If cash is king, then there is definitely something peculiar with how AT&T's (T) stock price has languished even as other telecom providers have flourished. In the last 5 years, Verizon (VZ) has provided investors with a 43% return while AT&T sputtered along at just 9.24% - trailing the S&P 500 (SPY) as well, which had a return of almost 49%. And this despite steadily growing free cash flow.
Most of the underperformance has occurred from early 2017. At the start of 2017, AT&T was actually outperforming both Verizon and the broader S&P 500 index, but then started to lag into 2018. Then investor concerns over high debt levels and integration challenges related to the Time Warner acquisition caused the stock to collapse in the second half of the year.
And even though it reported strong earnings, it missed estimates and reported subscriber losses that spooked the market. Shares fell more than 8% on October 24 th alone.
While the Time Warner deal made sense, many investors were left to wonder whether it came at too much of a risk and too high of a price. And more importantly, will the company be able to continue to invest in other growth initiatives with higher debt levels and higher interest expenses? The company was downgraded to Baa2 by Moodys and to BBB by S&P Global. It was all investors needed to 'capitulate'.
The stock ended up losing 22% in 2018 which now begs the question: is it a good time to buy?
We've read reports and articles arguing both sides of the debate. On the one hand, AT&T is rolling out 5G ahead of schedule and earlier than any of its competitors, while the recent acquisition of Time Warner gives it a library of content to stream across its network. Throw in the company's three-tiered Netflix (NFLX) killer and Xandr – the advertising platform that will optimize its ability to target ads – and you have a recipe for success, right?
On the other hand, there is the matter of $180 billion of debt the company currently owes and with a lower credit rating, the cost of that debt will only rise. Then there is a long slew of risks, not to mention the heightened level of competition in the space from Amazon (AMZN), Disney (DIS) - which recently purchased Fox - and others - and you have an argument for the stock to continue to decline.
Debt
Since a company has to be able to stay in business to be able to implement its business strategy, we first looked at the company's ability to remain solvent and remain current on its debt payments. At a current debt level of $187 billion, it is the highest ever debt burden the company has had to manage and its interest payments are equally elevated from a historical comparison.
But the company is also much larger now and despite a burgeoning debt/equity ratio, which currently stands at 0.76, the company's assets have also ballooned to over $530 billion. I'm not suggesting the debt level is nothing to worry about, but when looked at in relative terms, it doesn't seem as high as the absolute number initially portrays.
The current debt/net adjusted EBITDA is roughly 2.8x and the company expects to reduce it to 2.5x by the end of 2019. That is roughly an $18 billion to $20 billion reduction in debt, which sounds intimidating, but can actually be almost entirely covered by the company's free cash flow.
There is also the potential $1B proceeds from the sale of Hulu, which can be used to pay down debt as well. The $1B estimated sale price is based on Disney's recent purchase of Fox, which also has an ownership interest in Hulu and is the likely buyer when AT&T decides to sell.
First to 5G
In it's last conference call, the company announced its introduction of 5G ahead of schedule and more importantly, ahead of any of its competitors. Despite first-mover advantage being less valuable today than in years past, with ever-changing disruptive technology, it does provide an advantage of sorts, even if only for the short-term. In the hyper competitive telecommunications industry, any advantage, however short-lived, is a welcome opportunity.
Other carriers have come out firing that what AT&T is currently touting as 5G is not reeeallly 5G - it's more like LTE on steroids. I'm not one to dispute for either side of that argument with my lack of technological expertise - but if its better than LTE, then I still think it gives the company a leg up on the competition. After all, the other carriers haven't launched 5G either nor LTE on steroids either.
Assuming it is 5G, AT&T was expected to launch 5G in Atlanta, Charlotte, Dallas, Houston, Indianapolis, Jacksonville, Louisville, New Orleans, Oklahoma City, Raleigh, San Antonio, and Waco. There will be another 7 by early 2019. The company expects 5G to continue to drive mobility, which is currently 40% of revenues.
Strategy
I've already mentioned some of the steps the company is taking. Much of the company's future success depends on the Time Warner merger, but there are other drivers that, when combined, make for a very compelling case that AT&T is going to be in the thick of the battle at the intersection of communication and entertainment.
The Time Warner acquisition allows it to access premium branded content and use its analytical capabilities for targeted advertising. This would put AT&T squarely against the Google's (GOOG) and Facebooks (FB) of the world and while there are benefits and drawbacks to playing on their turf, it opens up another revenue stream and perhaps more importantly, deepens its relationship with customers.
The Time Warner content will also give AT&T a weapon of sorts to use against current and future partners, such as Netflix. For example, it could take back libraries when those deals expire or negotiate better terms for access to that content – something that Disney has already begun to look at with their acquisition of Fox.
The acquisition synergies are expected to generate $2.5 billion to earnings by 2021. In 2019, the company expects $700K in a combination of revenue and cost benefits, $1.5 billion in 2020, and finally reaching the $2.5 billion in 2021 – which is likely to be made up of $1.5 billion in cost savings and $1 billion in revenue opportunities. Even in 2019, with a $700K benefit, that is $0.11 per share and yet analyst EPS forecasts for 2019 are just $3.58, compared to $3.52 in 2018. Is there a $0.05 per share value not being considered? From synergies alone, I would think EPS would be closer to $3.63.
Our Neighbors to the South
Despite ongoing discussions about a border wall and who will fund it and who is at fault for the government shutdown, Mexico is and will always be a key trading partner. It also happens to be one of AT&T's fastest growing markets. It now has over 17 million wireless subscribers – double its 2015 levels – and is the fastest growing wireless provider in the country.
There is also a big growth opportunity in other Latin America countries, where Vrio, the company's video operations across 11 countries, expects to start generating positive cash flows in 2019.
Xandr
If you get an eerie feeling every time you see an ad for a product or service you were just researching – or worse – discussing face to face with someone while your iPhone or Alexa was present – guess what? It's only going to get worse. Using targeting technology and perhaps eavesdropping by connected devices, the world of advertising is only going to be more intrusive not less.
AT&T's Xandr division, which was recently enhanced by the acquisition of AppNexus, is approaching $7 billion in revenues annually. The platform could be used to gain insights from customer relationships that could be leveraged to increase yields on advertising.
Three-tiered Netflix Killer
If you're thinking that Netflix and other streaming providers have an insurmountable lead on the streaming of movies, shows, and original content, think again. AT&T will soon be launching a three-tiered NetFlix killer. The service will consist of one of the following:
- Entry level package focused on movies
- Premium service with original programming and blockbusters
- Bundling of the first two with additional Warner Media content.
Ok, so Netflix killer may be a bit dramatic, but we know that content is king, and AT&T's recent acquisition of Time Warner was specifically to get access to TW's vast content library, which is likely to be less available to Netflix or cost more to access.
Follow the Cash
As I mentioned in the opening paragraph, the one thing that jumps out at me is how free cash flow for AT&T has continued to grow and yet, the stock price hasn't reflected it. It is probably the most important reason why I think the stock is a buy and not a sell and why I don't think the high debt levels will bring about the doomsday that bears are suggesting.
For 2019, Free Cash Flow is expected to reach $26 billion – that is AFTER capex spending of $23 billion!!
The chart below shows Free Cash Flow which is slightly different than how the company has reported FCF on their financial statements, but it is consistent directionally. If FCF in 2019 reaches $26 billion, then we should be looking at a price of slightly above $40. That is slightly above current consensus price targets of $35, but well within the high target price of $48.
FCF to Dividends
I also don't understand the comments about how the dividend is unsustainable at a dividend yield of 6.6%. The chart below shows the free cash flow quarterly compared to dividends paid. While certain quarters may indicate a 1/1 ratio of free cash flow to dividends, in many instances, the ratio of FCF to dividends is closer to 2.
With an expected dividend payout ratio of 50% - still comfortably low in our opinion – we don't see an imminent threat to the dividend either.
Risks
There are certainly risks to our optimistic views however.
- The wireless industry is arguably at a saturation point in the US and despite upgrades and the launch of 5G, marginal benefits may be less valuable to consumers in the future and they might be less likely to upgrade or pay more for faster wireless service.
- The intensity of the telecom industry and the fight for market share could further narrow margins and continue to commoditize the company's largest business segment.
- As the company looks to expand into other regions and countries, corruption and organized crime could create challenges not otherwise prepared for from years of operating in the US.
- AT&T has a large retiree and pre-retiree population which has created large pension and benefit obligations. The company relies on adequate returns to fund those obligations and any market declines could create a pension liability that impacts earnings in future years.
Valuation
Since we talked about free cash flow as the primary reason for our optimistic view on the stock, let's evaluate the current valuation based on the price/free cash flow instead of PE. From a Price/FCF perspective, the stock hasn't been this cheap since November 2009 when the P/FCF was under 8. In 2009, the stock price was at less than $24 and reached $38 before trading rangebound for two years before another spike to $44.
At a current P/FCF of 9.7x and a price of $31, we think the stock can easily get back to the upper 30s and even break through $40 if the integration and launch of 5G, er LTE Steroids goes smoothly.
Our Take
Despite very strong arguments that AT&T's debt levels are worrisome, we believe the company has a good handle on its obligations and a solid strategy to expand its service offerings and solidify its balance sheet. We believe the 6.7% dividend yield is extremely attractive in light of the company's strong cash flow generating abilities and think there is an added benefit of a potential increase in price of over 30%. For a solid former Dow component with return on equity of over 21.5%, this is a bargain.
