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Dividend Bubble a 'Double-Edged Sword' for Telcos

Antoine Gara | Staff Reporter
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For investors, the near 5 percent dividend yields of telecom giants AT&T and Verizon Communications proved a safe trade in 2012, amid continued Federal Reserve easing and an uncertain economic backdrop. Now, as both carriers prepare for fourth-quarter earnings, the Fed's low interest rates are proving a "double-edged sword."

While low interest rates continue to make AT&T and Verizon a safe yield trade for flighty stock market investors, the Fed's support of cheap money is also wreaking havoc on their balance sheets.

Notably, AT&T and Verizon now face multibillion-dollar fourth-quarter charges as they adjust unfunded pension liabilities to reflect lower projected interest-based earnings. Meanwhile, low rates are also increasing the present value of pension liability.

On Thursday, AT&T said it will take a $10 billion charge as it adjusts the value of pension liabilities to reflect lower interest rates. In two simultaneous balance sheet adjustments, AT&T will record an actuarial loss of roughly $12 billion as it lowers its return estimates on assets to cover pension plan liabilities from 8.25 percent to 7.75 percent. AT&T is also lowering the discount rate on its unfunded pension liability from 4.3 percent, increasing the net present value of those costs.

AT&T's $12 billion actuarial loss is offset by roughly $2 billion in asset gains, putting the telecom giant's fourth-quarter earnings hit at $10 billion.

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In the fourth quarter, Verizon will record a similar-sized charge to reflect the impact of low interest rates.

In an 8-K filing with the Securities and Exchange Commission earlier in January, Verizon said it expects to record a pre-tax charge of between $7 billion and $7.5 billion in the fourth quarter due to a reappraisal of pension and post-retirement liabilities. Verizon also said it will record between $1 billion and $1.5 billion in charges as it calls in debts early and books restructuring costs.

For AT&T and Verizon, the pension losses don't impact operating results or margins, which will be closely followed by investors and analysts as they try to quantify the impact of Apple iPhone 5 subsidy costs on wireless earnings.

Still, for some watchers of telecom stocks, the earnings-wrecking fourth-quarter charges highlight a hitch in the logic that makes both dividend-yielding telecom carriers attractive investments in a low rate environment.

A year ago, telecom sector analyst Craig Moffett of Bernstein Research highlighted a troubling interplay between low interest rates and pension liabilities as one reason to hold a negative view of both carriers.

"Last year, we downgraded AT&T in the wake of declining interest rates, noting that low prevailing interest rates are a double-edged sword," wrote Moffett, in an Friday note to clients. "Low interest rates make AT&T's and Verizon's dividend yields enticing for investors. But it's precisely these low rates that wreak havoc on the Telcos' massive unfunded pension and OPEB liabilities," the analyst added.

At the early part of 2012, Moffett took exception to telecoms like AT&T, Verizon, and Sprint Nextel as investments, ahead of their outperformance through the first half of the year on strong wireless earnings and M&A speculation.

In particular, Moffett highlighted earnings-wrecking Apple iPhone 5 subsidies, margin declines, pension liability and capital spending as reason for caution, amid the sector's outperformance.

While Moffett's view proved mistimed for much of 2012, a recent string of analyst downgrades thanks to AT&T and Verizon's expected declines in wireless margins and both companies' recent underperformance, supports the underlying analysis.

As part of AT&T's Thursday 8-K filing, the carrier also disclosed it sold 10.2 million iPhones in the fourth quarter, more than previous analyst estimates. The disclosure caused Moffett to further cut his earnings estimates for AT&T and Verizon, in a Friday analysis.

While the analyst's bearish 2012 analysis of the telecom sector is likely to finally play out in fourth-quarter earnings next week, it might also set the stage for another strong year for the telecom sector.

Evercore Partners analyst Jonathan Schildkraut wrote in earnings previews that a fourth-quarter miss on iPhone subsidy costs could represent a buying opportunity for AT&T and Verizon investors.

After taking in AT&T's disclosure, which also contains $175 million in Hurricane Sandy related operating charges, Schildkraut reiterated that perspective. "We] believe that weakness resulting from this margin pressure could lead to a buying opportunity," he wrote of AT&T and Verizon's upcoming earnings.

Gimmie Credit analyst Dave Novosel wrote in a Friday note that while pension adjustments and smartphone user growth will hit upcoming telecom earnings, they could pave the way for gains in coming quarters.

"[It] seems to us that companies are typically looking in the rearview mirror when it comes to pension discount rates," Novosel wrote in a Friday research report that argues rising interest rates could eventually reverse pension actuarial losses. Meanwhile, a short-term iPhone subsidy margin hit could give way to "substantial profits" over the long-term for AT&T and Verizon, argues Novosel in the report.

Verizon reports earnings on Jan. 22, with analysts expecting 51 cents a share in adjusted profit on $29.8 billion in revenue, according to analyst estimates compiled by Bloomberg. AT&T reports on Jan. 24 with analysts expecting an adjusted profit of 46 cents a share in $32.2 billion in revenue, the Bloomberg data show.

By's Antoine Gara

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