AT&T's Deleveraging Path Faces Uncertainty From Lead Cable Allegations

AT&T's stock this week dipped to lows not seen in over three decades following a report from The Wall Street Journal (WSJ) that exposed the company's link to toxic lead-sheathed cables deployed by its predecessors in the late 1800s through the 1950s to power landline phones.

The WSJ identified over 2,000 lead-clad cables spread across America on poles, in-ground, and under waterways. Random testing showed that lead levels in nearby soil and water exceeded EPA safety guidelines, triggering fears of 3M-like legal liabilities that could drag on for years.

AT&T has responded that "these cables represent less than 10% of our copper footprint of roughly 2 million sheathed miles" and that it would "work cooperatively with all stakeholders to address new safety concerns."

That said, authorities and regulators still haven't officially identified the full extent of the problem or the best way to mitigate the lead exposure – making it hard to estimate how big of a financial hit these cleanup costs could be for AT&T and others.

With limited information available, major research firms have refrained from providing precise estimates on the financial impact of the issue. However, a smaller shop has estimated the potential remediation expenses for the telecom industry to reach almost $60 billion.

Based on current cable line ownership, that shot-in-the-dark estimate assumes AT&T would be on the hook for roughly $35 billion and Verizon a much smaller $8 billion. But projections will likely fluctuate in the coming months as analysts learn more.

The uncertainty of these potential cleanup costs adds to AT&T's already challenging environment, with new subscriber growth stalled and little recovery to date on the firm's substantial investments (more than $140 billion over the past 5 years) in 5G and fiber cable infrastructure.

The capital intensity required to build a 5G network and expand fiber cables, not to mention the ill-advised acquisition of Time Warner in 2017 for $85 billion, propelled AT&T's debt levels to historical highs, pushing the firm's leverage ratio to around 1.0x above management's target level.

Before the lead-cable revelations, the BBB rated AT&T had made some notable deleveraging progress by shoving nearly 30% of the firm's net debt onto Warner Bros. Discovery as part of the Time Warner divestiture that led to the telecom giant's dividend reduction last year.

And the firm planned to chip away at its remaining $137 billion of book debt using its approximately $6 billion of annual retained free cash flow after paying common and preferred stock dividends.

A multibillion-dollar legal liability, however likely, would represent a significant portion of AT&T's retained cash flow and meaningfully delay the telecom giant's debt reduction plans.

Alongside sluggish subscriber growth and higher-for-longer interest rates, this potential development could prompt management to be keener on conserving cash for more aggressive debt reduction.

With AT&T's dividend projected to consume around 60% of free cash flow (after deducting preferred dividends) in the year ahead, it represents the company's biggest use of capital and could feel more pressure if this scenario materialized.

Recognizing the potential for this new lead cable issue to slow AT&T's deleveraging path, we are downgrading the firm's Dividend Safety Score from Safe to Borderline Safe.

AT&T's Dividend Safety Score is lower than Verizon's given its higher exposure to the fallout from toxic lead-coated cables and the firm's slightly more stretched debt profile.

Based on the information known today, we expect AT&T to continue prioritizing the dividend, especially considering free cash flow is expected to grow around 10% in 2024 simply from fewer capex needs as 5G investments scale down.

However, AT&T's outlook could change once more clarity emerges about the financial impact of lead-sheathed cables. We will keep monitoring this developing story, including a review of the firm's earnings report on July 26.

For now, we plan to continue holding our AT&T shares in our Conservative Retirees portfolio (AT&T represents less than 1% of the portfolio).

With AT&T shares trading at an unusually high dividend yield and expectations that the firm will continue generating stable cash flow as a provider of essential wireless services, we are willing to hold through this noisy period.

Should AT&T's financial outlook deteriorate further due to lead cable developments or incremental growth headwinds, we would revisit our position and the company's Dividend Safety Score.