Shares of AT&T (NYSE:T) have declined by 10.9% from their 52-week high of $38.58 attained in October. At $34.36 per share, the stock offers an attractive forward dividend yield of 5.2%. I believe the pullback presents investors a valuable opportunity to accumulate shares at a tempting valuation. In this article, I will elaborate on my value analysis that supports my bullish view.
AT&T's valuations appear to be somewhat below the intrinsic level based on the company's solid financial performance relative to its peers' (see comparable analysis table below). Analysts on average predict AT&T's revenue, EBITDA, and EPS to grow at 2-year CAGRs of 5.7%, 12.0%, and 96.3%, respectively, over the current and next fiscal years. The growth estimates are generally stronger than the averages of 5.7%, 7.5%, and 20.9%, respectively, for a peer group consisting of AT&T's primary competitors such as Verizon Communications (NYSE:VZ) and Sprint Nextel (NYSE:S). On the profit side, although most of AT&T's profitability and capital return measures are below the par, the performance gap is not significant. The company carries a lower level of debt as reflected by its below-average debt to capitalization and debt to EBITDA ratios. In terms of liquidity, AT&T's trailing free cash margin is fairly in line with the peer average. Due to the lower leverage, the company was able to maintain an above-average interest coverage ratio. However, both AT&T's current and quick ratios are below the par, reflecting a mediocre balance sheet.
To summarize the financial comparisons, AT&T's mediocre profitability should be a primary drag on the valuation. However, the firm's better growth prospects and solid wireless market position should substantiate a stock valuation that is at least in line with the peer-average level. Nevertheless, the current valuations at 6.0x forward EV/EBITDA and 13.7x forward P/E represent an average valuation discount of 10.8% to the peer-average trading multiples, suggesting that AT&T may be slightly undervalued.
AT&T's forward P/E multiple is currently trading in line with the same multiple of the S&P 500 Index (see chart below). I believe the relative valuation level implies that the stock is reasonably priced provided that 1) AT&T has a significant market share in the consumer wireless sector; 2) the stock's 5.2% dividend yield is considerably higher than the dividend yield of only 2.2% for the S&P 500 Index; and 3) AT&T's long-term estimated earnings growth rate at 6.2% is just slightly below the average estimate of 7.9% for the S&P 500 companies.
As such, assuming a target forward P/E multiple of 13.5x, which is fairly consistent with the market level but still below the peer average, and supposing that the analysts' current 2014 EPS estimate of $2.75 can be sustained, this scenario would imply a stock value of $37.13.
Over the past 3 years, AT&T's dividend yield has been trending down from approximately 7.0% to the current level. Aside from the company-specific and the equity market factors, another primary yield driver appears to be the 10-year US Treasury yield (see chart below), which has a 3-year correlation of 0.7 with the stock's dividend yield. The reason behind the high correlation is apparently due to the strong demand from the income-oriented investors as they have been aggressively seeking for high-yield investments. Since the monetary easing is likely to continue for some time, I expect the Treasury yield will remain low and thus the near-term upside for AT&T's dividend yield would be limited. Essentially, this market force will provide a solid downside support for AT&T's share price.
Since fiscal 2009, AT&T's dividend per share has been raised by a steady rate at around 2.4% (see chart below). The company has recently announced a dividend increase from the current annualized level at $1.76 to $1.80 in fiscal 2013. Given that the annual free cash flows were historically above the annual dividend payments (see chart below), AT&T appears to have an ample capacity to maintain the current pace of the dividend growth. Supposing that the company would continue to raise the dividend by 2.4% to $1.84 at the end of 2013 and the dividend yield would remain in the range between 5.0% and 5.5%, this scenario suggest a stock value range between $33.48 and $36.83.
I also performed a DCF valuation which incorporates the market consensus estimates for AT&T's revenue and EBITDA from 2012 to 2016 (according to Capital IQ, see DCF chart below). The analysis also models AT&T's updated annual capital expenditure guidance of $22.0B from 2013 to 2015. It should be noted that the WACC assumptions are fairly conservative given that 1) The risk-free rate is based on a normalized 10-year US Treasury yield at 2.3%; 2) The cost of debt is set at 6.0%, which is slightly higher than AT&T's existing debt yields with a 10-year maturity; 3) The beta of 0.63 is based on AT&T's peer average, and it is above AT&T's current 5-year beta of 0.56; and 4) A company specific premium of 3.0% is applied to account for the financial projection risk.
This model yields a share price of $36.88. By lowering the terminal growth from 1.5% to 0.5%, the stock price will only decline to $30.50.
Bottom line, the three valuation approaches suggest that AT&T is now trading at a favorable valuation level, and the price downside is well protected. The company has recently announced a significant investment plan for the next few years to substantially bolster the firm's broadband connectivity and capability which could mean a potential upside for the stock. The plan details are elaborated by Piper Jaffray's research analyst, Christopher M. Larsen, in his recent research note (according to Thomson One, Equity Research):
"AT&T announced a program that will invest $14B in its wireless and wireline networks over the next 3 years. In mobile, AT&T will expand LTE coverage to over 300M POPs by year-end 2014. In wireline, AT&T will expand U-verse coverage to an additional 8.5M customer locations. The company will also upgrade U-verse speeds to as much as 75Mbps in U-verse locations and 45Mbps in locations served by an IPDSLAM. In 25% of the company's customer locations, where it is not feasible to build an IP network, AT&T will leverage its LTE wireless network to offer high speed data and voice services. These investments will help support the connected life, including the connected car, mobile payments and AT&T digital life solutions (home automation and security)."
In the light of a tempting risk/reward profile, I recommend acquiring the shares now.
The comparable analysis and DCF charts are created by the author, all other charts are sourced from Capital IQ, and all financial data in the article as well as the revenue and EBITDA estimates in the DCF chart are sourced from Capital IQ.