Last week I wrote an article entitled "Why does AT&T have a 5% dividend yield?" that generated significant buzz from the Seeking Alpha community.
One user posited an interesting question in the comments that I felt like exploring further - what would happen to the dividend and the AT&T (NYSE:T) share price if AT&T were to spin off its real estate assets, such as the copper and fiber networks, into a REIT?
This is a difficult question to answer but below is my best attempt to explore the idea. Lastly, I've included a quick explanation on REITs for those unfamiliar with the topic - if you're already knowledgeable on the topic, feel free to skip down to my assumptions.
REIT stands for real estate investment trust and is a type of business entity like a corporation or LLC. In order to qualify and maintain the REIT status, the entity must comply with the special requirements outlined by the SEC - one of these being that more than 75% of the assets need to be real estate.
Real estate, however, is a rather loose term. As REIT.com explains:
Over the years, the IRS has concluded that properties like communications towers (on which space is leased to communications companies and which were approved by the IRS in 1964), railroad tracks (which are leased to transporters of freight and passengers and were approved by the IRS in 1969), electrical transmission infrastructure (leased to energy providers and approved by the IRS in 2007), and gas pipelines (leased to natural gas providers and approved by the IRS in 2007) fit within the original definition of real estate and therefore are eligible property.
In exchange for meeting the requirements, REITs are allowed to disperse more than 90% of their taxable income to unit holders without paying tax, theoretically creating significant value for unit holders.
One recent example of a REIT conversion that caught the interest of the telecom industry is Windstream (NASDAQ:WIN). Windstream announced on July 29th that the company would spin-off assets into a REIT in order to:
... accelerate the company's transformation by enabling greater network investments that will enhance service to customers while providing the REIT with opportunities to grow and diversify.
While that might be Windstream's intent, REIT conversion doesn't always generate value for shareholders. Albert Alfonso, a fellow Seeking Alpha contributor, wrote an excellent article questioning how much value the REIT spin-off created for Windstream shareholders.
The rest of this article will be spent exploring if a REIT spin-off makes sense for AT&T.
The objective of this analysis is to determine how much value is created for shareholders if AT&T were to spin off its real estate assets into a REIT. In order to perform this analysis, I had to make a few significant assumptions and feel it is appropriate to call them out before reviewing the analysis:
- Only the Plant, Property and Equipment assets on the balance sheet are transferred into the new hypothetical REIT.
- The remaining assets on AT&T's balance sheet remain with the AT&T corporate entity.
- Current AT&T shares undergo a 2:1 reverse split and in exchange current AT&T shareholders receive a unit of the new AT&T REIT.
Step 1. Estimating the new AT&T REIT Distribution.
In order to estimate the new annual distribution for unit holders of the new hypothetical AT&T REIT, two pieces of information are necessary:
- The total amount of real estate assets currently on the balance sheet.
- An estimate of how much income the real estate assets would produce.
With that information, the total annual distribution can be calculated by multiplying the total income by 90%, the minimum distribution ratio accepted by the SEC.
The chart below shows the existing plant, property and equipment on AT&T's balance sheet and the return on assets for the past five years.
Assuming the average ROA is about 4% and assuming AT&T could maintain a future ROA of 4%, the total income per year on real estate assets of $275B would be $11B. Multiplying by the minimum payout ratio of 90%, this would yield a total annual distribution of $9.9B.
In assumption 3 above, I indicated that for this analysis it would be assumed that AT&T shares underwent a 2:1 reverse split and shareholders would receive one unit of the new AT&T REIT in exchange, therefore based current shares outstanding of 5.2B, the total units of the new AT&T REIT would be 2.6B units. This would provide a total annual distribution per unit of $3.81.
Step 2. Estimate the AT&T REIT Unit Price
The new hypothetical AT&T REIT unit price can be calculated using the total shares outstanding and either total income or total book value in conjunction with an appropriate reference P/E or P/B ratio.
From above, the total assets of the new hypothetical REIT were $275B and were earning approximate income of $11B, which yields an earnings per unit of approximately $4.23.
The book value, which is total assets less liabilities, or in this case, $275B in assets less depreciation of $164B (see chart below), is approximately $111B or $43 per unit.
Step 3. Estimate Dividend of Remaining AT&T Shares
The new hypothetical AT&T REIT acquired all plant, property and equipment. Looking at the charts below, AT&T presently has about $275B in PP&E, $163B in depreciation and total assets of $278B.
Therefore, after the spin-off, the existing AT&T shares would have about $168B in assets. Assuming the same 4% ROA as before, this would yield a total income of $6.7B.
Assuming the payout ratio remains the same as current AT&T shares, the dividend post spin-off can be estimated.
Using a payout ratio of 53% on earnings of $6.7B, AT&T would pay total annual dividends of $3.6B, or assuming 2.6B shares remain, $1.37 per share.
Step 4. Estimate new Share Price of Existing AT&T Shares
Similar to the analysis done for the hypothetical REIT unit price, the price of the existing AT&T shares can be estimated using earnings or book value and the appropriate multiplier. In this case, because the assets left on AT&T's balance sheet will be mostly intangibles, I believe an earnings approach makes more sense.
As the chart below shows, the current P/E ratio for T is 10.1:
Based on total earnings of $6.7B and 2.6B shares outstanding, EPS is $2.59 per share making the price of the existing AT&T shares $25.9 per share with the current P/E ratio.
Step 5. Putting it All Together
Assuming an investor had two shares of AT&T before the REIT spin-off, post spin-off the investor would have one share of T and one share of the new AT&T REIT. The below table summarizes investors' positions post spin-off.
|T Shares||REIT Shares|
|Share Price||$25.9||$112 - 168|
|Dividend per Share (annual)||$1.37||$3.81|
|Dividend Yield||5.3%||2.3 - 3.4%|
In this hypothetical scenario the REIT spin-off would provide significant value to the investor. On the low side, the shareholder would see an immediate capital gain of $68 and an increase in annual distribution of $1.32 per share.
It is clear a spin-off of AT&T's real estate assets into a REIT could unlock significant value for AT&T shareholders, but it is important not to lose sight that all of this is just hypothetical.
While I believe this article provides a great example of how value can be unlocked through a REIT conversion, it is very dependent upon the assumptions I made. The reality is that if AT&T were to do a REIT conversion, the value created for the shareholder would largely be determined by how the deal is structured and could differ drastically from some of the assumptions I made here.
Lastly, I want to make it clear that I haven't seen any press releases from AT&T or heard any news to suggest a REIT conversion is being considered by the AT&T board.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Black Coral Research, Inc. is a team of writers who provide unique perspective to help inspire investors. This article was written by Clinton Holmes, President of Black Coral Research Inc. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment adviser or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.