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Investing  | January 7, 2019

We all know that AT&T's (T) stock has been in a downward spiral for quite some time and eventually dropped below $27, trading at an almost 7.5% yield back then. Since that low on Christmas Eve, the stock has recovered nicely and started off the new year in much better fashion helped by several bullish analysts' picks and stellar results from "Aquaman".

Now, as the yield has retreated to around 7%, every dividend investor should seriously consider the stock. The risks are high but so are the rewards and in fact I can only imagine two outcomes. Either the stock will make you rich over time due to staggering compounding effects from reinvesting slowly growing dividends or the various risks AT&T is facing will materialize sending down the stock even more, eventually forcing the company to cut its dividend and you have financially died trying.

T data by YCharts

Let's find out which factors are impacting either outcome.

The Negative Scenario

If the negative scenario turns out to materialize, investors will be confronted with sharp capital losses and a substantial reduction in dividend income. The two main factors for this scenario are:

  • Significantly worse than expected erosion of video subscribers
  • New streaming service to be launched in late 2019 will not be able to compete with Netflix (NFLX) and Disney (DIS)

Eventually, as a result, earnings and cash flow will shrink and ultimately not allow the company to proceed with its aggressive deleveraging unless it significantly cuts the dividend. As the name suggests, this is a very "negative" scenario, and while unlikely in my opinion certainly not impossible.

Erosion of Video Subscribers

In 2019, it is "Game On!" for AT&T as this will be the year which shows whether its strategy of bundling content and entering the streaming wars can and will pay off. AT&T itself expects stable EBITDA from its Entertainment Group for the year, but behind that assessment is a complex and diverse set of "gives" and "takes" that can make or break that guidance.

Source: AT&T Analyst Event November 2018

For me the biggest question marks are behind the first two bars: "video subscriber losses" and "linear improvement" which AT&T basically expects to completely cancel out each other. I don't have the insights into AT&T's daily operations to assess that projection, but what I can do is lay out some risk factors AT&T has to cope with.

In the last quarter, AT&T lost almost 300,000 video subscribers as it dropped promotions mostly around DirecTV Now and instead raised prices by $5. This is the latest observation of an alarming trend that has AT&T see total DirecTV Now subscribers collapse to 49,000 in Q3 2018, down from more than 300,000 in Q2 and roughly the same over the corresponding period during the previous year. If that signals the beginning of an accelerating downward trend, it is certainly a big concern for the company. But I do not want to be too pessimistic here as there are always two sides to a medal.

The customers AT&T is losing could be high-value or low-value customers, and according to information from AT&T's earnings call, it is mostly:

"folks that are just jumping from promotion to promotion and really spinning in the industry between us [AT&T], Hulu Live, YouTube TV".

Although that information is publicly available here on Seeking Alpha, I believe that only a fraction of investors ever gets to know about that, but it is crucial in understanding that. Although the 300,000 loss in video subscribers looks sky-high, it was actually significantly better than what AT&T expected. And as a result...

"That customer base that we burned off, if you will, in the third quarter, and that we may or may not going forward chase in any given quarter, is always available. It's very promotionally-sensitive and price-sensitive, so you can always go get that business when you find the economics to do it so - or advantageous as a result of, for instance, what you can do on ad-supported models."

This implies that the big drop we saw in Q3 is very unlikely to continue in Q4 as you can only lose those "promotionally-sensitive and price-sensitive" customers once while those highly-engaged with the service are much more likely to pay that additional $5 and have a much lower churn. Speaking in terms of churn, though, AT&T cannot afford to let it out of control as too many customers leaving mean declining profits and less cash flow to be channeled towards debt repayment.

This will be especially relevant for the current Q4 during which a lot of subscriber additions from late 2016 will come off promotional pricing. Assuming those are not the low-value customers AT&T can just burn off as it could easily attract them back into the system at the right price, AT&T might have to secretly increase its promotional activities in Q4 to manage churn and keep its guidance.

High Uncertainty About the New Streaming Service

AT&T will launch its new big streaming service in Q4 2019 that comes with a three-tier pricing setup.

Source: AT&T Analyst Event November 2018

While in theory that setup looks appealing, in the end, it will all come down to three ingredients: pricing, quality and quantity of content, and customer service. As a German living in Germany, I have never used any AT&T product or service, but based on personal consumer spending for Amazon Prime (AMZN) and Netflix (NFLX) and the monthly TV bill, I'd pay €15 for the premium service, and I personally believe that this will be most highly sought after tier based on the initial feature set shown above. However, before AT&T goes full-scale with that approach, I sure hope that it will test multiple setups and price points with different customer segments and also run tests mirroring the setup of extremely successful yet unprofitable Netflix. And don't forget, when AT&T goes beta with its service, Disney (DIS) will already go live with its own Disney+ streaming service.

The number of cord-cutters is estimated to have already reached 25M in the U.S. by end of 2017, much worse is expected to happen over the next 5 years. According to eMarketer, the number is expected to more than double as an estimated 20% of the population could have cut the cord.

This is a forecast which is as good as any other forecast, but regardless of what exactly the data figures in and what it doesn't, it is impossible to argue against the fact that traditional cable and satellite TV is in decline. The most important reason for people to cut the cord is price which has drawn millions of Americans to cheap monthly packages from Amazon Prime, Hulu and Netflix. The fact that industry leader Netflix is posting multi-billion dollar losses due to high and rising cost for content is reason for concern overall but won't help AT&T in retaining its customers.

In fact, it actually hints at the fact that it will be very tough for AT&T to sell bundled packages at higher prices than its default DTV NOW offering to customers. As long as the price remains cheap, there is no reason to expect cord-cutting from slowing down which in turn means that AT&T faces a big challenge to bundle its content from Time Warner with DTV NOW at prices that offset the decline of its traditional cable business.

And we should not underestimate the enormous lead of Netflix. AT&T has more than 170 million direct-to-consumer relationships but "only" a postpaid subscriber base of around 78M whereas Netflix's total subscribers were a staggering 130M by the end of the September quarter. It is true that Netflix is losing billions at this stage posting negative cash flows all-year and investing many more billion dollars into its content. And although the growth has slowed down domestically and internationally, it is still growing at an unprecedented rate. What's more, Netflix has been incredibly successful with its international expansion with revenues soaring over 70% between Q1/2018 and Q1/2017 and eclipsing the growth in cost of sales and thereby increasing margins.

Also, it is predicted that Netflix will be able to double its 2014 streaming revenues by 2020 and continue to grow at around 8% CAGR annually.

This is a very steep hurdle for AT&T to take and once the streaming wars between AT&T, Disney, Amazon, Netflix and potentially Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG) are really starting, it is anyone's guess how customers will react. There is a whole array of questions such as...

How many streaming services can and do they want to afford? How many hours a day are they really using these services? Which one will be the cheapest? Which one will offer the best value?

While I personally believe that there is enough space for all of these services to exist, customers are unlikely to own more than 2 simultaneously as you only have a limited amount of time to consume them anyway. Also, none of these products are must-haves. Netflix has had tremendous success so far but not in terms of profits. Its low price, its wide content and its family-friendly pricing structure (remember that you can share an account with several people) have pushed subscriber levels to record levels but none of these is a competitive advantage other services are not able to copy and improve on. In fact, it was found that 56% of customers find pricing to be the most appealing feature for Netflix. It is not Netflix's platform, its content, its level of service or its "coolness" which ranks highest, no, it is just pricing implying that customers may easily switch to another service if it offers even better pricing.

The Positive Scenario

While the negative scenario only discussed impact in a qualitative manner (any numbers would just be pure speculation), the positive scenario will be all about numbers but before that a few qualitative assumptions:

  1. AT&T will be able to grow cash flows
  2. AT&T will be able to return to its target leverage ratio below 2
  3. AT&T will be able to stabilize its Entertainment Group and successfully establish its streaming service

If the business performs in that manner, then the current yield will make you very rich, certainly in terms of quarterly dividend income but also very likely in terms of capital appreciation.

An Income Strategy Session

Now that the stock is trading at a 6.9% yield, long-term oriented investors should really welcome that opportunity to add to their position. In essence, if you are a long-term investor, this is exactly the kind of market reaction you would like to see. It allows you to lower your cost basis while the business is making the necessary transformation steps towards the future. The day-to-day noise with heavily followed stocks like AT&T is tough to ignore, and it may be one of the most difficult challenges to have the conviction to hold and add to your position in these times.

Now that the stock is trading at a 6.9% yield, long-term oriented investors should really welcome that opportunity to add to their position. In essence, if you are a long-term investor, this is exactly the kind of market reaction you would like to see. It allows you to lower your cost basis while the business is making the necessary transformation steps towards the future. The day-to-day noise with heavily followed stocks like AT&T is tough to ignore, and it may be one of the most difficult challenges to have the conviction to hold and add to your position in these times.

After 5 years, the net YoC has already risen to above 8%, and after 10 years, it would reach more than 12%. This is a very conservative scenario as it does not factor in any stock price appreciation and only minimal dividend growth.

It is extremely unlikely that the stock will stay flat over such a long period of time. If it did and really were able to continue to grow its dividend it would be a once-in-a-lifetime opportunity to generate massive income. Let's now run the numbers for a different scenario where all other things being equal we will assume that the stock will grow 6% annually, i.e. that we will only be able to reinvest our dividends at higher prices.

In that scenario, we would generally have lower yields on cost and less dividend income but substantially higher total returns. After 5 years the net YoC will be just below 8% and after 10 years just below 11% and thus around 1.5pp below the previous scenario. However, the investment values after 5 and 10 years will largely differ:

  • Investment value after 5 years: $10,360 or an almost 107% gain with the respective yearly net dividends depicted below
  • Investment value after 10 years: $18,500 or an almost 270% gain with the respective yearly net dividends depicted below

In the 10-year scenario, the CAGR would be a mind-blowing 15.7% and the stock would be at around $56. If AT&T executes its strategy well, this could indeed mean returns almost twice as high as what we would expect to generate by investing in the broad markets.

Investor Takeaway

In summary, I don't know where AT&T stock will be heading but what I do know is which factors we need to observe and which potential returns we could generate if the positive scenario plays out. There is no investment which is 100% safe. This is just the nature of investing. With zero risk, you will get zero return. With substantial risk, you could get even more substantial returns as modeled in the case of AT&T.

It is really "Game On" for AT&T and while 2018 has been a year investors will want to forget, 2019 could be one to remember. Several analysts and authors on Seeking Alpha have picked AT&T as one of their top picks and conviction calls for 2019. Bank of America Merrill Lynch named AT&T a "high conviction idea" for Q1, JPMorgan a "top pick" and expects "strong results" and Seeking Alpha's The Value Portfolio mentioned it as his "top investment idea for 2019".

I can certainly relate to these calls and unless AT&T will report a disastrous Q4 result in its Entertainment Group, the upside potential is tremendous especially when AT&T quickly makes progress with deleveraging as it has been guiding.

But I can also relate to the negative scenario I outlined above. There are multiple risks the company is facing and while neither of them will bring down the entire company, they can easily hurt the bottom-line to a degree where the illustrious dividend yield has been a yield trap.

You will either get rich with market-beating returns and record dividend income or (financially) die trying when the bears got it right and AT&T's transition and transformation into a digital company won't work out as expected/hoped.

Personally, I remain long in the stock and have added to my position at a 7% yield. Very soon, on January 9, the stock will go ex-dividend which could potentially provide an even better entry opportunity.

To keep track of upcoming ex-dividend dates, I use the Dividend Calendar & Dashboard Tool. This handy tool allows me to view respective next ex-dividend dates and provides an automated dividend dashboard. Here is a sample screenshot of my portfolio's dividend performance and the dividend calendar which also shows that AT&T (and by the way Verizon (VZ) as well) will indeed go ex-dividend on January 9, 2019:

Although the year has just started, the relative strength of AT&T over this very short time period already demonstrates what could be in store if the bulls got it right.

T data by YCharts

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