Originally published Oct. 12, 2016
By Ben Reynolds
AT&T (NYSE:T) is the only Dividend Aristocrat in the telecom sector.
What does it take to be a Dividend Aristocrat?
- Be in the S&P 500
- Meet minimum size/liquidity requirements
- 25+ Years of consecutive dividend increases
Growing dividend payments every year for 25+ consecutive years takes a strong and durable competitive advantage. That's likely why the Dividend Aristocrats Index has performed so well.
- 10.3% CAGR over last decade for Dividend Aristocrats Index
- 7.2% CAGR over last decade for S&P 500
There are currently only 50 Dividend Aristocrat stocks. You can see all of the Dividend Aristocrats here.
AT&T stands out even among the Dividend Aristocrats. It is the only telecom Dividend Aristocrat. It also has an unusually high dividend yield of 4.9%.
The company has paid increasing dividends for 32 consecutive years. The company is widely expected to announce another increase in mid-December of 2016. You can see AT&T's quarterly dividend history since 1984 below.
One of the common misconceptions about dividend stocks is that they provide below average returns in exchange for current income. AT&T has slightly outperformed the market over the last decade (including dividends). The image below shows this performance.
We know AT&T is a high quality business with a strong competitive advantage that has rewarded investors with competitive returns and high dividends over the last decade. This article takes an in depth look into the investment prospects of AT&T.
AT&T can trace its corporate history back to the invention of the telephone. The company was founded in 1875 by Alexander Graham Bell, Gardiner Hubbard, and Thomas Sanders.
The Bell System became the American telephone monopoly. The monopoly was broken up into 8 companies in 1984 by the Department of Justice.
Today, AT&T is the largest wireless carrier in the United States based on its $242 billion market cap. The company is the 11th largest publicly traded corporation in the United States based on market cap.
AT&T divides its operations into 4 segments. The percent of total EBITDA each segment generated in the company's latest quarter is shown below.
- Business Solutions generated 50% of EBITDA
- Entertainment Group generated 23% of EBITDA
- Consumer Mobility generated 26% of EBITDA
- International generated 1% of EBITDA
The Business Solutions segment controls the company's business wireless, data, and legacy voice businesses. 55% of the segment's revenue comes from wireless revenues.
The Entertainment Group segment contains the company's video/ad sales, IP voice/data, and other legacy businesses. 70% of the segment's revenue comes from video/ad sales.
The Consumer Mobility segment controls the company's United States wireless revenue.
The International segment is comprised of AT&T's recent investments in Mexico and DirecTV Latin America.
AT&T has grown earnings-per-share at 4.6% a year over the last decade. Dividends have grown at 3.8% a year over the same period.
AT&T actually posted record earnings-per-share highs in 2007 of $2.76. The company is expected to eclipse this number in 2016. Still, growth has been sluggish over the last several years.
Part of the company's fairly weak growth is the result of changes in the telecommunications industry. Wireless revenue has grown rapidly - while traditional wireline revenue has fallen significantly. Changes in the industry force AT&T to reinvent itself.
The company is spending heavily on acquisitions to grow going forward. AT&T's large acquisitions over the last few years are shown below:
The company's growth plans center around expansion into Mexico (and Latin America with DirecTV), and media growth which will increase advertising revenue.
The company's geographic expansion into Mexico makes sense. It is the next logical growth step for the company geographically, outside of the United States. The International segment is still in its infancy, generating just 1% of EBITDA for the company.
Continued synergies from both cross-selling and cost reductions should help AT&T grow a bit faster over the next several years than it has over the last decade.
AT&T's management is expecting long-term earnings-per-share growth of around 4% to 6% a year. This is in line with 10 year numbers - and a bit higher at the median. The company' growth expectations appear reasonably, however.
Competitive Advantage & Recession Performance
A business cannot grow its dividends for 32 (soon to be 33) consecutive years without a strong and durable competitive advantage.
Bell's monopoly was broken in 1984. But the wireless industry today is the next best thing (for investors) - an oligopoly.
The United States wireless telecommunications market is dominated by the following 4 companies:
Together, these 4 companies have greater than 90% market share. AT&T and Verizon are the two largest players. Both have greater than 30% market share.
The wireless industry is so concentrated because there are sizeable and significant barriers to entry into the industry.
- Up-front costs of building infrastructure
- Wireless spectrum usage costs
- Scale advantages
- Brand recognition
AT&T benefits from all of these. The company has a strong and durable competitive advantage.
To give an idea of the amount of cash required to compete in wireless spectrum usage, wireless spectrum auctions regularly raise $30 to $40 billion, with the bulk of that paid by the largest players (AT&T and Verizon).
Costly spectrum auctions make it impossible for businesses without massive capital to take part in the industry.
The telecommunications industry is closely tied to the government, for better or worse. This results in intense lobbying. AT&T is one of the country's biggest spenders on lobbying.
This should appeal to shareholders, as some studies show lobbying spending has one of the highest ROIs of any investment. The ethics of lobbying is left to the reader's discretion. The image below shows AT&T's lobbying spending by year:
Click to enlarge
Source: Open Secrets
AT&T's strong competitive advantage helps to insulate profits from recessions. The company typically locks consumers and businesses into long-term contracts which create smooth, utility like cash flows.
The company's cash flows per share through the Great Recession are shown below:
- 2007 Cash flows per share of $5.36
- 2008 Cash flows per share of $5.56
- 2009 Cash flows per share of $5.46
As you can see, the recession barely dented the company's stable (but slowly growing) cash flows per share. AT&T maintains a reasonable payout ratio of around 70% of earnings. This is prudent given the company's stable cash flows.
Valuation & Expected Total Returns
AT&T stock is currently trading for an adjusted price-to-earnings multiple of 14.1. There are two ways to value AT&T.
- Relative to today's elevated valuation
- Relative to the S&P 500's historical average valuation
AT&T has traded for a 0.75x multiple to the S&P 500's price-to-earnings ratio over the last decade, on average.
The S&P 500 is currently trading for a price-to-earnings ratio of 24.8. This implies a fair price-to-earnings ratio of 18.6 for AT&T. Based on current market levels, AT&T appears undervalued.
Based on the S&P 500's historical average price-to-earnings ratio of 15.6, AT&T should trade for a price-to-earnings ratio of 11.7.
If you factor in interest rates, the S&P 500 is trading around what one would expect for fair value. Of course, interest rates are widely expected to rise somewhat over the next several years.
Let's look at 2 scenarios:
Scenario 1: In 5 years, the S&P 500 is still trading for a 24.8 price-to-earnings multiple, and AT&T has 'caught up' to its historical average 0.75x multiple to the market. This would boost returns by 5.7 percentage points a year.
Scenario 2: Interest rates rise, and the S&P 500 goes into a recession. Five years from now, the S&P 500 is at its historical average price-to-earnings ratio of 15.6. AT&T follows suite and trades for a price-to-earnings ratio of 11.7 (0.75x the S&P 500's). This would drag down returns by 3.7 percentage points a year.
I expected earnings-per-share growth of 4% to 6% a year from AT&T (as discussed in the growth section of this article). The company is currently yielding nearly 5%. This gives expected total returns of 9% to 11% before changes in the valuation multiple.
Using 'scenario 1', this implies expected total returns of 14.7% to 16.7% a year. Using 'scenario 2', this implies total returns of 5.3% to 7.3% a year.
Of course, there are a near infinite number of valuation multiple scenarios that could play out over the next several years. At current prices, AT&T looks undervalued relative to the market today.
AT&T is a high yielding dividend growth stock with a strong competitive advantage. The company has an above average rank using The 8 Rules of Dividend Investing due to its strong yield, lower than average volatility, and reasonable price-to-earnings ratio.
AT&T will likely make a good addition to conservative income investor accounts looking for stable dividend income that grows in excess of inflation.