AT&T: This Dividend Aristocrat Offers 13-14% Total Returns Over The Next 10 Years

Summary

• AT&T offers investors a 6.9% dividend yield at current prices, along with a history of delivering dividend increases since 1985.
• Despite risks, AT&T is well-positioned to continue its dividend growth streak for years to come, with accelerated dividend growth once deleveraging is complete.
• AT&T is currently undervalued by 18.6% using the average of my valuation methods.
• AT&T offers patient, long-term income investors total returns of 13-14% over the next 10 years.

As I've come to find since I began investing in September 2017, Wall Street and many retail investors have a short-term view. This presents opportunities for dividend growth investors with a long time horizon. As we've seen numerous times lately, companies have been getting clobbered this year despite reporting otherwise solid results on guidance that is lower than expected.

Image Source: imgflip

One such example of a company that recently reported earnings and subsequently got clobbered was AT&T (NYSE:T).

I'll cover in more detail the dividend and the prospects of the dividend going forward, the opportunities and risks to consider, what I believe to be fair value for AT&T going forward, how that compares to the current price, and wrapping up how all this translates into the potential for market-beating returns over the next 10 years.

Reason #1: AT&T's Dividend Aristocrat Status And Safe Dividend

Image Source: Simply Safe Dividends

While AT&T garners a lot of criticism from the Seeking Alpha community, with many complaining of the weak dividend increases the past few years, nobody can deny that AT&T has a rich history of providing safe, growing dividends.

There's a reason that AT&T was known as the prototypical "widow and orphan" stock. The company operates in an industry that is an oligopoly with fellow competitors Verizon (VZ), T-Mobile (TMUS) and Sprint (S) (with T-Mobile and Sprint aiming to complete a merger). This type of market structure has allowed AT&T to deliver tons of cash to shareholders throughout the years. Though AT&T won't make investors rich overnight like a tech startup, I view it as one of the more sure investments available.

In fact, the company has increased its dividend every year since 1985. While AT&T's 10-year dividend growth rate of 2.6% struggles to keep pace with inflation, I believe that the company has finally reached a period where it will soon be able to accelerate that dividend growth once again (which I'll discuss more in my second reason).

Before delving into that, we'll be analyzing the safety of AT&T's dividend using both the EPS payout ratio metric and the FCF payout ratio metric.

Image Source: AT&T Q4 2018 Slide Presentation, slide 7

According to AT&T's Q4 2018 Slide Presentation, the company produced $3.52 in EPS for FY 2018. Using the $2.00 of dividends per share that the company paid in 2018, this equates to a 56.8% payout ratio. Moreover, with the company expected to generate EPS of $3.61 in FY 2019, the $2.04 annualized dividend for 2019 would mean a slightly improved payout ratio of 56.5%.

Though AT&T primarily operates in a capital-intensive business, the current payout ratio would indicate the dividend is safe for the time being.

Image Source: AT&T Q4 2018 Slide Presentation, slide 8

Moving on to the FCF payout ratio, we can see that the company's fourth quarter payout ratio came in well below 50%, at 46%. The company also improved its FCF payout ratio to 60% for FY 2018.

Having discussed both AT&T's EPS payout ratio and FCF payout ratio, it's reasonable to conclude that the dividend is well covered by both the EPS payout ratio and the more highly touted FCF payout ratio.

We'll later discuss events that could adversely affect this dividend coverage in the years to come, but for all intents and purposes, I believe the dividend is in no immediate danger.

Image Source: Simply Safe Dividends

In fact, as we'll delve into next, the company has tremendous potential to return to its 20-year dividend growth rate of around 4% in a couple years.

Reason #2: AT&T's Opportunities For Growth In 2019 And Beyond

While AT&T had a quarter that left much to be desired, it remains important for us as long-term investors not to miss the forest for the trees.

Although critics will inevitably argue in the comment section below that AT&T is dead money, (citing the stock price as effectively going nowhere in the past 10 years), it's important to note that during that time the company has paid $18.20 per share in dividends, which would be equivalent to a 5.1% annualized return by holding AT&T for the past decade.

Yes, it's significantly underperformed the market in the past 10 years, but we have to remember that:

1) That's the past and the investors of today will only benefit from future growth going forward.

2) I believe that AT&T has growth opportunities going forward that it will be able to capitalize upon.

The first attribute of AT&T that I view as a plus is the capital-intensive business that it operates in. In other words, the $150 billion that AT&T spent maintaining, expanding, and upgrading its networks between 2012 and 2018 makes it incredibly difficult to compete with AT&T on a national scale.

In fact, that's actually the reason that T Mobile and Spring cited as one of the primary factors for the desired merger. While Sprint is loaded with debt, this potential merger would allow the combined entity to invest more in its network and be roughly equal to AT&T and Verizon in scale.

To make being competitive even more difficult for AT&T's rivals, the majority of AT&T's markets are mature. This lack of growth makes it unattractive for anyone looking to compete against AT&T.

While the number of cord-cutters rose to 33 million in 2018 (up 8 million from the year prior), this also means that smaller competitors looking to steal market share from companies like AT&T be discouraged, given the massive costs of building out a wireless, cable, or satellite network for a market that is already mature.

Management is continuing to make the strategic moves necessary to ensure that AT&T isn't able to be uprooted by competitors.

We can look no further than AT&T’s wireless division, which generates about 50% of EBITDA. In spite of T-Mobile's price war in recent years, AT&T has attempted to maintain market share and stabilize average revenue per user by bundling its wireless services with the TV services offered by DirecTV, creating a more compelling value for customers.

With the acquisition of Time Warner for $85 billion, AT&T became a media powerhouse in the process. The 70+ TV series produced each year by Warner Brothers, in addition to Turner Broadcasting owning dozens of channels, and over 140 million global HBO subscribers mean that the WarnerMedia entity offers unparalleled entertainment options.

AT&T plans to leverage this rich content by releasing a three-tiered streaming platform later this year. The company plans to offer HBO-licensed films, HBO originals, and Warner Bros and Turner content as separate streaming services. Films will be the lowest priced, while each tier that adds more content will be more expensive.

Image Source: AT&T Q4 2018 Slide Presentation, slide 12

In addition, AT&T is attempting to leverage its growing content and media segment to transform its new Xandr digital advertising business into a key source of high-margin (75% EBITDA margin) and fast-growing clash flow. In the meantime, WarnerMedia is generating roughly 6.5% annual revenue growth while also delivering strong margins, making it one of the company's fastest growing and most profitable businesses.

The company also continued strong growth in Mexico via Vrio, adding 1 million subscribers in the last quarter and 3.2 million during FY 2018.

Image Source: AT&T Q4 2018 Slide Presentation, slide 9

With the closing of the Time Warner deal in 2018 for $85.4 billion, AT&T's massive debt expanded even more. This caused critics to question the debt taken on to close the deal and along with cord-cutting, has caused a languishing share price since the merger closed.

What the bears don't seem to take into account is how prolific AT&T is at producing cash flow, generating $22.4 billion in FCF in FY 2018. AT&T is diligently working to aggressively deleverage.

Using the $12 billion in FCF left after dividends and $6-8 billion in non-core asset sales and real estate sales, AT&T expects to pay down $18-20 billion in debt in 2019 alone.

Image Source: AT&T Q4 Investor Briefing, pg. 19

While I agree with AT&T's move to pay down debt, we do need to realize that although not ideal, the current balance sheet situation of over $171 billion in debt isn't as catastrophic as bears make it out to be. If the company wasn't aggressively paying down its debt, I'd obviously be a bit worried. However, as we've illustrated, AT&T is showing a strong commitment to reducing its debt.

Though the interest coverage ratio of AT&T hovers just above 3 (at 3.1), as AT&T aggressively pays down debt and grows its EBIT in the low-single digits, that interest coverage ratio will improve considerably in 2019 alone, and even more so in the years following 2019.

Image Source: AT&T Debt Information

AT&T's excellent cash flow generation and commitment to aggressively deleverage its balance sheet has earned AT&T investment grade credit ratings from all three major credit rating agencies.

This leads me to believe that while AT&T's balance sheet presents a bit of a risk in the short-term, this risk will only continue to weaken in the years to come as AT&T continues to deleverage.

If AT&T is also able to leverage the content of WarnerMedia and roll out a successful streaming service in 2019, the deleveraged balance sheet and more resilient business will eventually warrant a higher valuation multiple that will result in capital gains for those patient enough to collect their massive dividends over the next few years.

Image Source: AT&T Q4 2018 Slide Presentation, slide 4

Despite the trend of cord-cutting that persisted in 2018, the company executed well in closing the Time Warner deal that has been accretive from the get go. Xandr will provide tremendous growth at fantastic margins in the years ahead, in addition to the 5G rollout potentially offering solid returns. Solid subscriber gains in Latin America will continue to transpire, laying a strong foundation in both 2019 and the years following.

It's these growth catalysts that have prompted analyst estimates of earnings growth in the range of 5-6% annually over the next 5 years as AT&T expects to realize cost synergies from the Time Warner acquisition.

When we factor in the growth catalysts and the aggressive deleveraging of the balance sheet by management, it's reasonable to conclude that AT&T will resume stronger dividend growth in the early 2020s.

Risks To Consider

While AT&T has historically been a safe stock offering few risks, every business comes with its own unique set of risks which we'll delve into with more depth.

On the wireless side of AT&T's business, the saturation of smartphones and rise of T-Mobile have only intensified competition for existing subscribers. The major providers like AT&T have been forced into offering unlimited data plans in order to maintain their subscriber bases, which has resulted in losing out on the lucrative data overage fees that were common in the past.

Because of the price wars that T-Mobile has started, AT&T has struggled in raising its prices on post-paid mobile subscribers. Should the T-Mobile and Sprint merger be approved by the Justice Department and the FCC, T-Mobile and Sprint would roughly equal Verizon and AT&T overnight, resulting in even fiercer competition in an industry that is already highly competitive.

According to Fierce Wireless, T-Mobile CEO John Legere has said if the merger is approved that T-Mobile plans to challenge not only AT&T and Verizon, but also to become a dominant player in internet.

"I plan for the New T-Mobile to be the country’s fourth largest in-home [internet service provider] by 2024, freeing millions from the likes of Comcast and Charter in the process!” T-Mobile CEO John Legere

While 5G is a possible growth driver for AT&T, the risk is that its traditional broadband business could be disrupted. T-Mobile's pricing war if the merger is approved by regulators would only continue to pressure AT&T, and lead to lower returns on 5G than the returns that were enjoyed in the current 4G era.

Yet another concern is that AT&T has been plagued with the trend of cord-cutting for years. The acquisition of DirecTV back in 2014 by AT&T has proven to be horrendous for lack of a better word.

The rise of over-the-top streaming services have been a major reason for DirecTV losing hundreds of thousands of subscribers (off the base of 23 million).

Image Source: AT&T Q4 Slide Presentation, slide 10

Overall, traditional video subscribers declined 391,000 which isn't the most encouraging news.

Image Source: eMarketer

While the OTT streaming business offers strong growth in the years ahead according to eMarketer, that strong growth is prompting much more competition in the space.

According to eMarketer, here's how many monthly U.S. viewers current streaming services have.

• Netflix (NFLX): 148 million
• Amazon Prime Video: 89 million
• Hulu: 55 million (60% owned by Disney)
• HBO Now (AT&T): 17 million
• Sling TV (DISH): 6.8 million

With massive competitors such as Netflix (NFLX), Amazon (AMZN), and Hulu to contend with, along with Disney Plus (DIS) (which will offer exclusive Disney content and new original Marvel live action TV shows) being released soon, AT&T's new streaming service with Time Warner content will face much competition in trying to win its stake of the growing OTT streaming business.

The strategy that content is king and that it's the key to growth in pay-TV services (which was arguably the primary motivation for the Time Warner acquisition) could be difficult to execute on in such a competitive landscape, given that there are over a dozen (and counting) major streaming options at this point and this will certainly be a task for AT&T management to handle.

After all, AT&T's return on invested capital or ROIC has fallen from the among the best in the industry at 15% in 2013 to the worst in the industry at 6% in the past year (primarily due to the colossal failure that was the DirecTV acquisition), per Simply Safe Dividends.

With the questionable acquisitions of CEO Randall Stephenson's past, this is certainly a risk to emphasize. Management must execute properly in order to win this lucrative market. They haven't executed well in recent years and this time needs to be different in order for my thesis to prove at least mostly correct. Simply put, Time Warner can't be another DirecTV.

One final risk that will be minimized in the coming years is the massive debt that AT&T has incurred as a result of past acquisitions. At $171 billion of debt as of year end 2018, this company has loads of debt that accompanies its loads of free cash flow. However, as was highlighted earlier, the company is deleveraging and plans to aggressively deleverage its balance sheet in the future.

The major risk to AT&T on that front is if it is unable to be competitive in the OTT streaming services industry. Any degradation in the core businesses of AT&T would pose a threat to AT&T in the long-term, making this seemingly minimal risk into a more dangerous one.

Reason #3: AT&T Is Approaching Deep Undervaluation

Now that we've established that AT&T is a company with a strong dividend history that offers a high probability of accelerating dividends in a couple years despite risks, it's reasonable to ask how undervalued is AT&T.

Image Source: Investopedia

In using the Dividend Discount Model or DDM, AT&T is undervalued. I used the current annualized dividend of $2.04 a share, a 10% required rate of return, and a long-term dividend growth rate of 4%.

When we plug these values into the DDM formula, we arrive at a fair value of $34.00 a share. This would mean that AT&T offers 15.7% upside from the current price of $29.38 a share (as of market close on January 30, 2019). Moreover, the company trades at a 13.6% discount to fair value, which place it in reasonably undervalued territory.

In examining Morningstar's data on AT&T, we can see that the dividend yield of 6.9% compares favorably to the 5-year average of 5.5%. As we've established, this discrepancy isn't because the company's fundamentals are deteriorating, but simply that the market is overly bearish on AT&T and that's reflected in AT&T's valuation metrics at the present time. If the dividend yield returns to its 5-year average of 5.5%, this would imply that the company would hold a fair value of $37.09 a share. Further, this would mean that the company offers 26.2% upside in valuation expansion. Using this metric, AT&T is trading at a 20.8% discount to fair value, which is firmly undervalued.

Interestingly, Morningstar also places a fair value estimate of $37.00 a share on AT&T stock. This would mean AT&T is trading at a 20.6% discount to fair value, while offering 25.9% upside.

When we average the three fair values together, we arrive at a fair value of $36.03 a share. This would indicate AT&T is currently trading at an 18.5% discount to fair value, offering 22.6% upside in terms of capital appreciation when AT&T eventually arrives at fair value.

Summary: AT&T Offers A Strong Dividend, Growth Catalysts Moving Forward, And Is Currently 18.5% Undervalued

Having discussed AT&T's dividend, we can arrive at the conclusion that AT&T's dividend should be reasonably safe. As the company deleverages, that dividend safety will continue to grow, allowing the dividend safety score to increase from a mere 55 (and borderline) to 60+, which is safe. AT&T's annual dividend growth should also accelerate to around 4% once deleveraging is complete.

Despite the risks, AT&T boasts growth catalysts if management is able to execute on the company's strengths. This should bode well for growth going forward.

As discussed above, AT&T is currently undervalued by most metrics. I believe that the company is approaching deep undervaluation. This deep undervaluation will act as a spring on investment returns over the next 5-10 years as the stock returns to fair value.

Finally, when we combine all these factors we can see that the company offers investors a chance to invest in a quality company at a compelling valuation. This should allow new investors an entry yield of 6.9%, earnings (and eventual dividend growth) of 4-5%, in addition to ~2.1% annual valuation multiple expansion over the next 10 years (this figure could potentially be higher depending on when AT&T returns to fair value).

All told, I believe AT&T offers investors at current prices the opportunity for 13-14% annual returns over the next 10 years. AT&T arguably doesn't even have to offer any valuation expansion despite its current deep undervaluation, with even a static valuation multiple still offering annual total returns of 10.9-11.9% over the next 10 years, thereby delivering alpha compared to any of the major market indices.

Analyst’s Disclosure: I am/we are long T. 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.