AT&T (T) reported strong revenue and free cash flow (FCF) for Q4 and 2022 on January 25. However, AT&T's board may not hike its dividend, which has stayed level for the past 4 quarters. As a result, covered calls are now becoming popular as a type of pseudo-dividend income hike.
The company reported FCF was $6.1 billion during Q4. This was substantially higher than the $3.8 billion in FCF generated during Q3 and $5.1 billion a year ago. This means that the annual $1.11 per share dividend, which costs about $2.0 billion each quarter, has more room to pay down debt.
No Dividend Hike Likely
That could be why management kept talking about the “credit quality” of the “attractive” dividend being paid during the Q4 conference call. That implies the board may not increase the dividend per share this quarter.
For example, management presented the following table about FCF and the dividend cost in the supplemental info. It shows the dividend payout ratio in the past 2 quarters.
It shows that the dividend cost is just 33% of the company's free cash flow, down from 70% a year ago. In other words, there is much more room left to pay down debt. This is a primary goal of AT&T management. They want to reduce the net debt down to just 2.5x its EBITDA (earnings before interest, taxes, depreciation, and amortization) cash flow. That is likely what management is referring to in terms of the credit quality of the dividend at this level.
For example, at the end of Dec. 31, net debt was $132 billion. This was down $24 billion from a year earlier. The company reported that its adjusted EBITDA for Q4 2022 was $10.2 billion. So, on a run-rate annualized basis, that works out to $40.8 billion.
As a result, the net debt/adj. EBIDITA ratio is 3.24x. That is still over the 2.5x goal and implies debt has to fall by another $30 billion or so from $132 billion to $102 billion (i.e., $102 billion/$40.8 = 2.5x). That could take another year of FCF at this level and implies there is no room for a dividend hike or major share buybacks for that matter.
Covered Calls as a Dividend Hike Alternative
After all, management is quite aware that AT&T stock, at $19.07 per share, has a very high dividend yield. For example, the $1.11 dividend per share divided by $19.01 equals 5.839%.
However, shorting covered calls in AT&T stock is now becoming more popular as evidenced by the volume of calls traded, as I have written about before. This means investors who own at least 100 shares of AT&T stock can short out-of-the-money (OTM) calls at strike prices well over today's price to create extra income.
For example, the $20.50 strike price in the March 10, 2023 expiration period, one month from today, trades for 5 cents per call option. This means that an investor who owns 1,000 AT&T shares worth $19,070 at today's price can put in an order to “sell to open” 10 call contracts and immediately receive $50.
This results in an immediate yield of 0.26% (i.e., $50/$19,070). If it can be repeated each month over a year, the additional yield works out to 3.15%. So think about that. That represents a 53% hike over the 5.839% dividend yield.
Moreover, the stock would have to rise by 7.50% on or before March 10 before the investor would be forced to sell the stock at $20.50. However, that still means the investor gets to keep the extra 7.50% capital gain.
A more conservative way to play this would be to short March 31, 2023, calls at the $21.00 strike price, 10% over today's price, trading for 7 cents per call option. That is an even higher dividend yield of 0.0367% or 4.4% on an annualized basis.
The bottom line here is that investors can get around the lack of a dividend hike with AT&T stock. They can increase their income by shorting out-of-the-money calls.
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On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
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