AT&T (T) has caught the eye of many income-oriented investors throughout 2018 because of its share price weakness. We have been long the stock as long-term investors and have been pounding the table due to the market’s irrational treatment of this company for a year now. We said that AT&T is cheap at these levels in the low $30s and that we think the Time Warner Acquisition will be a major boon for the company long term. In this regard, I personally have recently added a position recently. With all of this in mind, we thought it made sense to update on AT&T, which is yielding 6.5% after its recent sell-off.
The fact that the AT&T’s dividend yield is now more than double the interest rate on the U.S. 30-year bond seems to point towards the fact that the market believes AT&T’s yield is unsustainable. In short, we disagree. In this piece, we will examine the income-oriented metrics surrounding AT&T’s yield, as well as the value proposition that the shares present to investors at today’s beaten down levels. To us, the market’s current treatment of AT&T is irrational. T’s relative strength index has fallen well into oversold territory, and this treatment of the stock may be creating an attractive long-term opportunity for income-oriented investors.
We feel compelled to write this bullish report about AT&T because this is a company that so many love to hate, and honestly, we don’t see why. To a certain extent, we think AT&T has been politicized, either subconsciously or not, because of the current administration’s attacks on CNN and AT&T’s new ownership of that network via Time Warner. In this day and age, it seems that everything is overly politicized in this country. We think it is too bad. But, regardless of whether or not you watch CNN and enjoy the content it provides, the network continues to be profitable, which is what matters most for AT&T. Instead of focusing on sentiment-driven things like political opinions, we think investors are much better served focusing on T’s cash flows, its underlying fundamentals, and the valuation that its shares present.
With this in mind, we want to highlight the fact that due to its current weakness, AT&T is now trading at valuations not seen since the trough of the Great Recession. As you can see on the F.A.S.T. Graph below, AT&T is currently trading for less than 8.8x Trailing 12 Months (‘TTM’) earnings, which is below the level that the stock hit in the spring of 2009!
Source: F.A.S.T. Graphs
We can’t rationalize that. Sure, AT&T has an enormous debt load which we will touch on, but as far as corporate outlook goes, we are not sure why the market is placing the same premium on shares today as it did when some believed that the modern financial system could potentially collapse.
On a forward looking basis, T is even cheaper. This is another reason that we believe the stock is being irrationally discounted. Analysts aren’t expecting to see a ton of EPS growth in 2019 and 2020, but they are expecting growth. This stock is being priced as if it’s going into a significant earnings recession, and that’s not the picture that the 30 Wall Street analysts who cover the company are painting. Right now, the average EPS estimate for 2019 is $3.61. The consensus EPS estimate for 2020 is $3.67. This means that the stock is trading for just 8.3x 2019 estimates and 8.17x 2020 estimates!
Recent Earnings Report
AT&T just reported its 3rd quarter results. During the earnings report and accompanying conference call, AT&T management reiterated full year EPS guidance of $3.50. That was slightly below the market’s expectation of $3.53; however, it still represents a strong, double-digit growth over 2017’s $3.05 figure. At this point, we think it is fair to note that not only did AT&T’s EPS increase by double digits during Q3, but sales, cash from operations, and free cash flows did as well. This $3.50 EPS guidance is well above the company’s $2.00 annual dividend, representing a payout ratio of 57% (or a dividend coverage of 174%).
Management also reiterated full year free cash flow (or FCF) guidance of ~$21b. This is well above the $17.6b of FCF that T generated in 2017. This figure is also well above T’s dividend responsibilities. In the recently reported Q3, T’s free cash flow dividend payout ratio was 56.1%. It’s worth mentioning that this ratio is lower than the 54.2% a year ago. That’s because T’s dividend related expenses growth outpaced free cash flow growth during the quarter. This large bump in both figures y/y is due to the Time Warner acquisition.
Continued Growth Moving Forward
Moving forward, we think it is likely that this trend reverses. We suspect that AT&T will increase its quarterly dividend by the normal $0.01/share when it announces the December dividend which should only increase the dividend expense in the low single digits while we think it’s possible that free cash flow growth at a mid-high single digit clip as AT&T further integrates Time Warner’s assets into its distribution model.
A Dividend Aristocrat
Speaking of T’s $0.01 dividend increase, now’s the time to mention that we’re talking about a dividend aristocrat here. AT&T has increased its dividend for 34 consecutive years! The nice thing about adding reliable dividend growth to a high-dividend yield is that investors not only receive the passive income that they’re looking for, but the purchasing power of that income stream is protected from inflation. This is why we prefer owning equities to bonds when looking for passive income. Sure, bonds offer more security, but they don’t offer protection from the erosion caused by inflation over time.
This long history of increases is yet another reason why we believe that AT&T’s dividend is safe. Shareholders, both institutional and retail, rely on AT&T for income. They have had for decades. The company knows this. And therefore, it knows well that any dividend cut would lose the faith that it has built up with the income-oriented market and cause significant damage to the stock price.
No CEO wants to be the one in charge when a multi-decade dividend growth streak is at hand. Sure, this is all speculative and isn’t back up by concrete figures, but we are fairly certain that AT&T CEO Randall Stephenson would do whatever it takes, even if that meant selling off assets, to preserve the sanctity of T’s illustrious dividend (in the Q3 conference call slide show, AT&T management notes that non-core asset sales and capital market considerations are potential options, should free cash flow not cover debt requirements, yet they made no mention of cutting the dividend).
A Closer Look at the Debt
Thankfully, the CEO shouldn’t have to come to those drastic measures as to cut the dividend. The primary threat that many see when it comes to T’s yield is the company’s enormous debt load. At the end of Q3, T reported a total debt load of $183.4 billion and a net debt load of $174.7 billion. This is a worrisome figure, without a doubt. However, roughly 90% of the company’s debt is fixed rate, meaning that the company is protected from rising rates. Furthermore, as management noted in the recent conference call, rising rates are actually somewhat bullish for the company (so long as they rise at a slow and steady rate) because rising rates decrease the company’s pension liability, which serves as a bit of a hedge against the trouble that rising rates may have on the non-fixed portion of T’s debt portfolio.
Right now, T’s net debt to pro forma adjusted EBIDTA ratio is 2.85x. The company plans to pay down debt in the short term to reduce this figure to 2.5x by the end of 2019. Management expressed confidence that they’re on schedule to do this in the recent quarterly report. They also noted that they plan on returning it to normal historical leverage ratios by 2022.
Looking at AT&T’s debt maturities, we see that the company will need to retire $73b of debt during the next 5 years. That seems like an enormous amount, but it’s important to realize that this company is on schedule to produce $21b in free cash flow in 2018, and by 2023, it’s possible for that figure to be nearly $30b/year.
So, as long as T’s free cash flow growth outpaces the company’s dividend growth, it seems very likely that T will be able to both continue to provide investors with a reliably growing dividend and reduce the debt on schedule. The company currently receives a BBB credit rating from Standard & Poor’s. While this isn’t exactly stellar, it is investment grade, which will help them to receive competitive rates should they have to roll over any maturities moving forward.
An Unjustified Selloff
If debt doesn’t appear to represent a dire threat, then what other reason might have caused the stock to sell off nearly 22% year to date?
In a large part, it appears to be because of the company’s exposure to the media business. AT&T has chosen to go down the path of integrating media/entertainment assets into its existing distribution system. Some (like us) view this as a bullish divergence by management. The content that T can provide with its distribution network differentiates it from its competition.
We’re living in a digital age now. The 5G revolution appears to be just around the corner which will totally disrupt the traditional media landscape. High quality streaming content will be easily accessible once the 5G infrastructure is put in place. This, alongside the rise of the “internet of things”, should create immense demand for data from the providers. We believe that this demand will commoditize data over time. As the world becomes more dependent on broadband, I can foresee a time when these providers will be regulated like the utilities are with electricity. In this situation, having a diversified revenue model and access to alternative growth markets will lead to valuation premiums. AT&T should have this with its media/entertainment content as well as the advertising platform that it is developing alongside the Time Warner assets.
In the short term, we suspect that T’s exposure to media could continue to act as a headwind. The markets hate uncertainty, and the cord cutting phenomena is creating quite a bit of that in the media landscape. However, once that process plays itself out, we suspect that the leaders left on the playing field will be those who have the strongest content portfolios. Historically, we’ve seen consolidation happen in the entertainment industry, and I don’t think that’s going to change. Scale is important when selling advertisements and, ultimately, the brands with the largest eyeball appeal will win out.
T is well on its way to becoming one of those successful giants with the Time Warner assets, which include CNN, TNT, TBS, the Warner Bros studios, and one of the most successful over the top platforms in existence: Home Box Office (‘HBO’). With Time Warner, AT&T now has exposure to a nice variety of programmed and live television, including extensive sports rights (especially with the NBA, which is probably the hottest sports league in America with regard to growth), and major film productions. Very few media names can compete with T’s portfolio at the moment, and we expect to see it continuing to build out that portfolio over time with excess cash flows (once debt is reduced to normal levels in the medium term).
Media names are very attractive now. This is in large part due to what we call the Wall-E thesis, which is based upon the future reality depicted in the Disney animated film where it got its namesake where humans essentially sit around all day, get fat, and consume content while robots take care of them. We don’t think it will necessarily play out exactly like that, but as 5G ushers in increased automation, human society will become ever more efficient. This should lead to more free time for individuals, and that should result in increased demand for entertaining content that will fill a lot of this void. We want to own the companies who will benefit from this trend. The vast majority of them are low yielders like Walt Disney (DIS) or Comcast (CMCSA), but for those seeking high-dividend opportunities, AT&T is one of the best options out there.
So, in conclusion, we think AT&T offers investors an intriguing opportunity in the high-yield space. The company is yielding 6.5%, offers a safe dividend with a 174% dividend coverage, a long history of dividend growth, showing that the company has a culture of generosity towards its shareholders, and a dirt cheap valuation. It’s rare that a single investment checks all of these boxes. The debt is the major downside to AT&T at the moment, but as discussed, management appears to have a plan to reduce it, and the company’s massive cash flows support this plan. Any equity investment comes with risk. No dividend in the market is inherently safe; they’re all at risk of being cut. However, companies like AT&T don’t become dividend aristocrats on accident and when looking for reliable high yield, we have been willing to bet a portion of our savings on this wonderful company. The recent pullback creates a unique entry point for conservative dividend investors; A high quality 6.5% yield selling on the cheap.
A note about diversification: To achieve an overall yield of 9%-10% and optimal level of diversification, we recommend a maximum allocation of 2%-3% of the portfolio to individual high-yield stocks like AT&T, and a maximum of 5% allocation to high-yield exchange traded products (such as ETFs, ETNs and CEFs). For investors who depend on the income, diversification usually results in more stable dividends, mitigates downside risk, and reduces the overall volatility of your portfolio.
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Disclosure: I am/we are long T.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.