A little while back, I wrote an experimental article on what I termed my "FCF 5" tests. These were five tests of a company's free cash flow.*
After some very helpful comments from readers^, I have adjusted this a little. As with the last one, however, it remains experimental, so please feel free to contribute suggestions in the comments section below. They would be greatly appreciated.
AT&T is fairly evenly split in its revenues between wireless and wireline businesses. Its wireless segment controls about a third of the entire U.S. wireless market (Verizon (NYSE:VZ), its largest rival who I review elsewhere, holds another third). It is, therefore, a dominant force in the U.S. telecom and media segment
AT&T has invested heavily in its infrastructure of late and recently purchased DIRECTV, opening up new opportunities. For over 30 years, it has quietly but efficiently provided investors with a growing dividend, marking it as one of the small number of dividend aristocrats.
But how does this dividend aristocrat fare against my Five FCF tests? Let's take a look.
CROIC: Cash Return on Invested Capital
My FCF tests open with the CROIC, or Cash return on Invested Capital. Closely related to the more familiar ROIC, this involves dividing the FCF by the sum of the long-term debt and equity of the business.
My general target is for a company to consistently hit a CROIC of 10% or more. In other words, I want the business to consistently return at least $0.10 in cash for every $1 of capital invested.
So how does AT&T do on this front? Not bad, but it does fall short:
Over the last five years, it has averaged a CROIC of 8.76%. That is (with a little rounding) $0.09 of cash returned for every $1 invested. Not bad, but clearly falls short of my $0.10 target.
AT&T has to be said to have (narrowly) FAILED this first FCF test.
EV/FCF: Enterprise Value to Free Cash Flow
Next, I turn to the EV/FCF valuation. This I use in place of the more familiar P/E multiple. Rather than relying on the more easily gamed share price and earnings per share metrics this gives us a better indication of the underlying value of the business and its cash-generation abilities.
Here I have a fairly simple target. All I look for is an EV/FCF value of 22 or less. Highly cash-generative businesses often attract higher valuation. A target of 22 allows for this whilst also keeping a lid on accepting excessive valuations.
Currently, my calculations suggest that AT&T trades on an EV/FCF value of 24.8. Clearly, this is just above my target figure.
However, I also like to take into account future FCF figures in this valuation. This I do for the next two years by taking the predicted sales/revenue figures for the company over the next two financial years and multiplying this by the average of two FCF/Sales ratio figures:
- The average FCF/Sales ratio from the last five years.
- The FCF/Sales ratio for the last financial year.
For AT&T, these are:
This gives us a value of 9.6%. Combining this with the revenue predictions for the next two years, we have estimated FCF figures like this:
Now this would suggest that FCF should be seen growing over the next couple of years. So what EV/FCF figure does that produce for the next couple of years? Well these:
This would suggest that the average EV/FCF multiple over the next two years should sit around the 19.3 mark. This is below my target of 22. I therefore count this as a PASS.
FCF to Debt
This is another important metric. Debt considerations are included in the above metrics. But stripping out debt specifically for analysis is also important.
AT&T, like many of its telecom peers, carries quite a significant amount of debt. In fact, its debt to equity ratio sits at around 74%.
Nonetheless, the thing that concerns me here is the FCF coverage of this debt. My general rule of thumb is that the FCF/Debt ratio is around 25% or more. In theory, this would mean that a company could repay the entirety of its debt load in four years just by using its FCF. In practice, this would be unlikely to occur. However, it does indicate the ability of the company to handle its debt load.
So what about AT&T? Over the last five years, its FCF/Debt ratio has averaged 21%. That is, of course, moderately below my target. This becomes more pronounced when looked at from a yearly perspective:
In recent years, AT&T has seen its FCF/Debt ratio drop fairly dramatically. During FY 2014, it sat at a lowly 12.3% - half my target.
This I have to mark down as a FAIL from AT&T.
Finally, we come to the dividend! What I analyze here is the FCF yield. That is, what would the yield be for the company, if it paid out all of its FCF as a dividend. My target here is 3.5% or more.
I also want to see a current FCF payout ratio that is sustainable. As a result, I want to see an FCF payout ratio of 75% or less.
So how does AT&T fare here? A mixed bag again:
Certainly, with an FCF yield of 5.68%, it easily sails past my 3.5% target. However, with a current payout ratio over 94%, it sadly fails on this front.
Now, assuming that my FCF predictions above are near the truth, we would see coverage heading back to a healthier sub-60% point in both of the next two years.
With AT&T's more modest FCF guidance in August 2015 of $13 billion, this would see coverage of the anticipated $1.88 dividend at almost exactly 75%.
I therefore feel I have to give AT&T a rather tentative PASS.
FCF Fair Value
So what about the fair value for AT&T? As you'd expect, I plan to use an FCF metric to assess this. On this occasion, I am going to roughly calculate the average EV/FCF valuation for the company over the last five years:
In AT&T's case, averaging these financial year-end EV/FCF figures, I come to a historic average of 16.9.
I then use this figure to multiply the average FCF per share derived by using that of the FCF per share in the last financial year and those predicted over the next two years. Doing so provides us with an FCF fair value price of $36.72.
With a current share price around the $34.40 mark at present, this would suggest that AT&T is currently a little undervalued compared to its historic valuation.
I therefore give AT&T another PASS.
AT&T presents us with a fairly mixed bag from the perspective of the FCF 5 tests. It passed three and failed two of the tests. However, none of these marks were convincing either way. The passes were as close to being fails as the fails were to being passes.
AT&T is a high-quality company with an attractive yield. It also appears to be trading a little under its fair value. I'd find it hard - despite its surprisingly high fail rate - to argue against buying into it today.
Nonetheless, patient investors may wish to wait until the FY 2015 results at the end of this month, which may push AT&T's grades higher. I'll take the time soon after to re-run these tests to see whether AT&T can make a more confident move towards either passing or failing the FCF tests I put to it.
* In this article, I use free cash flow as calculated by subtracting capital expenditure from operating cash flow.
Unless otherwise stated, all graphs and tables and the calculations contained within them were created by the author. Creative Commons image reproduced from Flickr user jeepersmedia.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.