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Telecom companies are typically known for their impressive dividends and AT&T (T) has been no different, consistently yielding in excess of 5%. The company currently provides a dividend yield of 5.06%. The stock has been a poor performer over the last 1 year significantly trailing both its biggest competitor Verizon (VZ) and the S&P500. T has appreciated by 4.4% over the last year compared to the 18% increase for VZ and 25% gain of the S&P500. Over this 52-week period, the stock has traded between $32.71 and $39.00. In this article, we will examine the company's fundamentals and perform a valuation analysis to determine if the stock is cheap at current levels.

Growth:

T has reported flat revenue growth rates over the past 3 years. The average annualized growth rate during this time period was 1%. Last quarter, revenues fell by 1% compared to the same quarter last year. However, the EPS was up 12% compared to the corresponding quarter of 2012. Going forward, analysts expect a long term growth rate of 6.5% on par with the projected growth rate of the industry. The growth rates are presented in the table below. The income numbers can be discounted owing to the $3 billion T had to pay Deutsche Telekom because of the failed acquisition attempt.

Growth Rates

3 Year

YOY

QOQ

Revenue

1%

1%

-1%

Income

-22%

84%

3%

EPS

-21%

-31%

12%

    

Growth Estimates

T

Industry

S&P500

Next Year

7.60%

4.30%

12.10%

Next 5 Years

6.48%

6.78%

9.40%

Profitability and Operations:

T has maintained fairly steady margins over the past 3 years. Gross margins have hovered around 57% -58% while the operating margins have remained stable in the 11% range. However, return on equity has declined from an average of 10% to 8% for the trailing twelve month period. Return on assets is also marginally lower falling from 4% to 3%. The profitability and operational metrics are shown below:

Profitability & Operations

3 Year

1 Year

TTM

Gross Margin

58%

57%

57%

Operating Margin

11%

10%

10%

Net Margin

8%

6%

6%

Return on Equity

10%

7%

8%

Return on Assets

4%

3%

3%

To compare T to its competitors, key operational and valuation metrics for its peers were obtained. The peer group selected for analysis included Sprint (S) and Verizon . The table below presents the peer analysis results.

 

 

Ticker

Mkt Cap

Price

P/E

P/S

Lt D/E

ROA

ROI

GM

OM

S

21.74B

7.2

-

0.62

338.11

-8.57

-10.11

41.04

-5.15

VZ

138.99B

48.57

122.23

1.21

143.61

4.63

7.14

60.05

11.36

T

192.78B

35.55

27.75

1.51

71.85

2.78

3.14

56.67

10.15

As shown above, T is the biggest player in the group and trades at a slight premium to VZ based on the P/S multiple. T has the lowest debt to equity ratio of the group. However, the ROA, ROI, gross margins and operating margins are all lower than VZ. S is the laggard among the 3 companies and is currently making a loss.

Valuation:

Valuation analysis was performed using relative valuation. A cost of equity of 12.2% was calculated and used in this analysis. Based on historical analysis, I arrived at a fair P/E ratio of 21 for T which was used in this analysis. The analysis is shown below:

Valuation

T

Next Yr Proj EPS

$2.70

EPS Growth Rate

6%

Future EPS (5 Yr)

$3.26

Expected P/E

21

Price 5 Yrs Out

$68.45

  

Unlevered Beta

1.06

D/E Ratio

36%

Current Tax Rate

40%

Levered Beta

1.29

Risk Free Rate

2%

Risk Premium

8.00%

Size Premium

-0.36%

Cost of Equity

12.2%

  

Fair Value

$40.78

Current Price

$35.55

% Overvalued

-15%

In addition to the analysis above, sensitivity analysis was also performed to evaluate the impact of the growth rate and cost of equity on the final valuation. The result of this analysis is shown below:

 

 

  

Growth Rate

 

$40.78

4.5%

5.5%

6.5%

7.5%

8.5%

Cost of Equity

10.2%

41.8

43.0

44.2

45.5

46.8

11.2%

40.1

41.3

42.5

43.7

44.9

12.2%

38.5

39.6

40.8

41.9

43.1

13.2%

37.0

38.1

39.2

40.3

41.4

14.2%

35.6

36.6

37.7

38.7

39.8

As shown in the above, based on my analysis, the fair value of T is $41 a share implying a return of 15%. Adding dividends, a return of 20% is possible. Trading at $35, assuming my P/E is accurate, the sensitivity analysis results indicate a fair cushion on both the growth rate and cost of equity. I would use this underperformance of T stock as a buying opportunity and look to initiate a position in the company.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision)

Source: AT&T - Upside Potential Of 20%