AT&T (NYSE:T) recently stunned investors with two big announcements. First, it plans to spin off WarnerMedia, which it bought less than three years ago, and merge it with Discovery (NASDAQ:DISCA) (NASDAQ:DISCK). AT&Ts investors will receive new shares equivalent to a 71% stake in the new company, while Discoverys investors will control the remaining 29%.
AT&T claims the new company will generate $3 billion in annual cost synergies and compete more effectively against Netflix and Disney in the streaming wars. However, the decision also abruptly reverses AT&Ts plans to merge its distribution networks and media content.
Second, AT&T plans to reduce its dividend to account for the distribution of WarnerMedia to AT&T shareholders. It expects the slimmer AT&T to only spend about $8 billion of its annual free cash flow on dividends after the deal closes, compared to nearly $15 billion last year.
Image source: Getty Images.
In other words, AT&T will cut its dividend nearly in half and end its 36-year streak of annual dividend hikes. It will no longer be a Dividend Aristocrat of the S&P 500, an elite title reserved for members of the index that have raised their payouts annually for at least 25 straight years.
AT&T currently pays a forward dividend yield of 6.5%, so investors should expect a lower 3%-4% yield after the deal closes in mid-2022. The new media spin-off probably wont pay a dividend, since it will likely reinvest most of its cash into fresh content for WarnerMedia and Discovery.
Thats a lot of information for AT&Ts investors to process, but most of them are likely wondering if the dividend cut means its time to sell the stock.
AT&Ts dividends didnt help it beat the market
AT&T significantly underperformed the S&P 500 over the past five years. Its total return, which includes its reinvested dividends, rose just 3%.
AT&T trailed the market for three simple reasons. First, it bought DirecTV and AWS-3 spectrum licenses in 2015, then acquired Time Warner in 2018. Those three massive purchases caused its long-term debt to skyrocket.
Second, its DirecTV and Time Warner purchases quickly backfired. DirecTV, which was intended to expand its pay-TV business, lost subscribers to streaming services and became a dead weight. Time Warners TV and movie divisions struggled throughout the pandemic, and it needed a lot more cash to catch up to Netflix, Disney, and other platforms in the streaming market.
Thats why AT&T sold a 30% stake in DirecTV earlier this year and recently decided to spin off WarnerMedia. In other words, it burned billions of dollars by biting off more than it could chew.
Lastly, T-Mobile US (NASDAQ:TMUS) surpassed AT&T as the second-largest wireless carrier in the U.S. after it merged with Sprint last year. T-Mobiles 5G network also has a broader coverage area than AT&T and Verizon (NYSE:VZ), thanks to its use of lower-band spectrums.
AT&T was so distracted by its media strategies that its wireless business lost its competitive edge. AT&T now has to increase its marketing expenses to catch up, so its abandoning its expensive media ambitions. Yet most of this mess could have been avoided if AT&T didnt buy DirecTV and Time Warner.
What does AT&T expect for the future?
After the spin-off, AT&T believes its revenue will grow at a low-single-digit compound annual growth rate (CAGR), and that its adjusted EBITDA and EPS will grow by a mid-single-digit CAGR.
It expects to free up more cash for incremental investments in 5G and fiber broadband. It intends to expand its 5G network to cover 200 million people across the U.S. by the end of 2023 and reach 30 million fiber customers by the end of 2025. AT&Ts 5G ambitions are uninspiring since T-Mobiles 5G network already reaches 295 million customers across the U.S.
It expects to reduce its net-debt-to-adjusted-EBITDA ratio from 2.6 after the deal closes to less than 2.5 by the end of 2023. After the ratio drops below 2.5, AT&T will consider resuming its big buybacks -- which have been suspended since the start of the pandemic last year.
As for its dividend, AT&T plans to maintain an annual payout ratio of 40%-43% based on an annual free cash flow of about $20 billion. That would be much lower than its average cash dividend payout ratio over the past decade, and the removal of WarnerMedias business would reduce its total free cash flow.
Its time to sell AT&T
In short, investors should expect the new AT&Ts growth to remain anemic, its debt levels to remain high, and its dividend payments to be lower. Moreover, theres no guarantee that WarnerMedia and Discovery will fare much better in the streaming race as a stand-alone company.
AT&Ts low valuation might set a floor under the stock, but investors should sell it and consider buying better dividend stocks with comparable yields for now.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.Leo Sun owns shares of AT&T and Walt Disney. The Motley Fool owns shares of and recommends Netflix and Walt Disney. The Motley Fool recommends Discovery (C shares), T-Mobile US, and Verizon Communications. The Motley Fool has a disclosure policy.>
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