Investors do not often expect to find safety in technology and telecommunications, where trends come and go and start-ups are always emerging. Frontier Communications (FTR) and AT&T (T) are two exceptions to the rule with their low betas and stunning commitments to returning free cash flow to shareholders. Both firms, in my view, thus represent attractive investments given concerns over a double dip.
From a multiples perspective, AT&T is the more undervalued of the two. It trades at a respective 14.8x and 11.7x past and forward earnings; Frontier Communications trades at a respective 35.4x and 19.5x past and forward earnings. Moreover, the former has a consensus rating more toward a "buy" while the latter's rating is more toward a "hold." At the same time, Frontier Communications offers a staggering dividend yield of 13.3% versus AT&T's still staggering 5.9%. The question naturally follows how sustainable these distributions are ...
One way of gauging the sustainability of dividend yields comes through calculating the interest coverage and payout ratios. As of late October, Frontier Communications had an interest coverage of 1.6 and a FCF payout ratio of 64.7% - more than sustainable. Management has additionally reinforced its commitment to returning cash to shareholders, despite lowering its FCF estimate to around $1.1B for 2011 due partially to storms. Net debt, however, stands at $8B, a good margin above market capitalization. With that said, the acquisition of Verizon's (VZ) rural wireline assets is being optimized in a process that will inevitably clean up the balance sheet in the years ahead.
AT&T is also in a good position to keep paying its dividend yield given an interest coverage of 6.1 and an EPS payout ratio of 21.7% (see here for a more thorough analysis).
At the third quarter earnings call, AT&T's CFO, John Stephens, noted:
"We are very pleased with what we've accomplished in the third quarter and year-to-date, and we continue to see impressive strength in all our growth engines. Mobile broadband leads the way. Ralph will give you more details in a moment but we had a great quarter. Sales were strong across the board, with gains in every subscriber category. Smart phone sales were robust, even in a quarter where you might expect sales to slow. Branded computing devices were also strong, and we turned in impressive service margin results with our best performance in six quarters. There also is good news for our wireline business, where for the first time in three years, we posted sequential growth in total and business revenues. IP data continues to be the driver for business and in wireline consumer, where we continue to see positive results. The thing I'm most encouraged by is that in addition to solid earnings, we delivered excellent free cash flow. In fact, we had our strongest free cash flow in two years. That comes even with making significant CapEx investments. So you're seeing solid execution in every area of the business, which puts us in a great position heading into the fourth quarter."
During the third quarter alone, the number of U-verse broadband subs increased by half a million, which reassured me about the company's demand. The telecommunications firm also experienced sequential growth in wireline consumers, despite the higher operating expenses arising from storms and other unexpected costs. At the same time, strong projected iPhone sales - around 5.5M units sold for Apple (AAPL) through AT&T in the fourth quarter - will dilute margins due to high expenses in later quarters.
Going forward, I model revenue growing by a CAGR of roughly 1.7% over the next three years with a negative CAGR in wireline and a CAGR upwards of 6.5% in wireless. Capital expenditures are likely to increase by a rate in the low single-digits, but still remain a global leader in this metric. This level of innovation should help drive free cash flow to secure the dividend yield even more.
Additionally, I am also optimistic about AT&T winning the Department of Justice's approval to merge with T-Mobile sometime in 2012. The trial, which is a quarter of a year away, should influence confidence in this matter and thus presents an attractive inflection point for investors. Should the deal win approval, it will produce significant revenue and cost synergies largely due to unlocking international growth catalysts.
In terms of competition, I believe that AT&T faces substantial risk from Verizon (VZ), which was the quickest developer of 4G LTE technology and is very much undervalued, as I underline here. Sprint (S), on the other hand, is in a precarious position. Meanwhile, Clearwire (CLWR) is being left stranded by its partner and is currently experiencing a "do or die" moment as it bleeds negative EPS. Overall, I believe that AT&T has a solid path forward, especially with the T-Mobile merger.
Consensus estimates for AT&T's EPS are that it will increase by 1.3% to $2.33 in 2011 and then by 6.9% and 5.2% in the following two years. Assuming a multiple of 15x - slightly higher than currently - and a bear case 2012 EPS estimate of $2.40 yields a rough intrinsic value estimate of $36, implying a 23.5% margin of safety. Considering its impressive dividend yield, beta of 0.62, and high discount to intrinsic value, I believe that AT&T presents favorable reward with little risk.