Despite ambitious moves by AT&T (T) to position itself as a dominant player in the digital space as a provider and distributor of wireless connectivity and entertainment content, the stock has been repeatedly beaten down to near 52 week lows. The enormous debt load that AT&T has amassed has spooked the market in the light of rising interest rates, and highly publicized downfalls of other highly leveraged entities (see General Electric (GE)). While a high debt load is a reasonable cause for concern with any potential investment, AT&T's projected cash flow is sufficient to deleverage the balance sheet in a reasonable amount of time. Once this happens, earnings growth should begin to accelerate. The current price of just under $31 per share is an excellent opportunity to accumulate shares. With modest growth, AT&T is poised to deliver annual total returns of more than 20% over the next five years.
About The Debt...
AT&T took on a massive debt load in order to acquire DirecTV and Time Warner. To date, that debt pile stands at approximately $183 billion. This has left AT&T highly levered at 3.37X EBITDA. While the stock has been punished for taking this much debt on, the numbers won't look as bad in the near future. AT&T is a cash flow machine, generating gobs of cash from its stable mobile business. With Time Warner integrating into the business, management forecasted 2019 free cash flow at $26 billion at its recent analyst meeting.
The $26 billion FCF figure is a bit higher than the cash flow stream we have seen immediately post the merger. This sizable leap higher in the size of cash flows does a lot to dispel prior question marks I have had about the length of time it would take for management to get this debt under control. With the updated FCF outlook, the size of AT&T's cash "shovel" to dig itself out of debt grows to about $12 billion.
The updated timeline from management reflects the company operating at 2.5X EBITDA by the end of 2019. A leverage ratio of 2.5X exactly matches the ratio that I uses as my "warning sign" threshold. Given the excellent reliability of AT&T's cash flow, getting to this leverage ratio would essentially remove all concerns about the company's debt load and liquidity. The worst would be well past AT&T at that point.
As the debt comes down, the company's earnings growth and cash flow will improve as well. AT&T has paid approximately $7.77 billion in interest expenses over the TTM period (full year run rate post Time Warner is more than $8 billion). Given AT&T's float, this is stunting earnings per share by a full $1.19. As more debt is paid down, it will only unlock additional EPS growth.
About AT&T's New Growth Ventures...
It has been well known that the acquisition of Time Warner was the latest step in AT&T's massive transition from a telecom to a fully integrated data/content ecosystem. From once managing only the "pipes" that delivered data and content to customers, AT&T's transition gives the company extended competitive advantages in being able to leverage its complimentary assets to bring consumers value. This new model not only diversifies the business (mobile business now accounts for half of adjusted EBITDA), but unlocks options for innovation to fully take advantage of AT&T's integrated model.
We have already seen this some with AT&T's bundling of wireless services with DirecTV to win over customers (it worked for this guy). AT&T recently fleshed out its next step in this process by detailing its upcoming streaming service.
AT&T is launching its offering to the increasingly competitive streaming services market in late 2019. The service is multi-tiered, and will feature a collection of AT&T's newly owned intellectual property from HBO, tbs, TNT, Cartoon Network and Time Warner Studios - while including additional licensed content. While AT&T is already in the market bringing DirecTV to traditional cable consumers, this service will enable AT&T to effectively reach the pure streaming audiences.
AT&T is also gaining international steam with services gaining traction in Mexico and South America. While this segment only contributes 5% to EBITDA currently, there are already 31 million subscribers across 12 countries, generating more than $8 billion in revenue. The Latin American region boasts a population of more than 625 million people, so AT&T's low penetration rate leaves a lot of room for growth in the years ahead.
About The Investment Opportunity...
Despite these developments, and the manageable path out of its current debt load - the stock continues to face downward pressure from the market.
The continued struggles of the stock represent an ongoing buying window that remains open for investors. Analysts are projecting full year earning per share at $3.52. Given the current stock price of just under $31 per share, the earnings multiple against full year earnings is incredibly low at 8.7X. Based on AT&T's 10 year median multiple of 14.77X, the stock is potentially 40% undervalued against its historical norms.
If we look at valuation from a free cash flow perspective, the stock's boosted FCF post Time Warner has raised its yield to a staggering 10.30%. The stock market has given little respect to the improved cash flow streams of the business because of AT&T's debt load. This free cash flow yield is the highest it has been since the recession a decade ago.
Let's look ahead five years to form an approximate projection as to what an investment could look like. To put this together, we will make some modest assumptions about what will take place over these next five years.
Analysts and management alike are projecting low single digit earnings growth in 2019. However as the company realizes synergies and continues to develop its streaming/international growth engines, growth should accelerate some. We will assume an organic earnings per share CAGR of 5% over the next five years.
During this time, management will also be steadily paying down the balance sheet. Given post dividend cash flows of $12 billion by the end of FY18, let's conservatively assume that AT&T uses on average $9 billion per year over the next five years towards its debt. AT&T should see FCF grow over this time period, but for a margin of safety we will stick with $9 billion per annum. This would be a five year debt reduction of $45 billion. Management is expecting YE 2018 debt to total $170 billion. By end of FY23, that would place the total debt at about $125 million. This represents a reduction of AT&T's year end debt load of 25%.
An approximate 25% reduction in total debt would unlock about a quarter of interest expenses as newly found net income. Based on full year run rates (again these are rounded off numbers to illustrate a point) of about $8 billion in interest expenses, the $2 billion that is no longer being paid as interest would add another $0.31 per share to earnings.
So at the end of FY23, AT&T could sport earnings per share of $4.80 per share based on organic growth and lessened interest expenses. Assuming standard market conditions, it would be solid logic to assume that investor fears over AT&T's balance sheet are long gone by now. So if we use the median earnings multiple of 14.77X (which could move higher because AT&T's business model has changed), the resulting stock price would be about $71 per share. Now AT&T is paying a dividend of $2.00 per share, which will likely be $2.20 per share by then if dividend growth is projected out.
By end of FY23, investors will have realized a share price movement of $31 to $71. In the meantime, they will have collected an additional $10.60 per share in dividends. This total return per share of $50.60 would be good for a CAGR of 21.36%.
The market continues to suppress AT&T's stock because of worries over its debt load. However, free cash flow projections are more than enough to manage this. The current price of shares is so low relative to historical norms, that even modest growth over the next five years will result in outsized returns. AT&T's wireless business is solid, and growth should come from international opportunity as well as streaming services that will soon arrive. As AT&T continues to show progress in its near term goals, the current opportunity will likely expire.
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Author Disclaimer: Wealth Insights is an investor and investment author. His content is not geared to anyone's specific investment goals, time horizons, or risk tolerance. Content is for illustrative purposes only and is not intended to displace advice from a fee-based financial adviser. Accuracy of data is not guaranteed.
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.