How To Potentially Earn An Extra 7.5% Yield On AT&T's Overpriced Shares

| About: AT&T Inc. (T)

Summary

AT&T shares, despite the recent minor pullback, are still on fire over the past year, crushing both its major rivals and the S&P 500.

This means that, despite strong long-term growth prospects, shares are currently overvalued.

Which means they can potentially be used in combination with a conservative, leverage free, covered call option strategy to generate potentially 7.5% in additional income, or sell at higher prices.

BUT there are several risk factors and details you should know before deciding to try this strategy.

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AT&T (NYSE:T), which isn't known for strong, market thumping bull runs, has, nonetheless, crushed the S&P 500 as well as competitors Verizon (NYSE:VZ) and Comcast (NASDAQ:CMCSA) over the past year.

T Total Return Price Chart T Total Return Price data by YCharts

This has largely been due to record low interest rates sending yield-starved investors hunting for any stock paying a decent dividend. More importantly, this recent strong performance has sent AT&T shares into overvalued territory, potentially setting up more recent shareholders for a short-term loss due to a potential correction.

How you can use a very low risk option strategy to potentially generate an additional 7.5% worth of income from these overpriced shares?

Good long-term growth potential but shares have become richly valued

Don't get me wrong, I'm a big fan of AT&T's long-term prospects. Specifically, I think management's recent moves into pay TV via the DirecTV acquisition, when combined with aggressive synergistic cost cutting efforts, will turn the dividend aristocrat into an even stronger free cash flow machine. In fact, management is confident that within a few years AT&T will be generating $20 billion in annual free cash flow, or FCF.


Source: AT&T earnings presentation.

Source: Morningstar
Morningstar Fair Value Estimate Current Share Price Sell Price Premium To Fair Value Distance To Sell Price
$36 $40.96 $48.60 13.5% 18.7%
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That being said, with shares up so strongly over the past few months Morningstar analyst Michael Hodel thinks shares have overshot their five-year intrinsic value by about 14%. That assessment is based on his two stage discounted cash flow, or DCF model, which I consider one of the best medium-term intrinsic value approximations out there due to its conservative, fundamentals driven approach.

For example, Hodel recently raised his fair value estimate 10% from $33 to $36 due to his projected 3% top line growth in the company's wireless business. That's due to impressive continuing growth in wireless subscribers despite strong pricing competition from upstart rivals such as T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S).

This is mostly due to AT&T's aggressive investment into its massive national wireless infrastructure, which has kept pace with Verizon, the other 800-pound Gorilla in American mobile services. And while Morningstar is impressed with AT&T's strong results, including its record low churn rate, when it comes to holding the line on costs, which has allowed wireless margins to expand gradually over time, Hodel does expect AT&T will have to increase its wireless capex over the coming five years in order to keep pace with Verizon as it rolls out 5G, so called "mobile broadband" service. That's because 5G has the potential to be a truly disruptive technology that could upend America's current telecom industry, both on the wireless, and internet front.

Source: Morningstar, Gurufocus
TTM FCF/Share 10 Year Projected FCF/Share Growth Intrinsic Value Estimate Growth Baked Into Current Price Margin Of Safety
$2.72 5.5% $37.81 6.7% -8%
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Overall, I view Morningstar's 3% wireless revenue and 2.5% consumer entertainment growth assumptions as sufficiently reasonable to build a conservative valuation model around.

However, as I'm a longer-term dividend growth investor I prefer to use a 20-year two stage DCF model with a conservative 5.5% FCF/share growth rate over the next decade and 4% rate for years 11-20. I also use a 9.1% discount rate as this is the market's historical CAGR since 1871. Thus I view is as the hurdle rate that all potential investments need to clear in order to be worth the added risk of owning individual companies over a low-cost index ETF.

As you can see, while my model shows AT&T's improved growth prospects post the DirecTV acquisition giving it a higher fair value than what Morningstar estimates, nonetheless shares are still slightly overvalued.

That makes sense when you consider that academic studies show that a good rule of thumb for projecting long-term total returns is yield + dividend growth.

Sources; Yahoo Finance, Fastgraphs, Factset Research, Multipl.com, Moneychimp.com
Company Yield TTM FCF Payout Ratio 10 Year Projected Dividend Growth 10 Year Projected Total Return
AT&T 4.7% 67.2% 3.9% 8.6%
S&P 500 2.0% 39.1% 6.2% 9.1%
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And while analysts expecting AT&T to grow its dividend at close to its long-term 20-year historical rate over the next decade, which is nicely up from much slower growth in recent years, shares would still need a five-year average yield of 5.3% in order for investors to be realistically confident of beating the market's historical return.

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Source: simplysafedividends.com

How to generate nice yield from overvalued shares

For those who already own AT&T shares and looking to potentially lock in some profits right now, covered calls are a good way to generate additional income from your shares or ensure a slightly higher selling price.

Source: Yahoo Finance
Covered Call Premium/Share Effective Sell Price Premium To Current Price Premium Yield Annualized Premium Yield
Nov $42 $0.65 $42.65 4.1% 1.59% 7.5%
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For example, the November $42 calls currently pay $0.65 per share in premium, or $65 per contract, a premium yield or 1.6% over the next 80 days. That comes out to a potential additional annualized income yield of 7.5% should shares fail to trade at or above $42 by expiration.

In essence you are getting paid to hold onto your shares instead of selling them now by an investor who is willing to own shares at $42 but only if shares continue moving higher. In other words, the upfront payment of $65/contract represents a risk premium for you agreeing not to simply sell your shares at $40.96 but hold onto them for 80 days. If shares hit $42 or more by then, you'll have your shares called away at an effective selling price of $42 strike price for a +$0.65 premium or $42.65, a 4.1% higher share price than you'd get selling now.

If shares trade below $42 then the contract expires worthless and you keep your shares, the premium, this quarter's dividend and can write another covered call.

Risks to consider

Of course in a world of near zero or even negative yielding bonds, no one pays 7.5% annualized yields if their isn't some risk involved. In this case there are three risk factors to consider before deciding whether or not to write covered calls.

The first is event risk which means AT&T trading at or above $42 by expiration and having to sell your 100 shares per contract. If you are a die hard buy and hold dividend investor, primarily interested in AT&T for its rock solid dividend security, then covered calls aren't for you.

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Source: simplysafedividends.com

That's especially true if you've owned shares for a long-time and want to avoid generating a taxable event, that would mean 15% to 20% of your capital gains would end up going to the IRS.

The second risk to consider is financial risk, which means the chance that AT&T may turn around and decline while you are holding onto the shares covering the option contract. Remember this is the underlying reason that the call premium exists, to compensate you for simply not selling your shares right now but for holding out for a higher effective selling price of $42.65.

In other words, if Morningstar is right about its fair value is around $36, which by the way would result in the yield achieving its historical average of 5.3%, then you may end up kicking yourself for not having sold at close to $41 and now having the opportunity to get back in at a far more appealing price.

The final risk factor is opportunity cost. For example, if for whatever reason AT&T ends up marching up to fresh all-time highs of $45 or so by expiration, then your upside is capped by your effective sell price of $42.65.

Other details to keep in mind

In addition to the risks described above there are a few key details to also be aware of before writing covered calls on AT&T.

^VIX Chart ^VIX data by YCharts

First, keep in mind that you may want to hold off selling covered calls right now. That's because one of the key determinants of option premium, implied volatility, is at historical lows. In fact, the S&P 500 hasn't moved up or down 1% or more for 39 straight trading days, highly irregular behavior, especially considering that August and September are generally periods of relatively poor market performance.

Which means that, if you decide that covered calls are for you, consider waiting a week or two before earnings before selling your contract as implied volatility naturally rises prior to earnings, causing yields to fatten.

Another thing to keep in mind is that the annualized premium yield is just a broad idea of how much true income your shares can generate. That's because for any covered call under one year in duration, such as the Nov $42 call I'm recommending, the annualized yield assumes that not only will the call expire worthless, but that you'll immediately write another one with the exact same premium.

Since premiums are a function of several factors, such as share price, interest rates and most of all implied volatility, all of which can change over time, you can't really use the annualized premium yield as more than a very general guide to how much income any particular call can generate.

In addition, keep in mind that should you decide you don't want your shares called away, and AT&T is trading at or above $42 by mid November, you may want to buy to close to before the ex-dividend date. That's because, unlike put contracts, which include the dividend in their premium, calls don't. Thus, if shares are trading above the strike, the owner of the contract can choose to exercise the contract early.

If the time value of the contract, which decays to zero at expiration, is less than the dividend, then it makes financial sense for the owner of the option to take those shares in order to secure this quarter's dividend.

Third, while I didn't include commissions in my above calculation, never forget that at most you want to spend 2% or less on trading costs. Option commissions can vary from broker to broker, from $0.70 per contract with a $1 minimum with Interactive Brokers (NASDAQ:IBKR) to $12.95 for the first 10 contracts with Options Xpress.

In general I recommend Interactive Brokers both for their low costs and other option investor friendly factors such as free contract exercising. In this case if you were to sell a single Nov $42 call then you'd pay $1/$65 or 1.54% commission, which is reasonable.

Of course, the more shares you own, and thus the more covered calls you can afford to write to amortize the trading costs over, the lower your relative commission will be. For example, if you were a big enough whale who wanted to potentially sell 10,000 shares of AT&T, and thus write 100 November $42 calls, then eOptions's commissions of $3 +($0.15 X 100 contracts) or $18 would represent just 0.277% of the $6500 in premium you'd receive.

Finally, don't forget about taxes. By a fluke in the tax code, all option premiums, even those generated from long-term contracts, such as LEAPs (which can have a duration of up to 2 years), are taxed as short-term capital gains; in other words, at your top marginal tax rate.

Which means that you'll want to consider not just whether or not this particular covered call strategy is worth it for you but you also need to consider the rest of your portfolio as well.

For example, if you have short-term capital gains from other transactions in a taxable account, then selling Nov $42 covered calls might bump you up into a higher tax bracket. Of course, you're still better off in the end, assuming the contracts expire worthless, since you keep the majority of premium. However, in terms of calculating the potential reward/risk ratio you want to keep this in mind. It's also why, if at all possible, write covered calls in a tax deferred account such as IRA.

Bottom line: AT&T's shares are looking a bit rich, so here's a good, low-risk way to make them work harder for you, OR potentially sell at a higher price.

Don't get me wrong, covered calls, like all conservative income generating options strategies, aren't for everyone. In today's low volatility environment, with thin premiums, you may decide that the risks aren't worth the potential reward. However, if you haven't thought about this leverage free option strategy, and are considering lightening up your AT&T position, then I recommend you at least consider this potentially profitable tool, which many income investors have used in the past to good effect.

Disclosure: I/we 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.