# AT&T's Lowered Return On Equity Is Due To Lower Profit Margins

## Summary

Return on equity has decreased due to a decreasing profit margin.

The equity multiplier decreased due to an increase in retained earnings.

AT&T's return on equity is primarily due to having a high equity multiplier value.

Most investors take a look at return on equity as a measure of how well a company is doing with respect to net income as a ratio to shareholders equity on the balance sheet. Companies such as IBM (NYSE:IBM), Boeing (NYSE:BA), or Altria (NYSE:MO) even have huge returns on equity. Typically a high return on equity value is pretty nice to have, but not all returns on equity are equal.

Although it is a straight ratio as suggested, it is a bit more complex than that. Not many investors know this, but return on equity can actually be decomposed into three parts, made popular by DuPont (NYSE:DD) back in the 1920s. The decomposition of return on equity tells us three things:

1. Operating efficiency, which is measured by profit margin
2. Asset use efficiency, which is measured by total asset turnover
3. Financial leverage, which is measured by the equity multiplier

Prepare yourself for some algebra; I promise it will be pretty easy. We already know that profit margins are dictated by the equation of profit/sales. Total asset turnover is dictated by the equation of sales/assets and the equity multiplier is dictated by the equation of assets/equity. So when we multiply them all together we get the following proof:

 Profit * Sales * Assets = Profit = ROE Sales Assets Equity Equity

I for one am looking at return on equity in a much different manner now after learning this method. The part of the proof above that got me to investigate ROE more intently is the equity multiplier portion. Depending on how a company chooses to finance its assets (by debt or by equity), the equity multiplier can be really huge, causing the overall return on equity to be high. Personally I don't like a whole lot of debt on the balance sheet. But for capital structuring reasons debt can be used as a tax shield as taxes are calculated after interest payments.

I've chosen to evaluate AT&T Inc. (NYSE:T) today because since I've been writing about the company about a year ago, the return on equity has been declining. For the past year that I've been looking at the stock it has had the return on equity profile depicted in the table below.

 Article Date ROE (%) 13Feb14 20.8 28Jun14 20.6 01Aug14 19.9 24Nov14 18.7

Operating Efficiency

As mentioned earlier, operating efficiency is the profit divided by the sales. This in essence tells us how efficiently the company is operating from an operations, financial, and tax perspective. From the table below we see that the profit margin decreased by 70 basis points or 5.11% for AT&T from the second quarter to the third quarter. We see that net income has decreased and sales increased over the period. Nonetheless, profit margins decreased which partially explains the decrease in ROE. In AT&T's case approximately \$0.13 are generated in net income for every dollar in sales.

 3Q14 2Q14 Change Average Net Income (NYSE:TTM) \$4,279 \$4,482 -4.53% Average Sales \$32,793 \$32,593 0.61% Profit Margin 13.05% 13.75% -5.11%

Total Asset Turnover

From the equation I showed above, the total asset turnover ratio is defined by sales divided by assets. Total asset turnover gives us the big picture of how well the company is transforming all of its assets into sales. From the table below we see that the total asset turnover actually decreased from the second quarter to the third quarter. Total revenues increased slightly while average assets increased at a higher clip. This portion of the equation tells us that the ROE decrease is slightly related to the decreasing total asset turnover.

 3Q14 2Q14 Change Revenues \$131,171 \$130,372 0.61% Average Assets \$286,133 \$282,798 1.18% Total Asset Turnover 0.46 0.46 -0.56%

Equity Multiplier

The equity multiplier is the part of the ROE equation that I don't like. It's with this portion of the equation that a company can choose to get risky or play it safe. It completely depends on how the company manages its debt, equity, and on how well the cash flows are coming in to pay those debts. From the previous portions of the equation we pretty much determined that the ROE has decreased thanks to the profit margin primarily. An equity multiplier number of 3.12 is a little more than I like for my taste.

But it isn't until we break it out like I did in the table below that we can see if it is a good thing or a bad thing. As we can see assets have increased and equity has increased at a higher clip, causing the equity multiplier to decrease by 0.64%.

 3Q14 2Q14 Change Average Assets \$286,133 \$282,798 1.18% Average Equity \$91,660 \$89,935 1.92% Equity Multiplier 3.12 3.14 -0.64%

If we dig a little further we see that the equity value increased primarily because of an increase in retained earnings over the past year, which is a good problem to have.

 Equity Make-up 3Q14 2Q14 1Q14 4Q13 Common stock \$6,495 \$6,495 \$6,495 \$6,495 Additional paid-in capital \$91,064 \$91,057 \$91,027 \$91,091 Retained earnings \$34,165 \$33,554 \$32,402 \$31,141 Treasury stock -\$47,037 -\$46,825 -\$46,684 -\$45,619 Accumulated other comprehensive income \$7,926 \$7,851 \$7,666 \$7,880 Total stockholders' equity \$92,613 \$92,132 \$90,906 \$90,988

In Other News

Recently the FCC has been taking jabs at the company with respect to the company's halted investments in fiber due to remarks made by the CEO in mid November, but the company has reassured the halted investments are only related to new projects and not ones that are already in progress. Overall the company plans to spend about 14% less on capex projects during 2015 than what was spent on 2014 and this is something I don't mind as I'd like to see increased retained earnings to increase the dividend at a higher clip than the traditional 2.4% over the past five years.

Conclusion

AT&T has been stuck in neutral for the past year and every time I look to get out of it I seem to be staying in it because the dividend is just too juicy. But from what I pointed out in this article, not all returns on equity are created equal and in this case AT&T's return on equity is decreasing. It is primarily decreasing because of lower profit margins. When you multiply all the numbers together you get an ROE of 18.66%. This ROE makes AT&T the 9th highest in the Telecom Services - Domestic industry (out of 19 companies). I'd like to see AT&T increase its profit margins a bit more right now which will eventually increase retained earnings, and increase the ROE or the dividend payout.