AT&T Is Still Trying To Please Its Investors Too Much

| About: AT&T Inc. (T)

Shares of AT&T (NYSE:T) saw a modest correction after the telecom giant released its third quarter results. Basically there were no surprises in the report with wireless activities showing growth while wireline continues to decline at a modest pace.

The real issue however is that AT&T continues to built up leverage in order to please shareholders, which makes the stock quite risky despite the nice dividend yield in my opinion, especially in combination with possibility for opportunistic M&A action.

Third Quarter Results

AT&T generated third quarter revenues of $32.2 billion, up 2.2% on the year before, and in line with expectations.

The company reported net earnings of $3.8 billion, up from last year's $3.6 billion. At the same time, earnings per share rose sharply by some 14% to $0.72 per share, on the back of sizable share repurchases over the past year.

Note that GAAP earnings were inflated through gains on transfer of spectrum and income tax items. Adjusted for this, earnings per share came in at $0.66 per share, beating consensus estimates by a penny.

CEO and Chairman Randall Stephenson commented on the third quarter developments, "We're setting the standard for 4G LTE speeds and network reliability. Our fiber and U-verse expansion projects are ahead of schedule bringing high-speed broadband to millions more customers."

Looking Into The Results

AT&T added nearly 1 million subscribers over the past quarter, driving revenue growth. Total wireless revenues were up by 5.1% to $17.5 billion, including equipment sales. As is common lately, wireless data revenues were driving growth, increasing by 17.6% to $5.5 billion. Operating income of the unit rose by 3.4% to $4.6 billion.

AT&T saw postpaid ARPU increase by 3.1%, again driven by data packages which saw ARPU increase by 16.7%.

Some 75% of AT&T postpaid phone subscribers had smartphones, as the company sold 6.7 million smart phones, accounting for 89% of postpaid phone sales. Despite the rapid changes, total churn remained stable at 1.31%, actually being down 5 basis points compared to the second quarter.

Wireline revenues fell by 1.0% to $14.7 billion, despite a 28.1% increase in U-verse revenues. Wireline operating expenses actually rose by 0.8% to $13.1 billion, squeezing operating income which fell by 13.7% to $1.5 billion. Consumer revenues were up by 2.4%, driven by U-verse as tv and high speed internet subscriptions hit the 10 million mark.

The strategic business service unit reported revenues of $8.8 billion, down 2.6% on the year before. Legacy products continue to suffer, which could not be offset entirely by VPN, Ethernet, hosting and other IP services.

Valuation

AT&T ended its third quarter with $1.4 billion in cash and equivalents. Total debt increased towards $76.2 billion, for a fairly high net debt position approaching $75 billion.

Revenues for the first nine months of the year came in at $95.6 billion, up 0.8% on the year before. Net earnings rose by 1.9% to $11.4 billion, with diluted earnings per share increasing by 10% to $2.09 per share. At this pace, annual revenues of $128-$129 billion should be attainable as GAAP earnings could come in around $14 billion.

Trading around $35 per share, the market value AT&T around $186 billion. This values equity in the business at 1.5 times annual revenues and 13-14 times annual earnings.

AT&T currently pays a quarterly dividend of $0.45 per share, for an annual dividend yield of 5.2%.

Some Historical Perspective

Shares of AT&T traded around $25 per share back in 2004 to rise to levels in their low-forties by 2007. Shares fell back towards $25 again during the financial crisis in 2009 to slowly recover to a high of $39 in April of this year. Ever since, shares have seen a decent 10% correction to levels just below $35 per share at the moment.

Between 2009 and 2012, AT&T has grown its annual revenues by a cumulative 4% to $127.5 billion. The company reported peak earnings of $19.1 billion in 2010 after which earnings fell to $7.3 billion last year, expected to recover in 2013. The company retired 7% of its shares over the past year.

Investment Thesis

Shares of AT&T are trading roughly flat year to date, despite massive payouts to investors. This combined with massive capital expenditures for its LTE wireless network and U-verse fiber optic system, are leading to quite a build-up in leverage with the net debt position increasing towards $75 billion.

To offset the increase in leverage somewhat, AT&T is selling assets including leasing rights on 9,100 wireless towers to Crown Castle International (NYSE:CCI) for $4.8 billion, as announced last week.

For now investments in quicker and more reliable networks are paying off. The company added 363,000 contract wireless customers. This compares to additions of 151,000 last year and consensus estimates of 342,000 additions. Note that competition is not sitting still. Verizon Communications (NYSE:VZ) net added 927,000 customers over the quarter, while T-Mobile US (NASDAQ:TMUS) is seen to add more subscribers than AT&T as well.

These heavy investments, notably in the wireless activities are eroding operating earnings. While operating revenues rose by 5.1%, operating earnings only advanced by 3.4% over the past quarter. Even as network upgrades should create a competitive advantage for the firm, competition is stepping up as well.

Despite the high leverage employed already AT&T continues to spend heavily. It invests massively in the capacity of networks while returning cash to shareholders at a very high rate. On top of this AT&T continues to look at global opportunities to capitalize on the growth of mobile internet use, including the possibility for deals in Europe. Note that AT&T used to have big ambitions, attempting to acquire T-Mobile in the US for $39 billion in 2011. Earlier this year it acquired Leap Wireless in a $4.0 billion deal.

Note that potential deal making, heavy investments and an increase in leverage might create quite some uncertainty for shareholders, especially if headwinds may arrive. During the third quarter, AT&T repurchased $1.9 billion worth of shares, while paying out roughly $2.4 billion in dividends. Combined, it is spending some $17 billion per annum at this moment in time to please its shareholders for a combined yield to investors of nearly 10%. Yet this comes at a great expense, as it represents a combined payout ratio of roughly 120% of annual earnings, only adding to the debt position.

Back in July of this year I last took a look at AT&T's prospects. I concluded that the dividend yield was attractive, but investors should be aware of leverage and opportunistic M&A activity.

I concluded that investors should be a bit hesitant, given that AT&T might be rumored to get involved in European deals, which could provide few synergies, have little strategic rationale and would only add to the debt position.

I have to reiterate my conclusion from the time. 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.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.