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Stocks  | January 30, 2019

Despite a solid last quarter, AT&T's (T) stock continues to be stuck at rock-bottom levels. I consider this to be an outstanding entry point for what's been one of the best dividend stocks over the past 25 years. AT&T's dividend yield is more than 6.5% on an annual basis, which is near an all-time high and more than any other stock with a market cap greater than $100 billion. What's better is AT&T produces plenty of free cash flow to maintain and continue growing this payment. I also like that AT&T trades cheap based on multiple fundamental approaches including historical multiples, a comparables analysis, and a discounted cash flow model.

AT&T Dividend Analysis

The dividend has been provided uninterrupted since 1984 and increased every year since 1998 (20 years). As you can see by the chart below, AT&T's yield is at the upper end of its historical range. There are no issues with AT&T's performance and interest rates are still comparatively low, so I consider this a strong indication the stock is deeply undervalued.

In terms of dividend coverage, AT&T's payout ratio is at 66% (year-to-date), which is close to the company's average for the last couple of full years. This means there's plenty of room to continue growing the dividend payment and also plenty of room for safety should performance deteriorate. 2019 will be the first full year of performance after the Time Warner acquisition and I expect the dividend to continue looking solid.

  • Dividend Coverage Projection Assumptions - 2019 free cash flow projection of $21.7 billion just assumes the average of each company's free cash flow production over the last 3 full fiscal years (i.e., this equals $17.7 billion for AT&T and $4 billion for Time Warner). According to AT&T's latest earnings release, the company is expected to finish 2018 with at least $21 billion in free cash flow, so this expectation is conservative. 3-year free cash flow projection of $24.2 billion assumes the realization of $2.5 billion in synergies. I've increased the dividends paid by approximately $2.5 billion to account for the additional new common shares as part of the transaction.
  • AT&T's yield (6.56%), payout ratio (66%), and max yield (9.9%) also compares favorably to other large-cap high dividend stocks (note - max yield assumes each company pays out 100% of its annual free cash flow):

    • Exxon (XOM) - 4.53% yield (74% payout ratio; 6.1% max yield)
    • Verizon (VZ) - 4.32% yield (56% payout ratio; 7.7% max yield)
    • IBM (IBM) - 4.63% (52% payout ratio; 8.9% max yield)
    • Philip Morris (PM) - 6.04% (86% payout ratio; 7% max yield)
    • Altria Group (MO) - 6.62% (61% payout ratio; 10.8% max yield)

AT&T's Valuation At Historically Low Level

Based on historical valuation multiples, AT&T's valuation looks like a bargain across the board: (Data sources: Ycharts & Reuters):

  • Forward P/E of 8.5x (5-year average of 12.4x)
  • Forward PEG of 1.4x (5-year average of 2x)
  • Price/Sales of 1.2x (5-year average of 1.4x)

Not only do those valuations look good relative to the last 5 years, AT&T's P/S and P/E ratios look well-valued over a longer time span too. Over the last 20 years, these valuations were only at this level during the last recession and tech bubble.

AT&T Compares Favorably To Verizon

If you had to choose one large-cap stock in the telecommunications industry, it's generally going to come down to AT&T or Verizon and this comparison isn't even close. AT&T looks like a much better choice for the following reasons:

  1. AT&T trades 27% cheaper in terms of forward earnings and 12% cheaper in terms of EV/FCF.
  2. AT&T provides a significantly larger dividend than Verizon, and has a similar payout ratio. Over the trailing nine months, AT&T's payout ratio was 66% (see table above) and Verizon's has been 56%. Keep in mind that when equalizing the dividend payments, Verizon's payout ratio is much worse. Also consider that AT&T's payout ratio has been much more consistent historically where Verizon has typically had a hard time supporting its dividend.
  3. Both companies are considerably over-leveraged, but AT&T's free cash flow production puts it in a better position to manage its debt going forward.
  4. The Time Warner deal gives AT&T a strategic advantage over Verizon in my opinion. The entertainment and communications industry is continuing to consolidate and the Time Warner deal further diversifies AT&T's holdings and allows it to offer a wider selection of products to its customers.
  • Enterprise Value, Forward P/E, Price/Sales, EV/FCF, PEG Ratio, and Yield provided by Ycharts & Yahoo Finance.
  • LT Growth provided by Reuters.
  • Single Stage Cash Flow Model - 25% Upside Expected

    This model is conservative for multiple reasons. First, I've only assumed 2% cash flow growth. AT&T should be able to easily achieve that with inflation (i.e. price increases) and synergies achieved with the Time Warner Acquisition. For comparison, AT&T's long-term growth rate is 5.9% according to Reuters. Second, I've assumed a much higher beta (AT&T's actual beta is approximately 0.7x), which increases the required rate of return.

  • Risk-Free Rate - I used the yield on a 30-year Treasury bond.
  • Equity Risk Premium - This figure is calculated every month by Aswath Damodaran, a Stern Business School Professor.
  • Required Rate of Return - Calculated by multiplying the Equity Risk Premium by Beta and then adding the Risk-Free Rate.
  • Value of Equity = CF1/(r - g).
  • CF1 = 2018's estimated free cash flow of $21 billion.
  • "r" is the required rate of return and "g" is the long-term growth rate.
  • Wall Street's Opinion

    Wall Street is mixed on AT&T, but the overall consensus expectation still shows upside, which is consistent with my analysis. According to MarketWatch, the average target price is $34.24, which represents 12% upside based on the current share price of $30.66.

    Risks & Conclusion​​​​​​​

    There are a few risks worth pointing out. First, there's no guaranty that the integration of Time Warner continues to go as planned. There's always the risk that AT&T paid too much and synergies are never realized. The second major risk I see is AT&T's balance sheet. The Time Warner deal has increased AT&T's debt level to $183 billion and created a serious leverage issue. To put that in perspective, that's more debt than AT&T produces in annual revenue. However, the early indications of the Time Warner deal are positive. According to AT&T's last earnings release, all of WarnerMedia's units continued to show growth and AT&T's CEO had the following comments:

    Our U.S. wireless business is growing and it’s the single biggest contributor to our earnings and cash flow. WarnerMedia was immediately accretive in its first full quarter, contributing 5 cents to EPS, and our free cash flow grew by double digits."

    I also see AT&T's debt level as manageable. If you refer back to my dividend analysis, there's historically been leftover free cash flow, which can be used to pay down debt. The company has also consistently made a point to work leverage multiples down. As a last resort option, AT&T could also cut its dividend if needed. With those issues being understood, I still believe the risk/reward proposition is compelling. The stock trades at significant discounts according to my cash flow model, historical valuation multiples, and a comparables analysis. On top of that, the dividend yield of more than 6% will significantly increase compounded returns over time. The bottom line here is that there's significant upside if AT&T executes on its expectations.

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