What Should I Do With My AT&T Shares?

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About: AT&T Inc. (T), Includes: AAPL, BRK.A, BRK.B, GE, SPY, TWX
by: Mycroft Friedrich
Summary

Quantitative Analysis of AT&T shares using the power of free cash flow.

Analysis of AT&T from a Main Street vs. Wall Street perspective.

Shows the reader how to do a similar analysis on their own portfolio holdings.

Discusses "Capital Appreciation through Capital Preservation"

On June 14, 2018, Seeking Alpha Senior News Editor Jason Aycock reported the following AT&T/TWX closing details: stock/cash split, expected synergies. On that day AT&T (T) officially merged with Time Warner (TWX) and in the process created a powerhouse entertainment and mobile company. In this article, I will not discuss the various operations of the merged company and how each is doing, as you can read dozens of such articles on Seeking Alpha, both pro and con. What I will simply do is a quantitative analysis of AT&T's results on Main Street and then relate them to what an investor should do on Wall Street, using zero emotion.

Recently, I did a similar analysis of General Electric (GE) and in the comment section of that article, I was asked multiple times if I would do a similar analysis of AT&T using my Friedrich Algorithm. Therefore, the following is that requested analysis.

Since I have access to the historical data files of my Friedrich Investing System, I actually have the data files of what a subscriber to that system would have seen on the merger date for both AT&T and Time Warner and here they are.

AT&T

Time Warner

From looking at the Main Street price of Time Warner, in the data file above, AT&T's management bought a tremendous asset at an amazing bargain price. What follows is the analysis of the combined companies.

Main Street vs. Wall Street

In analyzing AT&T, we will present some unique ratios that our Friedrich Investing System uses and will present a real-time quantitative analysis that will demonstrate the power of free cash flow in the investment process. In doing so, we will also teach everyone how to analyze one's portfolio holdings on Main Street vs. Wall Street. At the same time, we will explain how the methodology involved in this analysis came about.

Main Street is where AT&T operates, and Wall Street is where its shares trade. The AT&T shares that one can purchase on Wall Street are in the public domain, and the company has little control over how each share will trade. AT&T is required to release its earnings reports each quarter and from time to time, it also provides press releases to its shareholders (and the general public) giving updates on how its operations are doing on Main Street.

Main Street is where AT&T invests in its own operations and sells to its customers. How well the CEO of AT&T and its management do in selling those products determines how profitable the company will be. Wall Street then reacts based on the success or failure of management to meet its goals. Main Street and Wall Street are thus interlinked, but because anyone with a computer (or even just a smartphone), an internet connection, and a brokerage account can buy or sell any stock at any time, expertise is not a requirement in order to invest on Wall Street.

This results in Wall Street being a very dangerous place to operate as many investors tend to invest through emotion or tend to follow the herd in and out of stocks. During bull markets, investors feel like they can do no wrong as "the rising tide lifts all boats." But when a bear market suddenly shows up, these same investors tend to panic and like lemmings stampede over the cliff. Thus, we have the classic case of "greed vs. panic."

Creation of the Friedrich Algorithm

Having noticed this problem some 35 years ago, I spent the last three decades building an algorithm called Friedrich. Our algorithm was designed to assist all investors (both Pro and Novice alike) and give them the ability to quickly compare a company's Main Street operations, to its Wall Street valuation (Overbought or Oversold condition). Friedrich can do this on an individual company basis or assist users in analyzing an entire index like the S&P 500, an ETF, Mutual Fund, or individual portfolio with the use of our Portfolio Analyzer. I recently did so when I compared Apple (AAPL) to the S&P 500 Index (SPY) Apple Vs. The S&P 500: Which Is The Better Investment?

Many years ago, while reading Berkshire Hathaway's (BRK.A) (BRK.B) 1986 letter to shareholders, I discovered a ratio, which Mr. Buffett entitled "Owner Earnings," or what we may consider to be Mr. Buffett's version of FCF or "Free Cash Flow." To my amazement, in that little footnote, Mr. Buffett explains how to use it and basically states that it is one of the key ratios that he and Charlie Munger used in analyzing stocks. In that article, he defined the term "owner earnings" as the cash that is generated by the company's business operations.

[Owner earnings] represent [A] reported earnings plus [B] depreciation, depletion, amortization, and certain other non-cash charges… less [C] the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume."

I have used this free cash flow ratio for decades, using data from the Value Line Investment Survey, whose founder was Arnold Bernhard. Mr. Bernhard was a big fan of free cash flow and probably introduced it sooner than Mr. Buffett did. I know this as I was able to calculate the FCF ratio using old Value Line's sheets for my 60-year backtest of the DJIA from 1950 to 2009.

In the backtest that I mentioned above, I demonstrated that if one can purchase a company whose shares are selling for 15 times or less its Price to Free Cash Flow Ratio, that the probability of success will dramatically increase in most cases. I have renamed the ratio the Bernhard Buffett Free Cash Flow ratio in honor of both men. The following is how that ratio is calculated.

Price to Bernhard Buffett Free Cash Flow Ratio

Price to Bernhard Buffett Free Cash Flow Ratio = Sherlock Debt Divisor / [(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/Diluted Shares Outstanding))

The above are the ratios I use when analyzing a stock on Wall Street, and below are the ratios I use when analyzing a stock on Main Street.

FROIC

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

What the FROIC ratio does is tell us how much forward free cash flow the company is generating on Main Street relative to how much total capital it has employed. So, if a company invests $100 in total capital on Main Street and generates $20 in forward free cash flow, it, therefore, has a FROIC of 20%, which we consider excellent. This is just one of the key ratios (66 in total) that we use to identify how a company is performing on Main Street, as it is our belief that if a company is making a killing on Main Street that this news will eventually show up on Wall Street's radar.

So, let us begin our analysis and at the same time try to teach everyone how to do a similar analysis on one's own portfolio. In analyzing AT&T's Price to Bernhard Buffett FCF ratio, we must first analyze AT&T's Sherlock Debt Divisor. Here is a detailed definition of what that ratio is:

Sherlock Debt Divisor

A major concern that I have these days in analyzing companies is the amount of debt each takes on relative to its operations and whether management is abusing this situation by taking on more debt than it requires. Debt, when used wisely, allows for what is called leverage, and leverage can be extremely beneficial within certain parameters. On the other side of the coin, the use of debt can also be excessive and put a company's future in jeopardy. So, what I have done to determine if a company's debt policy is beneficial or abusive is to create the Sherlock Debt Divisor.

What the Divisor does is punish companies that use debt unwisely and rewards those who successfully use debt as leverage. How do I do this? Well, I take a company's working capital and subtract its long-term debt. If a company has a lot more working capital than long-term debt, I reward it and punish those whose long-term debt exceeds its working capital. So, if this result is higher than the current stock market price, then leverage is being used and the more leveraged a company is, the worse the results of this ratio will be and the less attractive its stock will be as an investment.

Thus, having successfully defined the Sherlock Debt Divisor, we need the following four bits of financial data in order to calculate it for AT&T. TTM for those who don't know is "trailing 12 months" or as close to real-time data as we can get, based on when each company reports. The current analysis is taken from the AT&T's September 30, 2018 filing with the SEC.

Market Price Per Share = $29.91

Working Capital = Total Current Assets - Total Current Liabilities

Total Current Assets = $53,107,000,000

Total Current Liabilities = $65,420,000,000

Working Capital = $-12,313,000,000

Long-Term Debt = $168,513,000,000

Diluted Shares Outstanding = 7,372,200,000 (increased by 1.233 billion shares since 2017)

Sherlock Debt Divisor = Market Price Per Share - ((Working Capital - Long-Term Debt)/ (Diluted Shares Outstanding))

Sherlock Debt Divisor = $29.91 - ((-12,313,000,000 - $168,513,000,000)/ 7,372,200,000))

Sherlock Debt Divisor = $29.91 - ($-24.53) = $54.44

Since AT&T has more Long-Term Debt vs. Working Capital, we, therefore, must punish it and use the new $54.44 as our new numerator in all our calculations.

Wall Street Analysis of AT&T

Price to Bernhard Buffett FCF Ratio = Sherlock Debt Divisor/[(net income per share + depreciation per share) + (capital spending per diluted share)]

Sherlock Debt Divisor = $54.44

Net Income per diluted share = $33,549,000,000/7,372,200,000 = $4.55

Depreciation per diluted share = $28,217,000,000/7,372,200,000 = $3.82

Capital Spending per diluted share = $-21,586,000,000/7,372,200,000 = $-2.92

$4.55 + $3.82 + ($-2.92) = $5.45

Price to Bernhard Buffett Free Cash Flow Ratio = $54.44/$5.45 = 9.99

Now, if one goes to our FRIEDRICH LEGEND (on what is considered a good or bad result), you will notice that our result of 9.99 is considered excellent.

We last ran our data file for AT&T on December 10, 2018, and our Friedrich Algorithm gave a recommendation to our subscribers that AT&T is a "Strong Hold" as our Friedrich Data File and Chart below show. There you will also find the last ten years of AT&T's Price to Bernhard Buffett Free Cash Flow results.

Main Street Analysis of AT&T

Now that we have taught everyone how to calculate our Price to Bernhard Buffett Free Cash Flow ratio, let us now move on and teach everyone how to calculate our FROIC ratio.

This is how we calculate it:

FROIC means "Free Cash Flow Return on Invested Capital"

Forward Free Cash Flow = [((Net Income + Depreciation) (1+ % Revenue Growth rate)) + (Capital Spending)]

FROIC = (Forward Free Cash Flow)/(Long-Term Debt + Shareholders' Equity)

Net Income per diluted share = $33,549,000,000/7,372,200,000 = $4.55

Depreciation per diluted share = $28,217,000,000/7,372,200,000 = $3.82

Capital Spending per diluted share = $-21,586,000,000/7,372,200,000 = $-2.92

Revenue Growth Rate TTM = 2%

[(($4.55 + $3.82) (102%)) + ($-2.92) =$5.62

Long-Term Debt = $168,513,000,000

Shareholders Equity = $183,848,000,000

Diluted Shares Outstanding = 7,372,200,000

FROIC = (Forward Free Cash Flow)/ (Long-Term Debt + Shareholders' Equity)

$5.62/$47.80 = 11.75%

FROIC = 11.75%

Now, if one goes to my FRIEDRICH LEGEND again (on what is considered a good or bad result), you will notice that our result of 11.75% is considered good and tells us that AT&T on Main Street produces $11.75 in forward free cash flow for every $100 it invests in total capital employed.

On Main Street, AT&T is doing well, while on Wall Street it is considered attractive.

What To Do?

Going forward, you will notice that for the Main Street price in our chart above has erupted for AT&T, going from $38.59 in 2016 to $88.43 currently. So, on Main Street, the merger of AT&T and Time Warner gave a tremendous boost to AT&T. The price to Bernhard Buffett Free Cash Flow is also attractive. So, Main Street and Wall Street are both attractive for AT&T, but at the same time, we found three flies in the ointment, however:

1) Long-Term Debt per share = $22.86

2) Diluted Shares Outstanding increased by 1.233 billion.

3) Badwill to Price is 134%, which is 4 times greater than what we consider bad.

Badwill

Badwill is a ratio that I created that concentrates on a company's Goodwill + Intangible assets and shows potential manipulation or, in rare cases, fraud by management.

Here is the official definition:

BADWILL = is a way in which Friedrich catches manipulators. When companies do a lot of mergers and acquisitions, they tend to book a lot of Goodwill.

BADWILL = (Goodwill + Intangible Assets)/ Diluted Shares Outstanding.

When the Badwill to Price is 33% or greater compared to the stocks market price, we generally consider it to be a bad thing.

Now, most entertainment companies historically have a higher than average Badwill to Price, due to the fact that each tends to carry a large inventory of intangible assets, but 134% is excessive anyway you look at it.

Now since AT&T's management seems confident that it will dramatically decrease its large long-term debt pile, I would also imagine that the management team is aware of its badwill problem and will reduce that as well. For those owning shares in the company, it is important to be aware of the three flies in the ointment as excessive debt and badwill can crush a company if not handled properly.

Clearly, AT&T's management saw an amazing bargain in the assets of Time Warner and had no choice but to grab them. It is unfortunate that management had to increase the share count and reduce current assets by so much, (by paying out cash as well as shares for Time Warner) but it is what it is and in the end management had no choice.

The dividend for AT&T is fantastic and the payout ratio is just 38% ($2/$5.15), so those owning AT&T for the dividend, please sleep well at night because your dividend appears safe.

Friedrich believes that AT&T is a stronghold for those who already own the stock, but for those thinking about initiating a new position, he recommends waiting until the Badwill to Price is reduced. The reason we say this is because we are all about "Capital Appreciation through Capital Preservation" and the appreciation part of the equation has suffered lately and may take a while longer before Wall Street decides to like the stock again.

From the chart below it is obvious that Wall Street is not a big fan of AT&T at the moment, as the dramatic increase in diluted shares outstanding is not something that Wall Street likes.

AT&T's management had no choice but to create those flies in the ointment in order to make this deal for Time Warner and it would be smart for them to first digest the last few purchases it has made and stay away from the M&A arena for the foreseeable future.

In conclusion, it is my belief that free cash flow analysis is the ultimate tool when analyzing companies, and my hope is that you may add these ratios to your own investor toolbox in order to help you in your own due diligence. If you have any questions, please feel free to ask them in the comment section below.

Disclosure: I am/we are long AAPL. 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.

Additional disclosure: This analysis is not an advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.