My Dividend Portfolio: Evaluating AT&T

| About: AT&T Inc. (T)

I am a self directed dividend investor who manages my own portfolio. The portfolio is currently on track to deliver close to $27,000 in dividend income income for 2013. My objective is to try and get this close to $50k in annual dividend income within the next 5 years. I am considering AT&T (NYSE:T) as a possible addition to my portfolio.

AT&T is one of the dominant US telecom carriers along with Verizon (NYSE:VZ), Sprint Nextel (NYSE:S) and T Mobile (NASDAQ:TMUS). AT&T offers both wireline and wireless services to consumer and enterprise customers. The wireline business for most of the large US telecom providers has been in long term decline, with the wireless business being the growth engine for these companies, AT&T included.

AT&T has a market capitalization of $182B with revenues of $128B and a gross margin in excess of 55%. AT&T generates a net income of almost $7.5B. AT&T currently trades at a forward PE of 13 and a dividend yield of 5.3%.

There are some compelling arguments to support the investment case in AT&T.

Dominant Market Position: AT&T and Verizon have a combined wireless market share of more than 70% between them, with a number of small competitors including Sprint and T Mobile battling for the remaining market. The dominance of AT&T and Verizon is reflected in their profitability. Both maintain gross margins in excess of 55% and are solidly profitable. AT&T and Verizon have a combined net income for 2013 of close to $10B.

The gulf of the divide from AT&T and Verizon to the small wireless competitors such as Sprint is best illustrated by looking at the poor state of Sprint's financial position. Sprint has gross margins of only 40% and has been generating consistent losses for the better part of the last five years.

The business of running a telecom network is all about scale. A large subscriber base is needed to amortize the significant costs of network expenditure and purchasing spectrum. It's my view that given the high fixed costs in telecom, the US domestic industry can likely only sustain 3 competitors with AT&T and Verizon being the dominant 2, and a 3rd player made up of a combination of the remnants in the market.

Thus AT&T and Verizon are likely to share in the benefits of a duopolistic market structure while an effective "3rd player" is formed. This concentrated market structure results in very rationalprice behavior and limited price competition. It was notable that both AT&T and Verizon maintained unlimited pricing plans for approximately the same duration of time. Both moved to family plans and tiered pricing at approximately the same time. The absence of price competition is likely to lead to favorable economics and positive profitability for the medium term.

The wildcard here as far as long term pricing stability is any disruption that Sprint could bring to bear via its new owners, Softbank. While initially causing meaningful disruption in the Japanese market, Softbank has established itself as a rational player. If its behavior in the Japanese market is anything to go by, it may use short term pricing to gain a market share advantage before joining in more oligopolistic price matching behavior. Sprint clearly needs significantly more capital expenditure to be invested to upgrade its network before it can look to engage in material price disruption to change the status quo.

Stability of stock price: Verizon and AT&T pay out hefty dividends in the range of 5% and also experience less volatility than the broader S&P 500. In other words, higher-yielding stocks give you an incentive to stick around and give the dividend growth strategy time to work. You get paid to wait, even if there isn't any immediate capital appreciation for some time.

In fact, not only do you get paid to wait, but more importantly, higher-yielding stocks help provide a buffer against considerable market fluctuations. They help make it less likely that downturns in the market will result in younger investors getting scared by volatility and selling out.

This is because these higher-yielding stocks can still generate considerable total return purely from the contribution of a high dividend in spite of the general turmoil that may be happening in the stock market.

Verizon, for example, has a beta of only 0.45, meaning it moves approximately half as much in price as a general move in the market. Thus when the market takes a precipitous dip, Verizon doesn't dip as much, in general.

For a younger investor, reducing the amount of tension and stomach churning when establishing a portfolio can be very important in the early years to provide confidence to develop and stick to a strategy. Buying large, high yielding dividend paying stocks can be an important part of a balanced dividend growth strategy for young investors.

In 2008 for example, as the S&P 500 went into a nosedive and dropped 37%, Verizon stock not only outperformed the S&P 500 in terms of stock price performance, but in addition still managed to pay out a 5.4% yield, which may have provided a strong enough reason for a young investor to hold onto a stock.

There are a few arguments that run counter to an investment in AT&T.

Market Saturation: The last five years were a period of golden growth for US telecom' as subscribers essentially doubled down on their data plans. The results were significant growth in revenues and profits that AT&T and Verizon lapped up. With smartphone penetration rates now approaching 60% in the US, the data plan tail wind is slowing down. There's probably a couple of years still left to milk what's left, but not much more than that.

Current penetration of US wireless connections are in excess of 100%, meaning that most households have greater than 1 device per member in the household. That places a natural limit on the extent of growth that companies like AT&T and Verizon can continue to enjoy.

AT&T has made particularly good progress in driving Machine to Machine connections, which include such things as wireless enabling vending machines and wireless connected cars. Estimates indicate that AT&T likely has about 14.3M machine to machine connections, almost double that of Verizon. While this is impressive growth, at one time, the wireless carriers had hoped that subscribers would connect 2 or 3 devices each onto the wireless network. While that may still be possible, that hasn't panned out to this point, with tablets, watches and other connected devices largely going over wifi.

Wireless growth now coming from prepaid market: Growth that is occurring in the US market is increasingly coming from the prepaid segment of the market, with more tepid growth in the postpaid segment. Postpaid, or contract subscribers are significantly more attractive to AT&T and Verizon. The Average Revenue Per User (ARPU) of postpaid subscribers tends to be much higher than prepaid subscribers as they consume more data. Postpaid subscribers are also contractually bound to a carrier for the duration of the contract while the rate of churn among prepaid subscribers tends to be significantly higher.

Limited Dividend Growth: Dividend growth creates wealth. It's the secret sauce to keep your dividend machine cranking overtime and to drive a stock's price progressively high. AT&T and Verizon's dividend growth has generally only been in the 2-3% range over the last 5 years or so. Enough to preserve the real value of the dividend income, but not much more.


The investment case for AT&T is positive as far as industry outlook and preservation of profits are concerned. Growth drivers are rather modest however, and there is an absence of factors to significantly boost the status quo for profit and dividend growth, both of which have been modest for AT&T.

At 13x forward earnings, AT&T sits close to the midpoint of its historical 5 year valuation on a range of measures including price to earnings, price to cash flow and dividend yield.

While not at a bargain basement price, given its dominant position in an oligopolistic industry and the likelihood of steady, increasing profitability, I could be persuaded to accumulate on more significant falls in price. An opportunity to buy on a large pullback would definitely get my attention (such as that which occurred with my purchase of Telstra, the large Australian telecom, for an effective 10% yield).

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.