3 Reasons To Buy AT&T And Its 6.5% Yield

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About: AT&T Inc. (T), Includes: VZ
by: Michael Henage

Summary

If this quarter for AT&T was disappointing, maybe the word has a different definition than I'm aware of.

AT&T's plan to handle its over $170 billion in debt could be a reason to buy the stock.

WarnerMedia seems intent to take on Netflix, Hulu, and Disney's new service all at the same time.

It’s astounding the number of times I’ll read a headline about some company’s earnings, then look at the earnings report and get a completely different take. AT&T (NYSE: T) seems to be going through such a phase. Immediately following the company’s most recent earnings report, investors were left with significant doom and gloom and not much else. When a stock with a yield of roughly 6.5% might be misunderstood, there could be significant opportunity. If we dig into the company’s earnings, there are actually at least 3 reasons to consider buying the shares.

“A disappointing third quarter earnings report”

The first reason to consider buying AT&T shares, is the company’s last earnings report seems to be somewhat misunderstood. One of my favorite headlines said AT&T had, “a disappointing third quarter earnings report.” Another comment lamented, “it looks like the $240 billion conglomerate may have spread itself too thin.” It’s interesting that this quarter would be considered disappointing if we break down how AT&T did compared to Verizon (NYSE: VZ).

Since AT&T and Verizon go toe-to-toe for wireless customers, it makes sense to start with these divisions to see how AT&T stacks up.

Metric

AT&T

Verizon

Wireless Revenue

+3.3%

+6.5%

Wireless Service Revenue

-3.4%

+2.6%

Wireless Equipment Revenue

+19%

+23%

Postpaid churn

1.17%

1.04%

(Source: Verizon 10-Q and AT&T 10-Q)

I realize that AT&T’s numbers don’t match Verizon, but let’s be honest, they aren’t that far off. AT&T is growing overall wireless revenue based on the strength of equipment upgrades.

Mobility is one of AT&T’s biggest businesses, but is the company’s acquisition of Time Warner dragging on results as some headlines would suggest? Looking beyond AT&T Mobility, the company’s cash flow tells a story that is being largely ignored. An easy to way to compare companies in the same industry is by looking at what I call core free cash flow. Net income plus depreciation and amortization, and then subtracting capital expenditures, strips away many of the accounting adjustments that are non-cash.

If we compare AT&T and Verizon’s core free cash flow and compare it to revenue, we get how much free cash flow each company generates from each dollar of revenue. Over the last nine months, Verizon generated $0.15 of core free cash flow per $1 of revenue. In the same time frame, the “stretched thin” AT&T produced the same $0.15 per $1 of revenue.

Though AT&T is generating free cash flow at the same level as its peer, when it comes to operating cash flow, AT&T holds the superior position. With a quarter that caused, “the stock’s worst day in over 16 years” you wouldn’t think there was any good news. However, AT&T’s operating cash flow jumped by more than 22% annually, compared to an increase at Verizon of 11%. It’s hard to reconcile how a company that is doing so poorly could produce such strong cash flow growth. The disconnection between reports and reality is a key to the opportunity in the stock.

$174 billion reasons to worry

It may sound strange to suggest that a company’s massive debt is also a reason to buy the stock. However, AT&T’s $174 billion in net long-term debt presents an opportunity. More specifically, AT&T’s plan to pay down its debt is the second reason to consider buying the stock.

AT&T’s long-term debt is no secret, and the company is making sure that investors are well informed about how it plans to handle this issue. Many companies discuss their long-term debt as a ratio related to EBITDA. This makes sense, as many financing institutions use the same ratio to determine the level of risk the debt should carry. Since higher risk normally means higher interest rates, it’s critically important for companies to manage down this ratio.

AT&T’s CEO John Donovan said the company plans to get to a ratio of 2.9 times by the end of this year. He further suggested the company want to drop the ratio, “by the end of next year to the 2.5 times range.” We’ve already seen that AT&T is growing its operating cash flow, so it makes sense the company wants to put this increased cash flow to good use.

AT&T and Verizon are both determined to pay down debt and actively working to achieve this goal. Verizon’s net long-term debt declined by 4% annually. In the last nine months, Verizon used just over $7 billion to cover its dividend payments. The company generated enough free cash flow to pay dividends and still had nearly $8 billion in cash flow left over.

Looking at AT&T’s position, in the last nine months, the company spent nearly $10 billion in dividends, yet still had another $8 billion left over in free cash flow. This would seem to suggest, even with no cash flow growth, the company can do nearly $1 billion in free cash flow over and above dividends each month.

If AT&T put all its extra free cash flow toward debt repayment, and it seems like that’s the plan, net long-term debt would fall by nearly 7% per year. In addition, AT&T is looking to turn some of its other assets into cash to further attack its debt. The CEO said, “we also continue to look for ways to monetize our large asset portfolio.”

This wasn’t just an idle comment, as the company further said, “we’ve identified billions of dollars of other assets where we can do more.” The comment was an expansion on AT&T’s sale of its data center locations to Brookfield Infrastructure for $1.1 billion. AT&T’s own cash flow is enough to make a serious dent in the company’s debt. Any action to monetize assets, will just move the needle that much more quickly.

Genre defining programming

It seems like virtually every company with a catalog of shows wants to launch a streaming video service. From the outset of the AT&T and Time Warner deal, a streaming service was at the forefront. This brings us to the third reason investors need to consider buying AT&T. With classic shows like ER, to current hits like The Big Bang Theory, and iconic channels like HBO, the new AT&T has a lot to work with launching its own streaming business.

According to AT&T, the company’s WarnerMedia streaming service that is coming in 2019 will offer “genre defining programming that viewers crave.” What makes this service interesting to watch (pun intended), is the company already offers multiple streaming services that could meld into one. HBO Now is $15 a month, DC Universe costs $9 a month, and Watch TV costs $15 a month. If one customer subscribed to all these services, they would spend nearly $40 a month.

WarnerMedia seems to be ready to give Netflix and other streaming services a run for their money. The division’s CEO John Stankey said, “Our service will start with HBO… On top of that we will package content from Turner and Warner Bros.” In what seems to be a direct shot at Disney, Stankey went on to say, “What’s important to understand is that ours is a unified offering – we’re not expecting people to buy three different pieces.”

For investors wondering if WarnerMedia is going to go all in on its own service, the company was very clear on this point as well. AT&T said, “a quarter of the WarnerMedia library licensed to other streaming services comes up for renewal every year.” The bottom line is what’s good news for WarnerMedia is bad news for other services.

The bottom line

AT&T offers investors a significant yield of 6.5% and the company seems to be misunderstood. The most recent quarter, which was deemed as “disappointing,” didn’t appear to play out in this manner. AT&T grew wireless revenue and grew operating cash flow, and relative free cash flow matched Verizon.

AT&T gave investors a very clear picture of how it expected to pay down its debt. This plan should lower the company’s interest cost and risk in the future. AT&T plans to use its cash flow and asset sales in order to get its proverbial house in order.

For those who wonder how AT&T will monetize its acquisition of Time Warner, a unified streaming offering seems like a significant step. WarnerMedia seems intent on pulling its offerings from other services, while feeding its own business. Long-term investors are being given multiple reasons to buy the stock, and surprisingly the 6.5% yield is just the icing on the cake. Actually, the yield is like an entire additional cake on top of the cake. Long-term investors with a sweet tooth for income should take a bite.

Disclosure: I am/we are long VZ.

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.