AT&T's Call Options Attracting Buyers as Dividend Looks Secure

Barchart's Unusual Stock Options Activity Report (USOA) for Nov. 11 shows a large activity in the call options in AT&T (T). Given AT&T's strong free cash flow, the stock could rise from here, making its call options worth buying. 

This is mainly because the company's free cash flow (FCF) is now seen as more than sufficient to cover the quarterly dividend. As a result, the 5.8% dividend yield for T stock is too high, and the stock could rise, lowering the dividend yield.

AT&T's FCF Covers the Dividend

AT&T emphasized during its most recent quarterly conference call on Oct. 20 for Q3 that it was producing sufficient FCF. It generated $3.8 billion in FCF during the quarter. This more than covers the $2.0 billion in quarterly dividends (or $8 billion annually).

For example, here is what John Stankey, the company's CEO said during the call:

“At the same time, we hope this healthy free cash flow for the quarter gives you confidence in our ability to achieve our target for free cash flow in the $14 billion range for the year, a level that is more than ample to support our $8 billion dividend commitment.”

In fact, if it keeps generating $3.8 billion quarterly, the FCF will be $15.2 billion, which is 90% greater than the $8 billion dividend cost.

Here is what that means on a practical basis. The $1.11 annual dividend payment is more than covered by the $2.09 per share in annual FCF. So, at $19.05 per share, as of Friday, Nov. 11, the stock's 5.82% dividend yield (i.e., $1.11/$19.05) is probably too high. 

For example, at a yield of 5.0%, the stock could rise to $22.20 per share (i.e., $1.11/0.05 = $22.20). That represents a potential upside of 16% over today's price. This could also be supported by the market especially if interest rates keep falling. We can use this to look at AT&T's call options.

AT&T Call Options Look Favorable

The USOA report from Barchart shows that some institutional investors bought over 5,000 call option contracts at the $20.50 strike price for the Dec. 23 expiration date:

They paid 13 cents per contract at the midpoint for these call options, making the breakeven price $20.63 ($20.50 strike + $0.13 premium). That is still well below the $22.20 target price for T stock. If the stock rises to $22.20, or 16% from today's price of $19.05 (see above), the price of the call options will be worth $1.70 per share (i.e., $22.20-$20.50), or over 13 times the price paid at 13 cents. The profit of $1.57 (i.e., $22.20-$20.63) would be 12x the cost at 13 cents per share.

To be more conservative, let's assume T stock rises to $21.00 by Dec. 23, or 10% over today's price of $19.05. That would still give it a 5.29% dividend yield, which is very attractive. Moreover, the call option investor will have a profit of 37 cents per share (i.e., $21.00-20.63). This 37 cents profit per call option would still represent an ROI of almost 3x (285% on cost).

In other words, the call options for AT&T at this strike price ($20.50) for Dec. 23 look very attractive for bargain investors.

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