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Summary

  • The pessimistic forecast is for a 19%, annualized total return over 3 years with a base case of 2 years and a 25% annualized total return.
  • The outlook is positive for the Wireless and Wireline segments.
  • The technicals have been bearish for over 1 year.

AT&T (NYSE:T), the telecommunications services provider, reported strong 2013 results, which in this case means the company generated substantial free cash flow to equity. Also, operating revenues increased and adjusted operating income was relatively flat. For 2014, I'm forecasting revenues and operating income growth, but the free cash flows picture isn't as elegant.

With that said, the key challenge that AT&T may face is the substantial amount of capital the firm is investing in its wireline business, which has a lower return profile than the wireless business. This could be a misallocation of capital that adversely impacts the consolidated results of operations. But for now, AT&T is the U.S.'s best-of-breed telecommunications company.

As such, I estimate AT&T's long-term growth rate at 4%, and that leads to an intrinsic value estimate of $46 per share. The base case time span is for a two-year convergence period, which would be a 25%, annualized total return.

Recent Developments

  1. AT&T reduced the price of its one line, 2GB, with no annual service contract plan from $80 per month to $65 per month. The plan includes unlimited international messaging, which is in direct competition with Facebook's WhatsApp.
  2. AT&T won two innovation awards at Mobile World Congress: Best Consumer Mobile Service for Digital Life, and Best Mobile Enabled Consumer Electronics Device for FiLIP, which allows parents and children to be in touch at the push of a button.

Business Summary

AT&T Inc., through its subsidiaries and affiliates, provides wireless and wireline telecommunications services in the United States and internationally. The company has three reportable segments: Wireless, Wireline, and Other.

Wireless is the company's largest segment by revenue and operating income. But, unlike rival Verizon (NYSE:VZ), AT&T is able to generate healthy returns from its wireline business. Wireline had a 10.7% operating margin during 2013. Data and equipment are likely to continue to show strong performance with voice leveling out over the cyclical time frame.

For the year ending (in millions except per share data):

2012-12

2013-12

2014-12E

Operating revenues

$127,434

$128,752

$131,971

Adjusted operating income

$22,991

$22,895

$23,755

Adjusted net income

$14,753

$13,489

$14,517

Adjusted EPS

$2.54

$2.51

$2.79

Overall, 2013 operating results were flat relative to 2012 with the difference of the net incomes attributable mostly to differing tax rates. For 2014, right now, I'm forecasting 5% revenues growth with EPS growth attributable to operating leverage and share buybacks. Revenues in 2014, in my opinion, will be driven by postpaid wireless subscriber growth as well as growth in connected devices. Also, growth from wireline data could be partially offset by declines in voice.

For the year ending (in millions except per share data):

2012-12

2013-12

2014-12E

Cash flow from operations

$39,176

$34,796

$34,312

Capex

$19,465

$20,994

$21,000

FCFF

$19,711

$13,802

$13,312

FCFE

$24,464

$22,940

$8,312

DPS

$1.76

$1.80

$1.84

For 2014, I think cash flow from operations declines, but not as much as management is forecasting, because my expectation is that CFO comes in just below its historic range. That leads me to my expectation that free cash flow to the firm comes in just above $13B, which is higher than management's forecast of $11B. That free cash flow is forecasted to be spent on debt repayments and dividends.

2012-12

2013-12

2014-12E

Debt-to-capital

43%

45%

44%

Ending financial leverage

2.95

3.05

3.16

Cash ratio

0.15

0.10

--

Defensive interval

108 days

126 days

--

AT&T's solvency and liquidity positions deteriorated. But the reduction of total operating expenditure allows the cash in the bank to stretch further. I'm modeling a reduction of outstanding contractual obligations, but the timing of the reduction is rather uncertain. Also, the subscriber base, which pays monthly, provides a steady stream of cash, unless those subscribers switch to T-Mobile.

The quality of earnings during 2013 was excellent, which means that earnings should be persistent. That is based on both the balance sheet and the cash flows methods of evaluating earnings quality. Also, AT&T collected 103% of revenues in cash from customer.

As a consolidated company, AT&T is best-of-breed in the wireless industry. The firm is able to generate significant income from both its wireless and wireline businesses. Also, management continues to reinvest in operations in an attempt to maintain the advantages. Further, the firm's customer service experience is excellent, in my opinion. AT&T should be able to generate substantial returns on capital for the foreseeable future.

Risks

  1. The share price is likely to remain volatile, and investors could lose a portion or all of their investment.
  2. Investors should judge the suitability of an investment in AT&T in light of their own unique circumstances.
  3. A decline in the global economic growth rate and/or a decline in the pace of economic growth in the United States could adversely impact the results of operations and the share price.
  4. Competition in product development and pricing could adversely impact performance.
  5. Incorrect forecasts of customer demand could adversely impact the results of operations.
  6. Higher interest rates may reduce demand for AT&T's offerings and negatively impact the results of operations and the share price.

This section does not discuss all risks related to an investment in AT&T.

Portfolio & Valuation

(click to enlarge)

AT&T is in a bear market of minor, intermediate, and primary degree. The share price could be forming a head & shoulders top, but for now, I will call it a consolidation, which is a bear market of primary degree. When the 200-week simple moving average catches up to share price, I will have a better idea of if this is a primary top or just a consolidation period.

TTM

2014E

P/E

12.95

11.65

P/S

1.36

1.28

P/B

1.92

1.88

Base case intrinsic value

$46

Pessimistic intrinsic value

$36.80

I view the intrinsic value of the company as $46 per share. The long-term growth rate is estimated at 4%, which is just above GDP growth. AT&T is uniquely positioned to benefit from both the wireline and wireless growth of data usage. Also, while there are near term challenges to voice, there remains a place for, well, talking. The innovations that the company is bringing to market in connected home haven't fully developed into substantial contributors to operating revenues, but over the next 10 years, this could be a substantial driver of cash flows growth. AT&T is well positioned in its industry for the foreseeable future.

Optimistic

Base case

Pessimistic

Dividends

$1.38

$3.29

$5.28

Selling price

$46

$47.84

$49.75

Annualized return

46%

25%

19%

Based on the intrinsic value estimate, the annualized total return under the base case scenario is 25%, which would take two years to achieve. The pessimistic forecast, which is an excellent ROI, assumes a 3-year period for convergence between the share price and the intrinsic value estimate. The optimistic forecast assumes a one-year holding period.

Source: Why I'm Bullish On AT&T