Shares of AT&T (T) have returned 19.3% over the past 12 months. At $35.60, the stock is now trading at around the mid-point of the 52-week price band from $29.77 and $38.58. Under the current low-interest market environment, AT&T stock appears to be a decent investment given its tempting dividend yield at 5.1%. But is a buy decision warranted by the company's current fundamentals and the share price level? In this article, I will elaborate on the stock valuation analysis which may assist you in making an appropriate investment decision.
Sell-side analysts on average predict AT&T's revenue, EBITDA, and EPS to grow at CAGRs of 1.7%, 2.6%, and 6.8%, respectively, over the current and next years (see comparable chart below). Those consensus estimates are considerably below the averages of 3.6%, 5.3%, and 10.8% for a group consisting of AT&T's primary telecom peers. Similarly, the company's EBITDA margin is expected to expand by just 0.6% over the same horizon, compared to the peer average at 1.1%. On the profit side, AT&T's gross and net profit margins were able to outperform the peer averages, but the company's other margin and capital return metrics are below the par, though the difference is not significant. In terms of debt and liquidity, AT&T carries a relatively lower level of debt as reflected by its below-average debt-to-capitalization and debt-to-EBITDA ratios. The firm was able to maintain a free cash flow margin which is slightly above the par. Despite the lower leverage, AT&T's interest coverage ratio is on par due to its below-average profitability.
To summarize the financial comparisons, AT&T's relatively weaker growth potential and below-average profitability would likely be the primary drag on the stock valuation. However, given the company's strong market position in the US telecom sector as well as its solid free cash flow and dividend performance, I believe the stock's fair value should trade at only a modest discount to the peer-average level. The current valuations at 6.2x forward EBITDA and 14.0x forward EPS together represent an average discount of 11.1% to the peer-average trading multiples (see chart above), suggesting AT&T shares are fairly priced on a relative basis.
Alternatively, AT&T forward P/E multiple of 14.0x is currently trading at 3.2% discount to the same multiple of the S&P 500 Index, which stands at 14.5x now (see chart below). I am of the view that the slightly discounted valuation suggests a fair price level provided that 1) the trading multiple difference averaged a premium of only 4.7% in the past 12 months; and 2) despite the fact that AT&T's long-term estimated earnings growth rate of 6.0% is notably below the average estimate of 8.2% for the S&P 500 companies, the company possess a solid market position and the stock's dividend yield is markedly above the market average, which should be supportive to the valuation.
I also performed a margin of safety analysis from a dividend perspective. AT&T has a track record of raising dividend. Since 2010, the company has raised the dividend per share 3 times by 2.4%, 2.3%, and 2.3%, consecutively. According to a chart shown below, AT&T has been able to generate ample free cash flow to cover its annual dividend payment over the past few years, indicating that the current pace of the dividend growth is likely sustainable.
In addition, the stock's dividend yield appears to be highly correlated with the yield of the 10-year US Treasury Bond as the 3-year correlation is measured to be quite significant at 0.7 (see chart below). Since the treasury yield is unlikely to increase significantly in the near term, it is fair to anticipate a limited upside for AT&T's dividend yield at least in the near future due to its high correlation with the treasury yield and strong investor demand for high-yield assets. As such, assuming a target dividend yield range from 5.0% to 5.7%, and supposing that the annualized dividend per share would be raised by 2.0% from the current level at $1.80 to $1.84 in January 2014 payment period, this conservative scenario would suggest a 1-year stock value range from $32.28 to $36.80, or a favorable 1-year price return from -4.2% to 8.5% after considering the 5.1% dividend income.
On the qualitative side, Michael Hodel, a research analyst at Morningstar, wrote in a recent research note (sourced from Thomson One, Equity Research):
AT&T's strategy has evolved steadily in the months since the T-Mobile deal fell apart. The firm is pursuing an unconventional block of spectrum, a move that its industry influence allows. In addition, AT&T is reshaping its asset mix, selling its directory publishing arm and promising to unveil a new strategy for its rural fixed-line business in early November. These events reinforce our view that wireless and enterprise services are the core of AT&T's business today and that the firm enjoys solid competitive advantages in both. We expect the firm will continue to make steady progress in the rollout of LTE coverage, a key element of meeting consumer demand for wireless data services, while continuing to generate ample cash flow to support its dividend.
Bottom line, given the AT&T's healthy fundamentals, fair valuation level, and solid downside protection by the sustainable dividend yield, the stock should deserve a buy rating. To further enhance the margin of safety, investors may also consider selling out-of-money put options to either collect upfront premium or take a potential opportunity to acquire the shares at a lower price level.
All charts are created by the author and all financial data shown in the article and the charts is sourced from Capital IQ unless otherwise specified.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in T over the next 72 hours.