt, so lower rates would be bullish.
The concept of AI in tech is a potential catalyst for AT&T and connectivity, and we expect to learn more in coming quarters about any potential AI integrations or possibilities.
What are you doing here? Have more to add to the bullish points? What about the bearish points? Are you in the camp of a no recession scenario? A mild recession? Do you disagree with selling some of the position on pops and buying on drops? Are we wrong to think the market is going to have another selloff? Let your voice be heard.
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