AT&T: A Junk Bond In Equity Clothing

| About: AT&T Inc. (T)


Dividend is essentially a junk bond (without the priority).

Competition is intense and capital spending requirements are very high.

EPS growth is low.

AT&T (NYSE:T) pays the highest dividend, at 5.22% (as of June 24) of the 30 stocks in the Dow Jones Industrial Average. The $0.46/share dividend was increased by $0.01 in the fourth quarter of 2013. Through 2013, its payout ratio was 53% (per S&P Capital IQ). T trades at 12.8x 2015 estimated earnings (13.3x 2014 estimates- TDAmeritrade). With those statistics as preludes, you are probably expecting me to praise the Company (assuming you did not read the title). Not exactly. Instead, I would like to sprinkle some healthy skepticism on the positive outlook many yield-oriented investors hold.

Source: TDAmeritrade

My thesis is that AT&T is a slow growth company with considerable competitive risks and significant capital requirements. While the dividend appears secure, the quarterly payout appears to be the main reason to own T, and as such the stock price has a bond-like price vulnerability to increases in interest rates or inflation.

I had previously written about floating-rate senior bank loans like Nuveen Floating Rate Income (JFR) which yield, with minimal (my perception) risk, +/- 6%. The analysis prompted me to think about how similarly yielding AT&T might stack up. As I have come to believe, T is basically an unsecured (junk) bond; the security does provide a comparable return with respect to yield, but price appreciation seems speculative and uncertain while there appears to significant downside risk if (the enemies of bonds) interest rates and/or inflation increase.

Expected Earnings Growth is Minimal and Capital Investment Requirements Are Huge


While most think of AT&T as a cell phone carrier, in reality 46% of 2013 revenues came from the "old" wireline service (AT&T annual report). In its largest sub-segment, voice, wireline has experienced double digit revenue declines with data partially offsetting the drop. The wireline business is not a cash cow being harvested with minimal investment; AT&T spent over $10 billion in 2013 to support this business (significantly exceeding the segment's $6.3 billion income) and continues to face intense competition and alternative technologies.


The days of easy profits and fast growth in the wireless business are over. Everyone has a cell phone (90% of all adults and 98% of those 18-29), and almost everyone who wants (58% of adults) one has a smart phone (Pew Research Internet Project). In fact, T reported 2.3% and 2.6% sequential drops in voice revenue in its wireless segments from 2011 to 2012 and 2012 to 2013, respectively. The growth in wireless is coming from data, where during the same periods, revenue increased by a whopping 23.1% and 18.7%. In 2013, data comprised 31% of the revenue in the wireless segment, up from 27% and 24% in 2012 and 2011, respectively. Unfortunately for AT&T, earning incremental data revenue is not a simple matter of leveraging already built infrastructure; providing increasing amounts of data is going to require significant capital investment. In 2012 and 2013, AT&T spent $10.8 in billion and $11.2 billion in capital expenditures on its wireless business. Previously, analysts assumed capital spending would drop following the LTE build-out; the dramatic increase in data usage indicates capital spending and spectrum acquisitions will not stop anytime soon. Recent capital spending levels far exceeded the segment depreciation and amortization of $7.5 billion and $6.9 billion in 2012 and 2013, highlighting the dramatic increase in capital needs.

With the rapid growth in network capacity required to accommodate data, as well as stubbornly high spending in the wireline business, Raymond James increased its 2014 capital expenditure forecast for AT&T to $21 billion.

Consensus earnings estimates provided by TDAmeritrade call for AT&T's earnings to grow by 4% in 2015 and less than 3% in 2016, fueled largely, if not entirely by stock buybacks. These estimates are down from year end 2013 (2014- $2.65 from $2.68 and 2015- $2.76 from $2.86).

Source: TDAmeritrade

The projections reflect concerns about the impact of heightened competition by T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S) in the former duopoly, with Verizon (NYSE:VZ), wireless business and lower margins in the wireline business. The oft discussed merger of Sprint and T-Mobile has been dismissed as highly unlikely to occur for regulatory reasons, but would carry increased pricing and promotional risks for AT&T if the odds of a successful transaction increased.

On May 18, AT&T announced it was acquiring DirecTV (DTV) in a $49 billion merger. This transaction was defensive, coming shortly after the February announcement of the Time Warner Cable (TWC) - Comcast (NASDAQ:CMCSA) merger, and its impact is reflected in analyst projections. Interestingly, expensive and proprietary content (NFL Sunday Ticket) was the must-have for AT&T, demonstrating how valuable a non-commodity is to the Company, and the premium it will pay for something unique. Given that DTV is fighting to retain subscribers, as the same customers who cancel their wireline services consider getting their entertainment from the internet, not from a cable or satellite provider.


In 2013, T-Mobile began to aggressively promote its services on price and began delinking service costs from phone subsidies. AT&T, which uses the same GSM network technology as T-Mobile, was the prime target (as phones that work on AT&T's network could be used on the T-Mobile network with only a change in SIM card). In a price war, the player with a smaller market share has upside and incentive to spend while the share leader has to invest to maintain its position (or minimize its losses). AT&T has yet to face Sprint, whose leading investor Masayoshi Son, the founder of SoftBank, has also committed to increasing share and profits. It is no surprise that the Credit Suisse reduced its (postpaid) ARPU projection by 3% in 2014. S&P also identifies increased competition as a risk factor with respect to its earnings forecast.

As previously noted, AT&T is fighting a rear guard action with respect to wireline voice, and continues to invest heavily to support this business.

In summary, there are significant market risks and challenges involved with holding earnings essentially flat (excluding share buy-backs). At 13x 2015 earnings, AT&T trades at a comparable multiple to Verizon and Apple (NASDAQ:AAPL), both of which are faster growing.

Pension Obligations and Estimates

AT&T's had $53 billion in pension obligations on its books at the end of 2013. I'm not going to delve into pension math, expect to say that the Company's estimate of its plan returns is too high and will have to be adjusted downward (making the adjustment in 2013, allowed it to book a gain of $7.4 billion). The Company expects to make 7.75% on a portfolio that is 33% bonds and cash; assuming the bonds yield a generous 2%, the equity portion would need to yield 10.6% over an extended period to time. This math appears to be wrong, suggesting AT&T will have to contribute more cash to its pension (and book extra expense).


Bonds trade at an inverse to interest rates. As Fed Chairwoman, Janet Yellen, CNBC contributor, Jim Cramer and everybody in-between has pointed out, interest rates are going to rise. It is simply a "when", not an "if". If my theory is correct, AT&T stock will be negatively impacted by an increase in rates. Assuming it is more than fairly valued today (for example, as compared to VZ and AAPL on a forward basis), there is certainly downside risk. IBM, which I'd suggest might be a better peer (based on core earnings growth) only trades at 9x 2015 estimates. For AT&T, 9x consensus 2015 earnings suggest a downside of $25-$26 (only for illustration purposes as I acknowledge the analysis is overly simplistic).


So, you have a Company that is facing intense (and likely increasing) competition, has huge capital requirements, potential liabilities from its pension obligations and is not growing. AT&T trades at a level comparable to its faster growing "peers". The junk bond-like payout comes not from a bond, but as a dividend (not secured and last in line if something goes wrong) which is not likely to "adjust up" in the face of higher interest rates or inflation. I don't dislike AT&T, but simply find better alternatives on a risk adjusted basis. The family's position was sold earlier this year.

Disclosure: The author is long AAPL, JFR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.