With telecom undergoing consolidation despite regulatory challenges, the sector is likely to make winners and losers. Many are anticipating Sprint to be one of those "losers", which has set the bar very low. This struggling company actually has promising free cash flow potential above what the market appreciates. On the other hand, I believe that AT&T has the best risk/reward given its leading dividend yield, proven management, excellent expansion opportunities, and consistent growth.
AT&T trades at a respective 48.3x and 13.1x past and forward earnings. Consensus estimates for AT&T's EPS forecast that it will grow by 8.6% to $2.39 in 2012 and then by 7.5% and 7.8% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $2.54, the stock would hit $43.18 for around 30% upside.
Management remains aggressive in terms of increasing scale through takeover activity. Emerging market penetration remains a significant catalyst while a leading divined yield of 5.3% limits downside. AT&T has a stable and reliable business in terms of revenue growth. I rate the company a "strong buy".
Verizon trades at a respective 44.1x and 14.7x past and forward earnings. Consensus estimates for Verizon's EPS forecast that it will grow by 15.8% to $2.49 in 2012 and then by 11.6% and 11.2% in the following two years. Assuming a multiple of 17x and a conservative 2013 EPS of $2.76, the stock would hit $46.92 for 14.1% upside.
Verizon finished FY2011 with excellent performance. Management has further increased the dividend yield, which now stands at 4.9%. At the same time, the company is less than half as volatile as the broader market, which make Verizon a particularly safe investment. Accordingly, I recommend an investment for risk-averse income investors.
Sprint is currently bleeding money and in a highly precarious position. With that said, this has set the bar low for high risk-adjusted returns. To value, Sprint, I employ a DCF model. Based on my assumptions of (1) 6.3% per annum revenue growth over the next half decade, (2) operating metrics staying at historical levels, (3) a perpetual growth rate of 2.5%, and (4) a discount rate of 12%, I find that the stock may hit $7.50 - virtually tripling.
While my predictions for high returns stand in contrast to the bearish sentiment of many investors, free cash flow appears to be better than what the market acknowledges. Revealingly, two years worth of free cash flow in FY2013 and FY2014, by my estimates, will exceed market value. The company is now in its second phase of it turnaround efforts and thus carries significant risk.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.