One aspect to this market that has to be frustrating for portfolio managers is the inability to find "oversold" stocks, but after checking the charts this weekend, Telecom, particularly AT&T (NYSE:T) and Verizon (NYSE:VZ), look ripe for a bounce.
No question the defensive sectors like Telco and Utilities have both benefited from the chase for yield this year, particularly as the 10-year Treasury hit 1.39% in late June, early July, its lowest yield print since July 2012, when the 10-year Treasury yield also hit 1.39%.
Market Technicians would say we have a classic "double-bottom" in yields or a "double-top" in the 10-year Treasury price, (take your pick), from which we could infer that maybe "defensive" sectors are in the process of unwinding long-term gains.
The 10-year Treasury has been range-bound for two months, so let's see what happens.
AT&T reported a decent 2nd quarter, with revenue growth of 23% (distorted by DirecTV's closing in Q3 '15), operating income of +15% and EPS growth of +4%.
Weakness in gross adds, but a better Wireless operating margin helped the quarter. The tepid reaction for the iPhone 7 could actually be a plus for T given it takes pressure off margins for September and the 4th quarter, according to one analyst note I read.
The big improvement seen in Q2 '16 numbers was in the cash flow statement: While DirecTV was expected to improve free cash flow, it definitely delivered, and DTV added 342k subscribers, versus the 300k expected, with the point being that while expectations were high for the combination between T and DirecTV, the early metrics look good.
Here is the change in AT&T's trailing twelve-month (TTM) cash flow the last 5 quarters:
|TTM cash from ops||TTM free cash flow|
|Q2 '16||$38.2 bl||$16.7 bl|
|Q1 '16||$37.0 bl||$17.0 bl|
|Q4 '15||$35.9 bl||$16.6 bl|
|Q3 '15||$32.4 bl||$13.0 bl|
|Q2 '15||$30.2 bl||$9.8 bl|
Source: Internal spreadsheet from T's earnings reports and 10-Qs
As readers can see, while cash-from-operations improved for T, free cash flow improved much more.
Now I have to tell readers, if we look further back T was generating $16-$17 bl in free cash flow back in 2013 too, the pothole the telco giant hit resulted in T issuing quite a bit of debt (long-term debt jumped from $71 to $119 bl as of 12/31/15), which the excess free cash flow is now starting to pay down.
(From $122 bl in l-t debt as of 3/31/16, T paid down debt to $117 bl as of 6/30/15. It doesn't sound like much but that $5 billion is roughly half the annual dividend payment. The telco giant stopped repurchasing stock and paid down debt, which is probably a good thing.)
In terms of the dividend as a % of T's free cash flow, it was closer to 50% in 2012, and 2013, and then skyrocketed to over 100% in late 2014, and early 2015, and is now settling back into the 60% range.
T raises the dividend by $0.01 every year, which according to my math, and with the extra shares issued to acquire DirecTV means an extra $250 million per year is paid out through the $0.01 increase in the annual dividend.
The dividend is secure, but it will be interesting to see whether T management repurchases stock or pays down long-term debt.
Verizon: In Q2 '16, Verizon reported a noisy quarter with the $0.54 charge thanks to the settling of the strike. Revenue fell 5% year over year, and per Morningstar, saw tepid wireless customer growth.
Unlike AT&T, Verizon leveraged the balance sheet back in 2013 to buy the remainder of Vodafone. Like T, Verizon took long-term debt from $42 to $90 billion, and ultimately as high as $110.5 billion in the 4th quarter of 2014, but since has cut debt down to $93 billion as of June 30, 2016.
|TTM cash from ops||TTM free cash flow|
|Q2 '16||$32.9 bl||$15.9 bl|
|Q1 '16||$36.2 bl||$18.4 bl|
|Q4 '15||$38.9 bl||$21.1 bl|
|Q3 '15||$35.9 bl||$19.3 bl|
|Q2 '15||$34.7 bl||$18.3 bl|
Source: Internal spreadsheet from 10-Qs and earnings reports
Verizon's dividend as a percentage of free cash flow has risen from the 30% area in 2013 to being between 50-60% as of 2016.
Unlike the payout ratio, which I think is pretty much useless, since it combines a financial accounting derivative, i.e. earnings per share or EPS, with a hard cash number like the dividend to be paid annually, ultimately what matters is the total dividend dollars as a percentage of free cash flow over time, since it is free cash flow and its stability and health that determines the amount and any change in the dividend.
The longer term: Both T and VZ have added significant amounts of long-term debt over the last 3-5 years.
AT&T levered the balance sheet even further from $72 billion in l-t debt as of June 2013 to $117 billion as of June '16. Verizon levered their balance sheet from $42 billion in June '13 to $93 billion as of June '16.
What this means from a shareholder's perspective is that both telco giants are now faced with choosing between repurchasing stock or paying down debt when it comes to evaluating each company's capitalization,
T's total debt to capitalization is just 30% as of June '16 while Verizon's is 40%.
In terms of maturity schedules, both companies have the lion's share of the outstanding debt maturing after 2030.
|'18 est EPS gro rate||6%||2%|
|'17 est EPS gro rate||6%||4%|
|'16 est EPS gro rate||5%||-3%|
|'18 est rev gro rt||2%||0%|
|'17 est rev gro rt||3%||1%|
|'16 est rev gro rt||10%||-4%|
|Price to cash-flow||7(x)||7(x)|
|Price to free-cash-flow||16(x)||14(x)|
|Current dividend yield|| |
|Capex as % of cash-from-operations||50% ish||50% ish|
|Div as % of free-cash-flow||60% ish||40%-55%|
So what does it all mean? What has worried me over the years is the capital intensity of T's landline business and the capex requirements that segment requires, but when you look at the Statement of Cash Flows, both T and VZ have more in common than you might think. Still I think telco is ultimately a "cost-cutting" and expense reduction game, with mature businesses and levered balance sheets.
In terms of valuation, T has the slight edge today, with the acquisition of DirecTV, since it has boosted near-term growth, but DTV must continue to generate free cash flow for the telco giant.
T has a stated goal of $20 bl in free cash flow by 2020, which is a 25% increase from June '16's TTM free cash flow but T has hit this target before in late 2012, early 2013, so basically, T in 2020 will be back to free cash flow generation 7-8 years prior.
Morningstar has an intrinsic value on T of $36 per share, which puts the stock at a 25% premium to that valuation, while Morningstar's Verizon fair value estimate is $50.
Conclusion: While both stocks are technically oversold in the short term, there is plenty to worry about over the longer term. Both T and VZ are technology companies with the capex and fixed-cost base of old-school industrial giants. I also think a lot of "yield-chasing" means that there are weaker hands in both stocks that could disappear quickly if interest rates should ever rise to the point there is some sort of normalization returned to fixed-income markets.
That being said, the dividend yields are enticing, and both telco giant's dividends are safe. Don't expect much in terms of share repurchases by both companies since it looks like both companies want to reduce that long-term debt that has been added in the last 5 years.
AT&T becomes very attractive at $36, while Verizon gets very interesting at $46.
I'm giving the slight edge to T given the integration of DirecTV and the better free cash flow generation that will show up this year. The iPhone 7 launch matters. It could boost both stocks through year-end 2016.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in T, VZ over 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.