From industry-wide consolidation efforts to high capital expenditures, the communications industry is at an inflection point that will create winners and losers. Sprint (S), as I have explained here, is likely to fall in the latter camp. In this article, I will run you through my DCF analysis on AT&T (T) and then, to increase confidence, compare it to the fundamentals of Verizon (VZ) and Sprint.
I find that investors should consider smaller firms with excellent risk/reward, like IDT Corporation (IDT) and Cbeyond (CBEY). As the Street picks up on the solid fundamentals of the two firms, takeover activity may follow. For now, however, we will just review the bigger players. According to T1 Banker, AT&T is preferred over Verizon and Sprint.
First, let's begin with an assumption about revenues. AT&T ended FY2012 with $126.7B in revenue, which represented a 2% gain off of the preceding year. Analysts model a 7.6% per annum growth rate over the next five years, but I find this sentiment somewhat optimistic. But to keep the basic assumption in-line, I will model the same growth rate.
Moving onto the cost-side of the equation, there are several items to address: Operating expenses, taxes and capex. I model that cost of goods will trend slowly toward 46%, since that has been the general trend of late. I further model SG&A representing 28% of revenue - roughly around the historical three-year average. Capex is estimated the same way.
We then to need to subtract out net increases in working capital: We forecast accounts receivable as 11% of revenue and prepaid expenses as 3% of SG&A.
Taking a conservative perpetual growth rate of 1.5% and discounting backwards by a WACC of 9% yields a fair value figure of $34.94, implying 13.2% upside.
All of this falls under the context of disappointing fourth quarter results:
"2011 was a story of record mobile broadband sales and solid revenue gains. Revenues were up 2% for the year and 3.6% in the fourth quarter alone. Stronger-than-expected smartphone sales also impacted earnings and margins.
In the fourth quarter, we reported earnings per share of a negative $1.12. Excluding $1.54 of mainly non-cash onetime items, earnings per share for the fourth quarter was $0.42. One-time items included $0.65 of non-cash pressure from the year-end mark-to-market change for our benefit plans. The actuarial loss on benefit plans was driven by a reduction in the discount rate from 5.8% to 5.3%. While our investment returns were better than the overall market, they were less than our expectations but that was largely offset by better-than-expected force retention and medical cost management. $0.48 of the non-cash pressure is due to asset impairments in our yellow page and directory operations."
From a multiples perspective, the firm is slightly more attractive than Verizon. It trades at 12.1x forward earnings versus 13.8x for Verizon. It also has a 60 bps higher dividend yield at 5.8%. Verizon is likely to increasingly be the target of regulatory assaults as it pursues acquisitions, like AWS licenses. The firm already has more 4G spectrum then Sprint, AT&T and T-Mobile combined. Sprint is bleeding billions upon billions and has yielded disappointing net additions. Management is attempting to shift iDEV subs to CDMA, but this process has been doubted thus far.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.