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Shareholders in AT&T (NYSE:T) are not completely happy with the company's second quarter results. As revenue growth was solid, this came at the expense of margins and consequently profits.

While the current dividend yield seems extremely attractive, I am a bit worried about leverage and possibilities for opportunistic merger and acquisition activity.

Second Quarter Results

AT&T generated second quarter revenues of $32.1 billion, up 1.6% on the year before. Adjusting for the sale of the Advertising Solutions business, revenues were up by 2.6%. Sales came in ahead of consensus estimates which stood as $31.8 billion.

Disappointing was the 4.8% increase in operating expenses, totaling $26.0 billion. Consequently, operating income fell from $6.8 billion towards $6.1 billion, as operating margins fell by 250 basis points to 19.1%. Continued cost increases in the wireline business and increased smartphone subsidies are to blame.

Net income attributable to shareholders fell by a $100 million to $3.8 billion. Diluted earnings per share rose by five cents to $0.71 per share, on the back of sizable share repurchases over the past year. Normalized earnings per share, which exclude gains of 4 cents related to the sale America Movil's shares, came in at $0.67 per share. Earnings missed consensus estimates by a penny.

CEO and Chairman Randall Stephenson commented on the second quarter developments, "This was a solid quarter for revenue and customer additions across our key growth platforms. Our 4G LTE network is the fastest and the most reliable in the nation, and deployment is ahead of schedule."

4G LTE And Capital Deployment

The company reported strong operating cash flows of $9.5 billion. AT&T invested some $5.5 billion in capital expenditures, mostly related to the deployment of its LTE network. Free cash flow came in at $4.0 billion.

Its LTE network already covers 225 million POPs, being the fastest and most reliable network. The LTE deployment is expected to be completed in the summer of next year.

AT&T spent $3.3 billion to repurchase some 89 million shares during the quarter, a significant portion of its free cash flow generation. AT&T has some 272 million shares remaining under its current authorization.

Looking Into The Results

Wireless revenues continue to grow the business. Revenues including equipment sales rose by 5.7% to $17.3 billion. Growth was driven by a 19.8% jump in data revenues, which came in at $5.4 billion. The unit is furthermore driving the profitability of the firm, despite an 8% fall in operating income. Increased subsidies on smartphones resulted in operating income falling to $4.7 billion.

AT&T reported 551,000 postpaid net additions, up 70% on the year before. The company has 49.5 million postpaid smartphone subscribers. Some 73% of its mobile customers are using smartphones, boosting ARPU by 3.0% on the year.

Wireline activities continue to struggle as revenues fell by 0.9% to $14.8 billion. Operating expenses rose by 1.3% to $13.1 billion, resulting in a 16% fall in operating income, which came in at $1.6 billion. The company ended the quarter with 9.4 million TV and high-speed internet users.

Valuation

AT&T ended its second quarter with $4.5 billion in cash and equivalents. The total net debt position rose to $75.2 billion, for a sizable net debt position of around $71 billion.

Revenues for the first six months of 2013 came in at $63.4 billion, essentially unchanged from last year. Net income rose by a paltry 0.5% to $7.52 billion. At this rate, AT&T could generate annual revenues of around $129 billion on which it could earn around $15 billion.

Trading around $35.50 per share, the market values AT&T at around $189 billion. As such, the market values the firm at 1.5 times annual revenues and 12-13 times annual earnings.

AT&T currently pays a quarterly dividend of $0.45 per share, for an annual dividend yield of 5.1%.

Some Historical Perspective

Long term shareholders have seen returns of roughly 50% over the past decade. This understates the real returns to shareholders who currently receive a 5% dividend yield. If investors would have re-invested dividend proceeds, returns would have been much higher.

Shares are still trading a long way from highs of $42 set back in 2007. The financial crisis send shares to lows of $23 in 2009, but have recovered to current levels around $36 per share.

Between 2009 and 2012, AT&T has increased its annual revenues by merely 4% towards $127.5 billion. For the full year of 2013, the company is targeting 2% revenue growth.

Investment Thesis

Shares of AT&T have sold off a bit after reaching highs of $39 in April of this year. Essentially the bright spot in the quarterly report are revenues, which came in just ahead of consensus estimates.

Yet this revenue growth came at a cost. Wireless margins fell by 340 basis points to 42.4% as the company offered steeper discounts on smartphones to boost net addition growth.

The company net added 551,000 postpaid customers, ahead of consensus estimates and own targets of 500,000 additions. It is still lagging behind Verizon Wireless, the joint-venture owned by Verizon Communications (NYSE:VZ) and Vodafone (NASDAQ:VOD), which added 941,000 users over the quarter.

A positive sign is that the deployment of its 4G LTE network is ahead of plan. Growth was also driven by strong data revenues in the wireless business which continue to increase in importance. To support growth AT&T continues to make acquisitions. This includes the $4 billion deal with Leap Wireless (LEAP), announced last month.

AT&T seems somewhat restless after the failed $39 billion takeover attempt of T-Mobile USA. It tries to do too much at the same time with finite resources. It has huge capital expenditures budgets, acquisition ambitions, while it tries to please shareholders with higher dividends and share repurchases. All this has resulted in a high net debt position of over $70 billion at the moment.

AT&T is rumored to be involved with European deals, just as merger and acquisition activity in the industry is picking up in the continent. Such an opportunistic move, to possibly acquire portions of Vodafone or other carriers would be unwise to my opinion. Possible deal provide few synergies and little strategic rationale as they will add to the already high debt position.

AT&T's current valuation is largely based on the 5% current dividend yield. The company has furthermore used a lot of cash to retire almost 10% of its share base over the past year, which implicitly saves on dividend payments, allowing the company to raise dividends without actually spending more in cash.

While the yield is extremely attractive I would be more comforted if AT&T committed to not engage in opportunistic merger and acquisition behavior, and cut down the pace of share repurchases to contain its net debt position.

Source: AT&T - Attractive Yield But Be Aware Of Leverage And Opportunistic M&A