AT&T: Undervalued With A Great Dividend

| About: AT&T Inc. (T)

Investors in AT&T (NYSE:T) have had a pretty disappointing twelve months. Shares are currently sitting near 52-week lows while the S&P 500 hits new all-time highs. The broader market has left AT&T in the dust as investors look for riskier higher growth companies like Tesla (NASDAQ:TSLA) and Netflix (NASDAQ:NFLX). Thanks to this rotation, there are some stocks that offer extremely reasonable valuations even as many commentators argue that the broader market is close to being fully valued. AT&T is one such company that offers a fair valuation and solid dividend yield with the prospect for mild earnings growth. While T won't make you rich overnight, it is a great stock to generate strong returns over a longer term time horizon.

AT&T essentially operates two units: wireline and wireless. As has been well documented, wireless has been doing extremely well, partially at the expense of wireline. With cell phones, some consumers (particularly younger ones) no longer see the need to have home landline phones. AT&T's wireline unit has been dealing with customers losses while its wireless unit has consistently enjoyed subscriber gains, though mostly at a slower pace than Verizon (NYSE:VZ). To combat the decline of the landline, AT&T has focused on broadband and TV offerings with its U-verse product, which has helped to offset the weakness in traditional landlines.

U-verse has proven to be a successful product for AT&T with 10.7 million TV and high speed internet subscribers (all financial and operating data can be found here). Last quarter, AT&T added 630,000 internet subscribers and 194,000 TV subscribers. With over 25% annual growth, U-verse is now running at a $13 billion annual pace and should account for roughly 10% of AT&T's total revenue in 2014. Importantly, U-verse actually powered wireline revenue up 0.3% sequentially though it was down 1.4% year over year. With a diversification away from the landline, AT&T should see organic (net of divestitures) wireline revenue stabilize in 2014.

Investors should also note that the FCC has backed away from net neutrality, meaning major internet data users like Netflix will have to strike deals with internet providers to guarantee fast download times. In fact, Comcast (NASDAQ:CMCSA) struck such a deal with Netflix recently, though no financial details were released. I expect AT&T to reach a deal with NFLX soon, and other data users like Hulu, YouTube (NASDAQ:GOOG), and others may have to pay as well. This will provide some incremental revenue and be a positive for wireline margins going forward. The story in AT&T's wireline unit is stabilization with the potential for organic revenue growth in either 2014 or 2015.

AT&T's wireless unit continues to perform relatively well. Total wireless revenue was up 4.5% last quarter thanks to a very low churn rate of 1.11% and 566,000 postpaid net-adds. These figures suggest that the competitive pressure from T-Mobile (NASDAQ:TMUS) has been overstated, though it is an important risk I discuss in more detail below. Importantly, wireless data revenue was up 16.8% year over year as more consumers switch to data-intensive smartphones and add tablets to their wireless package. Further, operating margins improved to 21.4% from 14.5% last year.

Investors are concerned that a more competitive T-Mobile and Sprint (NYSE:S) will put pricing pressure on all wireless plans, which would adversely impact margins. In fact, AT&T has cut prices with additional smartphones in a family plan costing only $15/month and a $100 credit for every new line (details available here). Clearly, AT&T is unwilling to be undercut on price too much as that could threaten its subscriber base. I do expect T-Mobile and Sprint to keep a lid on pricing in the near term, though this does not condemn carriers to margin contraction. For years, smartphone subsidies were a leading expense and hurt margins. With a more competitive smartphone landscape that has moved away from an iPhone (NASDAQ:AAPL) monopoly, subsidies are shrinking, which is a positive for carrier margins. Additionally, new devices like smart-watches and machine to machine networking will provide significant incremental revenue opportunities. These trends should help to negate increased competition and keep margins relatively flat over the next twelve to twenty-four months.

Interestingly, AT&T and Verizon investors may also benefit from the FCC's negative stance on a possible T-Mobile-Sprint merger as the government would prefer four wireless firms to three (details available here). In reality, I think the market would be more competitive with three players. Right now, TMUS and S are relatively small when compared to VZ and T, which provides a limit to the pressure they can apply. In essence, the wireless market is composed of two strong and two weak players. By merging, Sprint and T-Mobile would have much larger scale and deeper pockets to effectively wage a price war. A market with 3 strong companies is more competitive than the current one. If the FCC were to change its stance on a deal, I would be more concerned about AT&T's wireless margins.

AT&T also has a strong balance sheet with $69.3 billion in debt against $91 billion in equity. Given the stability and size of its cash flows, it could take on even more debt if there were an accretive deal. With $33 billion in operating cash flow expected for 2014, the current debt load is far from burdensome. Having sold its stake in Verizon Wireless, many have conjectured Vodafone (NASDAQ:VOD) is a potential target, though AT&T cannot legally pursue one for three months. Vodafone has also been acquiring European cable operators, which makes the firm less attractive than when it was a purer wireless play. Given this, I do not expect T to make a major acquisition in the next six months. With Verizon carrying over $90 billion in debt in the wake of the Verizon Wireless deal, AT&T has the strongest balance sheet in the industry at this point in time.

In 2014, I expect AT&T to generate $32-33.5 in operating cash flow and spend $21 billion in capital-expenditures. The only real negative in the telecommunications business is that it is extremely capital intensive. On the flip side, that capital intensity provides a high barrier to entry that makes the emergence of new credible firms unlikely in the medium term. AT&T will likely return all of its $11-$12.5 billion in free cash flow to shareholders this year. Shares currently yield 5.8%, and the dividend will cost about $9.5 billion this year, which would leave about $2 billion for share repurchases.

AT&T has been aggressively buying back stock and repurchased 355 million shares last year or about 6% of all shares outstanding. While the pace did slow in the second half of the year, it still spent $1.9 billion in the fourth quarter. Free cash flow would support only $2 billion for all of 2014. With shares so low, I would encourage AT&T to add debt to buy back stock. With a dividend yield of 5.8%, AT&T could likely borrow at a lower rate, making such an action accretive to cash flow. I expect AT&T to use its strong balance sheet to borrow when appropriate and repurchase about $5-8 billion this year.

Overall, AT&T has a strong business with wireline stabilized and wireless showing mid-single digit growth. Competitive pressures are a bit overstated, and I would not look for significant margin deterioration this year. AT&T also boasts a fantastic dividend yield that is well covered by free cash flow. With some excess cash and a solid balance sheet, AT&T can either make opportunistic acquisitions or buyback stock. I expect the company to earn about $2.70 in 2014, so it has a forward multiple of only 11.8x. Given the negative sentiment around the sector at this point in time, I would not expect a quick and sharp rally, but the stock is extremely cheap at current levels and pays investors to wait. I would be a buyer of AT&T until 14x earnings or roughly $38.

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.