We previously published an article analyzing AT&T's (T) recent financial performance. We are aware of how the telecom industry's legacy wireline business is in a mature and declining industry phase, and we are starting to see signs of maturity from the wireless communications segment as well. Signs of maturity we are seeing from the wireless communications segment include decelerating revenue growth, reduced numbers of new subscribers, and year-over-year reductions in capital expenditures. While this may not be the kind of news that growth investors who are primarily seeking capital appreciation want to hear, this is great news for income-oriented investors. That's because we expect such trends to prompt companies to increase the proportion of free cash flows returned to investors in the form of dividends and share repurchases.
We saw this with AT&T this year as it has made $4.25 billion worth of net share repurchases in the first six months of 2012, whereas last year it was saving its cash in order to help finance the proposed $39 billion cash acquisition of T-Mobile USA from Deutsch Telekom. We then followed up our first article with our evaluation as to why AT&T and other telecom companies are reliable dividend payers. In this article, we will provide further detail on AT&T's wherewithal to pay dividends.
AT&T's Dividends and Its Debt Position
With $64.5 billion in outstanding debt as of Q2 2012, AT&T is most certainly not debt-free. However, we are more than aware of the fact that AT&T is a large, industry leading blue-chip telecom services firm and is certainly able to access the capital markets for whatever debt or equity it requires. AT&T paid $1.8 billion in interest expenses in the first half of 2012 on its $64.5 billion in outstanding debt for a weighted average cost of 5.58%. While AT&T may not be confused with a growth engine, we believe that the free cash flows generated by AT&T can be utilized at a rate of return well in excess of the 5.58% pre-tax (3.35% post-tax) cost of debt financing that AT&T utilizes.
If AT&T can't find investment opportunities that provide a return in excess of 5.58% pre-tax, it should be returning that cash to shareholders in the form of dividends and repurchases. Plus, if AT&T wanted to devote all of its operating cash flows to paying down debt (at the expense of reinvesting in its network or returning excess cash flows to investors), it could pay it off completely in less than two years due to its ability to generate $34 billion in operating cash flows annually since it acquired BellSouth. We can conclude that AT&T generates enough cash based on its $34 billion in operating cash flows to service its outstanding indebtedness and to continue returning cash to shareholders through dividends and share repurchases.
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AT&T's Dividends and Its Free Cash Flows
AT&T generates an average of $34 billion in operating cash flows annually and spends between $17 billion and $20 billion annually on capital expenditures. This results in annual free cash flows of between $14 billion to $17 billion, which can be returned to capital stakeholders in the form of debt redemptions, share repurchases, and dividends. In the past 12 months, AT&T generated nearly $16 billion of free cash flows and paid $10.3 billion in dividends to shareholders. We can see that AT&T's trailing 12 months free cash flows exceeded its dividend payments in the same period by 53%, and AT&T still had $5.5 billion remaining to use for dividends and share repurchases during this time period.
AT&T also repurchased $4.25 billion in net share repurchases during this time period. We also noticed that AT&T had reduced its YTD 2012 capital expenditures by 7% vs. YTD 2011 levels, and we believe that AT&T Mobility's decelerating growth rates will result in AT&T's capex budget remaining flat regardless of how AT&T doth protest about its low levels of network capacity.
AT&T's Dividends and Its (Equity) Capital Position
AT&T generates an average of $14 billion to $17 billion annually in free cash flows and also pays about $3.6 billion estimated annualized bond interest expense. The company has $64.5 billion in outstanding debt and $103.5 billion in book value shareholders' equity. Part of this book value is heavily influenced by the $69.76 billion worth of goodwill on AT&T's balance sheet. We can see that AT&T generates a pre-tax return on invested capital of between 10.5% and 12.2% annually.
On a tangible capital basis (which excludes the $69.8 billion in goodwill on AT&T's balance sheet), AT&T is able to generate a pre-tax return on tangible invested capital of 17.9%-20.9%. We can see that AT&T has a solid capital base and generates adequate returns on invested capital in order to pay bond interest, dividends, and net share repurchases. We expect that if the company cannot earn double-digit returns on invested capital with regard to its free cash flows, it is duty-bound to return the excess cash flows to shareholders through dividends and share repurchases. Otherwise, it is likely to blow $4 billion by bidding for broken-growth companies like T-Mobile USA.
AT&T's Dividend Yield Relative to S&P 500 and Barclays U.S. Aggregate
While AT&T's dividend yield of 4.7% is much lower than the 6% it saw in January; we can see that it certainly exceeds the 2% dividend yield of the S&P 500. Part of the reason why AT&T's dividend yield has moved down this year is because of the demand for any little bit of income from high-quality investments on the part of investors. AT&T's dividend yield of 4.7% also significantly exceeds the 2.5% annual yield on the iShares Barclays (U.S.) Aggregate Bond Exchange Traded Fund (AGG). While an equity investment in AT&T carries more ostensible risk than investing in bonds, we believe that an investment in AT&T offers a superior risk-adjusted and tax-adjusted return prospect than the Barclays Aggregate ETF.
With regard to taxes, investors outside of tax-advantaged investments accounts only have to pay a maximum tax rate of 15% on their dividends from AT&T or the S&P 500 vs. ordinary income tax rates of up to 35% on their interest income distributions from the Barclays Aggregate ETF. Plus, we believe that the Barclays Aggregate ETF carries significant interest rate risk due to the rapidly increasing national debt. We are well aware that the Federal Reserve is holding down interest rates with its monetary easing program. However, even notable investors like Bill Gross have tried their hand at shorting T-bonds. While we cannot predict a tipping point for if and/or when interest rates will increase, we believe that 2.5% is too low a return prospect, especially when it is subject to ordinary income tax rates.
In conclusion, we can't argue with yield-hungry investors who have a long position in AT&T. While AT&T is not our first choice with regard to investing in the telecom sector, we are more than aware that it is an industry leader in this industry. We can see that AT&T is able to generate a return on equity well in excess of its direct cost of debt capital and its indirect cost of equity capital, and because its wireless communications business is now seeing the deceleration to growth that has already hit its old, traditional wireline business, we believe that the company will continue to pay a dividend yield that is well above what the S&P 500 pays.
The new AT&T and its predecessor SBC have been paying dividends since 1984, and have steadily increased the split-adjusted dividend in that time. Based on the low interest rates on bonds, as well as the risk of interest rates increasing once the Federal Reserve ends its ridiculous monetary easing programs, we believe that AT&T offers a better risk/return prospect for income-oriented investors vs. typical high-grade bonds.
Source: AT&T/SBC dividend history.
Disclaimer: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.