AT&T Stock: Leverage Tactical Trading For Outsized Returns (Rating Upgrade)

Summary:

• We made a very controversial call to sell chunks of AT&T Inc. stock as it hit $19 and $20.
• The stock has tanked over 17% since reporting earnings.
• As we guided to tactically wait for well under $17 to come back into the name, we are once again ready to buy for income.
• Cash flow is key here, but with the yield now approaching 7%, you can generate more income not just by trading the stock around a core position, but through a covered call approach.

The markets are looking for direction, as they have been pinned in a range the last two months, and we just do not see meaningful upside much past 4200 on the S&P 500 Index (SP500). We think the max upside case here is the August highs, but from there, we are predicting a significant selloff as we work through the summer and into the fall.

The impacts of the Federal Reserve’s efforts to fight inflation have largely yet to be felt, while market leadership has been growth tech with great balance sheets in an AI-driven rise, which has led to positive sentiment in the market. We see a sentiment shift as likely as economic data continues to soften, and it could get ugly when there’s a race for the exits following this incredible rally. Simply put, we think risk-reward is imbalanced here. We are starting to take more defensive medium and longer-term positions, while still tactically trading individual tickers for added cash flow to boost some income holdings.

Today, we are now calling for a return to buy AT&T Inc. (NYSE:T) for income. The company is slowly seeing its financial position improve while investing in the future.

We guided members to start taking profits in AT&T between $19 and $20, with heavier selling over $20. We also shared this position publicly, much to the dismay of many commenters who thought this approach was ridiculous. We continue to believe trading around core positions to boost returns is a valid, and superior, play to simply buying and holding. We also said we would consider returning to shares when they dipped below $17.

Here, under $16.50 at the time of this writing, AT&T shares are down over 17.5% since that call, sparked in part by Q1 earnings. The quarter was mixed, and our primary concern is cash flow covering the dividend, as well as long-term debt. However, at a near 7% yield, we are looking to reenter AT&T here.

The play

We are treating this as a new position, but adjust as needed for trading purposes on your own holdings.

Target entry 1: $16.40-$16.45 (30% of position)

Target entry 2: $16.10-$16.15 (33% of position)

Target entry 3: $15.80-$15.85 (37% of position)

This weighting should lead to a yield of over 7% annually based on the current dividend. For added income, we recommend a covered call approach. While specific strikes and dates as well as exit points for core position trading are reserved for members of our trading service, when executed appropriately, you can increase your income here by 40%-60%. Timing will impact said returns, but we strongly recommend a covered call approach. Put selling to define entries for the second and third legs can also be considered.

Discussion

So, look, the Q1 report sparked this current AT&T selloff. Overall, our revenue expectations were slightly more conservative relative to consensus. Analysts covering the company saw $30.24 billion as consensus, while we expected revenue to be right at $30.2 billion, with minimal year-over-year growth. With $30.14 billion in revenues, it was a miss against consensus and our estimates. It was a very slight, however.

The thing is that this is a dog-eat=dog world in the big telecoms. But AT&T continues to be in growth mode in terms of accounts and customers. Wireless postpaid growth saw 0.542 million adds and also reported 0.272 million fiber net adds, which surpassed our estimate of 0.215 million fiber net adds. It should be reiterated that these postpaid adds continue to be industry-leading. AT&T is now covering over 160 million people. That is quite impressive and well above the pace management expected just a year ago.

So, revenue grew 1.4%, and with cost savings measures there was a bullish bottom line beat. Cost savings are preserving earnings, and the company is now on pace to see $6 billion in run-rate cost savings before the end of the year 2023. Analysts were looking for $0.59 in Q1 EPS, and this was surpassed by $0.01. Our target range was $0.56-$0.60, so this was at the higher end of our expectations. Operating expenses were $24.1 billion, about flat from a year ago. Operating income grew from last year to $6.0 billion, up $500 million.

AT&T for income

Our approach does allow you to generate some capital gain income, and recycle it over and over, but AT&T stock is a dividend income play. Put it this way, the $3.50-$4.00 in capital gains opportunity from $16.00/16.50 to $20.00 is worth nearly 6-7 quarters of dividend payments. It is not inconsequential. For the dividend, it is all about cash flow. Free cash flow is critical to covering the dividend, and the cash flow metrics spooked the Street a bit in Q1.

AT&T cash flow was much weaker than expected

Cash flow was simply a disappointment. The concern is whether it was a one-off, or if this was something larger. We targeted Q1 free cash flow of $2.5 billion. Free cash flow was just $1.0 billion, as cash from operating activities was $6.7 billion, and capex was $4.3 billion, while cash for vendor financing was a wildcard and was $2.1 billion. With dividends paid of $2.01 billion, after dividends, the free cash flow is negative $1 billion. Ouch.

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. We will see how Q2 pans out on this metric, and it is possible the payout ratio creeps up for the year to 70%. We will watch this closely.

AT&T’s debt remains the largest risk here

Debt has been coming down, but it actually increased sequentially. There are analyses which suggest AT&T and rival Verizon Communications Inc. (VZ) may have to step up their spending even more to catch up to rival T-Mobile US, Inc. (TMUS). That could weigh. Ouch. Keep in mind with interest rates rising so much that debt refinancing or new debt taken on will be at much higher rates and increase interest expense. While there are several years for most maturities, it is something to be mindful of. Debt, of course, is what the company uses to grow.

Looking at the AT&T balance sheet, we see there was an improvement in recent years, largely by selling off assets and paying down its debt. The debt was $137.5 billion, with net debt of $134.7 billion considering cash at the end of Q1. The net debt-to-adjusted EBITDA of 3.2X. That said, the company believes in the next two years it could get this to 2.5x. We will be pleased to see it dip under 3.0X within a year. That remains to be seen.

Outlook for AT&T stock

As we look ahead to 2023, we still see AT&T Inc.’s revenue growing 3%-4% on better pricing and more customer adds. The customer adds continue to be a strong metric for the company. We continue to see earnings coming in around $2.40-$2.55 for the year. That puts shares at around 6.5X FWD EPS, which is pretty attractive. Those who followed our trading guidance are being rewarded with an opportunity to start to come back into shares at a much better price.

Your voice matters

So, what did you think about this approach? Was waiting for AT&T Inc. stock at $17 too conservative? Did we simply get lucky, or were the signs there? Do you like the name for income? Do you sell around the core position? Do you embrace selling covered calls to magnify income? Do you have a better name for income to recommend? Let the community know below.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of T either through stock ownership, options, or other derivatives. 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.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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