AT&T Corp. (T) is down almost 6.0% on the back of generally underwhelming earnings (not bad, just underwhelming) and several analyst downgrades (all valuation driven). Wow, what a move, considering the earnings just weren't that bad, the underlying core fundamentals of the business remain sound (ensuring the most significant shareholder proposition, the dividend, is very much intact) and management has been highly proactive in returning even more capital to shareholders.
To defend the stock and argue why now is a reasonable entry point, let's quickly review some of the notables from the earnings release and argue some of the noise around the company.
Buying Back Stock with Debt … is Very Smart (for T)
Since 12/31/11, T has retired 7.1% of the outstanding common shares, for a net cost of $18.1 billion. Over that time frame, the company's outstanding Total Debt has increased to $74.1 billion from $64.8 billion (the net number is a bit lower now, as current Cash and Equivalents stands at $3.9 billion versus $3.0 billion as of 12/31/11). One could argue that T has undertaken a modest levered recapitalization to retire shares, which, in light of the expensive annual dividend of $1.80/share makes tremendous sense. Do the math: on 420 mm shares, the annual dividend expense is an after-tax $756.0 mm. The cost of an incremental $10.0 billion in debt to T has been around 3.0% on a pre-tax basis, so the cost of retiring the shares (using debt) is $300.0 mm in interest expense. T has saved roughly $450.0 mm in dividend expense (more when adjusting for taxes), which (again) is after-tax and creates more available cash flow for expanding the network, making acquisitions or even, buying more stock.
Now, I completely understand that adding debt adds credit risk. However, the core T businesses generates substantial Free Cash Flow ($19.5 billion in 2012, and $3.9 billion in the first quarter), even after accounting for dividends ($9.2 billion in 2012, and $1.4 billion in the first quarter). LTM TD/EBITDA stands at 2.40x, virtually the same as the 2.35x at 12/31/11 (before the incremental borrowing), highlighting that the despite the rise in debt, the enterprise is carrying the same leverage ratio (and it is worth noting that we are using real EBITDA, not adjusted, which would lower the ratios as both YE figures included non-cash charges resulting from pension expenditures). Most importantly, when you look at the capitalization table, T's financial management has done an exceptional job shifting to lower cost debt on the back of the current low rate environment (thanks Ben Bernanke). The point is that yes, T has borrowed more to fund the repurchase program, but the credit remains quite sound and the net positives (lower interest cost offsetting interest expense rising from more debt, as well as the reduced dividend expenditure) weigh in the company's favor in many respects.
Some might call the recent actions of management shenanigans, but I wouldn't. I would call the actions smart and quite savvy, within the context of the current capital markets environment. While management has indicated that the share repurchases are expected to slow (expect more capital directed toward the network and the business), the recent actions should not go unnoticed.
Too Much Attention is Being Paid to Wireless Phone Subscriber Growth …
T noted that 72% of current wireless phone customers own smart phones. Translation: that market is largely full. Further, this is no longer 2000. Owning a cell phone in the United States is not a luxury but rather, a common occurrence. The premise that one would get too excited about net postpaid additions seems off. The key (as I see it) now is not adding subscribers, as much as finding ways to continue to monetize and raise revenue from the existing subscriber base (without losing too many subscribers along the way), as well as maintain (and grow) margin. To that end, Wireless Data revenues were up 21.0%, at $5.1 billion for the quarter ended 3/31/13, versus the year-ago $4.2 billion (and Service revenues were up relative to the 12/31/12 quarter, but management did not break out data versus other services so apples to apples is not possible). Operating Income Margin for the wireless segment came in at 28.0%, versus 27.8% a year ago and 24.9% for the quarter-ended 12/31/12. Both metrics are very relevant to me, as the potential for subscriber growth slows and matures. While T showing a negative on phone subscribers isn't good (as the growth in postpaid additions was driven by tablets), one quarter does not a trend make. Let's give T another quarter to see if the trend on subscriber growths turns in the right direction (positive), while revenues and margin from the segment (especially data, which I believe is the key, as tablets and other devices will be the drives of data usage longer-term) expand. That represents a win to me.
On the back of the thwacking today, T now trades at 13.54x 2014 estimates, versus peer Verizon Communications Inc. (VZ) trading at 16.07x 2014 estimates. The dividend yield is 4.85%, versus the VZ dividend yield of 3.96%. Further, comparing T to other dividend yielding sectors (like Utilities or MLPs), it is pretty clear to see that (1) the T business is generally as stable, if not more so, than many other yield oriented defensive sectors, (2) T management has been among the most proactive in taking shareholder directed action, in terms of the share repurchases and the dividend and (3) T's valuation is among the most attractive, when comparing credit quality and the general stability of the business. Today, several of the "analysts" covering the stock downgraded T, largely on "valuation", which seems silly. Companies with high dividend yields are trading at extraordinary, multi-year high valuations, and T is trading at a discount to the broad universe (a point missed by sector focused analysts lacking a broad market view).
Earlier in the year, I made the decision to sell my VZ and hold T (wrong call, I know, and I was even nice enough to write about it). Let me ask you, the reader, a question: would you rather own 100% of the second best business in an industry that really has two major players (with everyone else being noise) or would you rather own 55% of the best business in that same two company industry, when the margin of differentiation is not overly substantive and the valuation favors the wholly-owned business? I like T for just that reason (on a relative basis), as both T and VZ have declining Wireline businesses and long-term pension obligations, but only T has 100% ownership of the wireless business, which is the growth driver and the business I really like. Look at the following chart, which shows the spread between owning T and VZ. With the spread at a multi-year wide, it would appear that the market is heavily discounting the differential which, when studied carefully, appears a bit overdone.
In light of the valuation dispersion, created by the damage today, it seems worthwhile to consider T both on a relative (to a VZ) and absolute basis, if looking for income at a fair price.