AT&T And DirecTV: Dividend Outlook Post-Merger

Since 2008, AT&T has established the custom of raising its quarterly dividend by a penny per share, or $0.04 annually. That pattern has taken the $1.60 dividend in 2008 up to $1.88 here in 2015. The slow rate of dividend growth during these past seven years has served an important purpose: It has given AT&T the chance to increase the amount of its annual profits that aren’t earmarked for dividends. Retained earnings are in important ingredient in establishing future growth because it represents the available cash to sink into new initiatives without having to borrow from banks or dilute shareholders.

In the past ten years, the dividend has gone from consuming 83% of AT&T’s profits to 68% of AT&T’s profits now. That starts to give the company wiggle room for buybacks, growth investments, acquisitions, or even dividend bumps at a faster pace. Lately, there has come news that AT&T will be able to successfully acquire DirecTV (though this is not yet cemented, and strings attached such as divestments remain a possibility). The appeal of DirecTV is this: It adds a significant growth component to AT&T’s generally slow-moving profit engine. DirecTV has grown cash flow by 33% annually over the past ten years, and 31% annually over the past five. Even with anticipated slowdowns (a decade ago DirecTV was only making $326 million per year in profit so it has a lot of room to run), DirecTV still has a fair shot of growing profits by 11-13% per year.

What that means for AT&T is this: AT&T makes about $13.5 billion per year in profit, and DirecTV makes about $2.8 billion per year. AT&T pays out $9.5 billion in annual dividends. With DirecTV under its umbrella, the dividend payout ratio will come down to 58% of profits. Other than the year 2007 when profits uncharacteristically jumped up for AT&T, this will be the lowest dividend payout ratio for the telecom since SBC Communications swallowed up AT&T and decided to trade on its name. If AT&T desires, this will give the company the capacity to AT&T to raise the dividend by more than the $0.04 annual dividend increase that shareholders have come to know.

If the DirecTV component continues to grow at 10% annually and the classic AT&T grows at around 3-4% annually, this merger can give the future growth rate a slight uptick to around 5% which is substantial for a company with $133 billion in annual revenues and an existing 5.5% dividend yield that takes $9.5 billion in cash per year to pay out.

As gratifying as larger than usual dividend increases may be, especially from companies that already pay out high yields, there is also a part that thinks it would be in the best interest of AT&T shareholders to use the lower dividend payout ratio as an opportunity to tackle the sizable debt on the balance sheet. Paying down debt is a thankless position—no one toasts the man who holds the dividend steady and reduces debt by 10% at the Christmas party—but it maximizes the potential of your future profits by allowing them to go towards future growth rather than paying off yesterdays, and provides protection in the even that cash flows decline significantly in a deep recession that lasts longer than expected.

Both AT&T and DirecTV carry unusually high debt loads for companies that operate in industries that are known for carrying high debt loads. In the case of AT&T, there is $75 billion in debt on the balance sheet. Stick around for 100 years, and operate in an industry that requires intensely large amounts of cash to grow, and that kind of thing happens. The pension AT&T owes its employees totals around $56 billion, and AT&T has it funded with $47 billion. AT&T’s cash position has grown unusually low—from $6 billion for most of the 2010s to $4.8 billion in 2012, $3.3 billion in 2013, and $2.4 billion now.

DirecTV is in a similar predicament, with $19.7 billion in debt. The pension isn’t really an issue, as it has $500 million in commitments and $400 million in the current plan. The potential issue is this: an AT&T that is combined with DirecTV carries $94.7 billion in debt, and that is something that is something that I would think most shareholders would like to see get cut in half. A low payout ratio from the merger would provide an opportunity to use excess cash to start paying down these obligations, but directionally, the debt has gone up rather than down over time so it would be difficult to expect a change in that.

In short, my conclusion is this: Immediately after the merger, AT&T’s dividend payout ratio will give the management much more discretionary options than we have seen since before the recession (really, since we have since the SBC takeover because the low payout ratio of 2007 was quite short-lived). The long-term earnings per share growth rate of AT&T ought to tick about a percentage point because of this deal. The capacity for a bit higher dividend growth is there, but there is a compelling reason to keep dividend growth low so that debt can be taken from high to moderate. The dividend payout ratio ought to lower, and at the very least, AT&T shareholders ought to be in better shape after the merger than before DirecTV entered the picture.