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Is This Widely Held Blue-Chip Entering A Death Spiral?

Monday, March 3, 2014 - 2:30pm

My grandma worked as a secretary for much of her life. Without my grandpa's knowledge, she squirreled away part of her monthly earnings into the stock market.

Like many investors of her era, she only cared about two kinds of stocks: electric utilities and telephone companies. Indeed, it was the perennial promise of ever-higher dividend payments that led my grandma to call AT&T (NYSE: T) her "no brainer" stock.

But if she were alive today, I would encourage her to sell off her shares in AT&T -- because the day is approaching when Ma Bell's dividend stops growing and starts shrinking.

A range of pressures are starting to hurt this once-venerable business, and the pressures are likely to deepen in coming years.

The Vultures Are Circling
Back in September, I noted that 106.5 million shares had been held by short sellers. Just-released short sales data shows that figure has surged 20 million in the first two weeks of February to a stunning 171 million. We're now talking about the most heavily shorted stock on the New York Stock Exchange, by a significant margin.

Six months ago, I suggested that the barriers to entry in the wireless telecom space were lower than many suspected, and some short sellers were anticipating an entry by a major tech firm such as Google (Nasdaq: GOOG) or Amazon.com (Nasdaq: AMZN).

That hasn't happened, but a radical price war instigated by T-Mobile (NYSE: TMUS) has had the same effect. Wireless services have historically been a remarkably profitable business, and as AT&T inevitably adjusts to the new pricing paradigm that T-Mobile has established, margins in this division are going to compress, perhaps sharply.

The timing couldn't be worse. AT&T's landline business is already in terminal decline, and its Internet backbone and business services units face intense competition.

Flickr/JeepersMedia
AT&T's landline business is already in terminal decline, and its Internet backbone and business services units face intense competition.

To be sure, AT&T delivered relatively robust results in 2013, as gross, EBITDA (earnings before interest, taxes, depreciation and amortization) and net margins hit all-time highs. Ongoing cost-cutting gets all the credit. But as we head further into 2014, the picture has begun to change. Free cash flow, which hit $13.6 billion in 2013, is likely to be more than $2 billion lower this year as deferred infrastructure investments must finally be pursued, according to analysts at Merrill Lynch.

As a result, AT&T is expected to pay out roughly 85% of this year's free cash flow (FCF) towards its dividend. Trouble is, management told investors on a recent conference call that profit margins at the wireless division are expected to be quite robust this year. It's as if management is ignoring the price wars kicked off by T-Mobile.

"The decline in excess FCF lessons room for error and could constrain AT&T's ability to respond to additional moves by competitors," note analysts at UBS. In effect, AT&T's desire to maintain its current pricing to ensure that FCF goals are met could prove short-sighted if it leads to market share losses that eventually erode profits anyway.

In each of the past four years, AT&T has boosted its dividend by a paltry 2%. Declining financial metrics may make it impossible to maintain that record, and the specter of a dividend cut can't be dismissed. For example, AT&T's return on equity has been 14.7% in each of the past two years, but Merrill's analysts think the figure will fall below 10% by next year. Operating margins, which hit 23.7% last year, are expected to drop 4 percentage points by next year.

Analysts aren't yet assuming a dividend cut, simply because it's never happened before for Ma Bell. But simply maintaining the dividend will eventually push the payout ratio above 100%. Short sellers think that thousands of shareholders will dump this blue-chip holding if a dividend cut is announced.

Such a move may not come in the next 12 months, but the T-Mobile price wars will likely lead analysts to start publicly contemplate such a move in coming quarters. That negative catalyst alone is reason enough to sell this stock now.

Risks to Consider: As an upside risk, AT&T could look to make more acquisitions, such as the recent Leap Wireless deal, to temporarily bolster revenues and profits. Some believe that the company will begin targeting the European market through an acquisition of Vodafone (NYSE: VOD). Vodafone has surged 60% in value in the past 12 months, making a potential deal harder to justify. AT&T could have acquired T-Mobile a few years ago at a fraction of its current price, which is surely leading to management indigestion these days.

Action To Take --> As I noted in my recent look at T-Mobile, that company anticipates taking major market share in the current quarter. Yet analysts don't appear to be incorporating such share shifts in their current forecasts. Short sellers are betting that first-quarter results are bound to represent an acknowledgement of wireless industry pricing pressures.

Short sellers are also looking ahead to the real possibility that this dividend payer will soon be a dividend cutter. As it stands, the current yield approaches 6%, but a modest drop in the payout, coupled with an eventual rise in fixed-income yields, means that the era of this "no brainer" stock may soon come to an end.

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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of T, TMUS in one or more of its “real money” portfolios.

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