Don’t look now, but AT&T (T) has quietly put together a strong rally thus far in 2019. It wasn’t long ago that T shares were much hated, trading below $30/share. At that time, I was essentially pounding the table for the stock. It’s rare that I have such conviction because I always recognize that there are risks in the equity space and there is no such thing as a no-brainer, but AT&T trading for ~8x earnings and yielding over 6% seemed about as safe as it can get from a stockholder's perspective.
I wrote a series of bullish articles about the stock back in the spring, yet I haven’t covered it since. At a certain point, publishing pieces based upon my bullish thesis was akin to beating a dead horse, because while I could harp on the low valuation and the safe dividend until the cows came home, I knew that only time and eventual hindsight could prove me right.
Here are the links to the prior AT&T articles that I wrote this year, if you’re interested:
- Why AT&T Is My Favorite High Yield Investment
- Why Comparing AT&T To General Electric Doesn’t Make Much Sense
- Verizon Is Not Worth 36% More Than AT&T
These pieces were published in March, March, and May, respectively, and thankfully the market has validated my opinion (I say thankfully because I’ve accumulated a large AT&T position into this bout of weakness, and if the stock continued to fall, I would have eventually found myself in a heap of trouble). Yet, as these articles show, I thought that possibility was an extremely low risk, which is why I felt comfortable going so overweight AT&T shares.
But, I’m not writing this piece to boast. Instead, I wanted to take another look at the stock now that T is making new 52-week highs, having rallied ~35% from recent lows, to see whether or not there is more room to run or if I should consider taking some profits off of the table considering the overweight nature of my current position.
So, What, If Anything, Has Changed?
It’s really interesting to analyze sell-offs and recoveries in hindsight. Sometimes, these situations offer logical conclusions with regard to the problem that sparked a sell-off and the solution that brought about the ensuing rally. However, in some cases, it’s difficult to pinpoint a catalyst for either and I think oftentimes, it’s then that we realize that the market isn’t always rational.
When you look at AT&T’s operations over the last year or so, they’re actually fairly consistent. In recent quarters, both revenue growth and EPS has been fairly close to analyst estimates. Sure, from quarter to quarter analysts will focus on things like DirecTV sub losses or wireless sub gains. They’ll highlight the performance of a certain film at the box office and/or talk about the company’s OTT streaming plans. Capital expenditures is always on the forefront of everyone’s mind, especially with the likely expensive 5G rollout on the way. However, at the end of the day, this is a company that just continues to generate massive free cash flows.
T has a much more diversified revenue stream now than it did 5 years ago. Some say that this is a bad thing because some of the new segments are underperforming (DirecTV really comes to mind here). However, I like the fact that T is not your mom and pops telecom anymore. I think having multiple segments contributing to cash from operations, ebbing and flowing together to create what appears to be a strong revenue stream, is a good place to be. Because of this, it’s easy for me to ignore the noise when it comes to quarter by quarter highlights and/or critics when it comes to individual business segments. To me, it’s best to take a step back and simply look at the cash flows.
Focus On Profits, Not Noise
|Free Cash Flow/Share||$2.16||$2.72||$2.78||2.82||$3.16||$4.01|
In short, operating cash flows and cash from operations have all risen nicely over the past 5 years or so. This is the case on a per-share basis as well, so it’s simply just about buying revenue in the M&A market. Also, a major complain that investors who focus too much on the short term and M&A issues like to make is that the moves that AT&T has made recently have put the dividend at risk. Once again, they’re focusing on the rising debt on the balance sheet while conveniently ignoring the massive cash flows that the company produces. As you can see above, not only have cash flows/share risen every year during the past 5 years, but over that period of time, the cash flow/share coverage of the dividend has dropped significantly.
I understand why so many people like to focus on the debt load. Admittedly, seeing big bank like debt levels on a non-financial stock is concerning. Right after the Time Warner (NYSE:TWX) deal was made, T was setting debt related records and this is surely going to attract bearish headlines. Yet, I’ve been fairly consistent in my belief that this AT&T sell-off has been based on irrational fear because this debt issue is not one that concerns me.
I’ve said this 100s of times already, but I’ll say it again: AT&T has the cash flow to pay down the debt and repair the balance sheet in relatively short order.
Sure, Time Warner carried debt of its own, but it was a highly profitable company and continues to be so. Furthermore, it was the last gem available on the auction block in the content space and I’m glad AT&T scooped it up. If T hadn’t bought TWX, I’m sure that someone else would have by now. And, the way that the streaming wars have gone, I have a feeling they would have had to pay an even higher premium than T did because as we’re finding out today, there simply aren’t that many high quality content producers out there which is why big-tech names are spending billions and billions every year on original content in their quest to attract consumer eyeballs to their platforms.
From 2017 to 2018, AT&T’s debt load increased ~31.5%. That is a lot. Making matters worse, the company’s free cash flows only increased ~23% in response to the closing of the Time Warner deal. This discrepancy should have been cause for some concern, though not enough (in my opinion, at least) to result in the ~35% sell-off we saw from the highs in early 2017 at ~$42/share to the lows of ~$27/share that we witnessed in late 2018.
Yet, we’ve seen T’s cash flows improve in recent quarters and now they’re nearly 60% higher than they were prior to the TWX deal happening. Also, as you can see in the graphic below, T’s debt load has consistently decreased. Lower debt and rising cash flows is a sure-fire equation for higher multiples on the stock.
|Q3 '18||Q4 '18||Q1 '19||Q2 '19|
|Cash From Operations||$12.3b||$12.1b||$11.1b||$14.3b|
|Free Cash Flow||$6.5b||$7.9b||$5.9b||$8.8b|
In the recent quarterly conference call, T’s management team remained confident that the company has what it takes to get the balance sheet back in order. Actually, they were so confident that they would hit their adjusted EBITDA/debt ratio of 2.5% that they mentioned the possibility of dedicating more cash flows to shareholder returns. Here’s a quick quote from the Q2 earnings report:
“We continue to pay down debt and are more confident than ever that we’ll meet our yearend deleveraging goal, and we’ll take a look at buying back stock.”
This comes on top of the company raising its 2019 free cash flow guidance to the $28b range and reaffirming the rest of prior guidance numbers which includes low single-digit EPS growth, a dividend payout ratio in the 50% range, capex of ~$23b, and achieving the aforementioned 2.5x net debt to EBITDA ratio.
In other words, it won’t be long before the company has re-set itself post Time Warner and I think in that situation one could argue that T should once again be trading in line with historical averages in terms of P/E ratio rather than the steep discount that is still being applied to shares.
Furthermore, I think it’d be fair to argue that AT&T shares deserve a higher multiple now than they did pre-merger because not only does the company have a much larger, more diversified free cash flow engine now, but interest rates are notably lower than they were back then, making T’s high dividend yield much more attractive on a relative basis to fixed income alternatives.
Looking at the F.A.S.T. Graph above, you’ll see that T’s long-term average P/E ratio is 14.5x. Granted, that includes the very high premium that the shares traded with during the dot-com boom, so when you change the chart to remove the 1999/2000 years from the data, T’s average multiple falls to ~14x. Looking at the last 10 years, we see that T’s average P/E ratio is ~13.4x (but this includes the single-digit multiples that the stock has traded with for the last year or so). Looking at all of this data, without trying to cherry pick a time period and/or average multiple that suits my needs, I think it’s fair to say that historical fair value here is in the ~14x range.
Now, while I think you could argue for a 14x multiple on shares today (which would represent a share price of ~$50), I’m not willing to place my fair value estimate so high, just yet. I do think that T’s management team is making great strides when it comes to repairing the balance sheet, but I’ll be the first to say that the increased debt load is a risk and therefore, current fair value estimates should reflect that. This is why I place fair value in the ~$40 area, which equates to an ~11x forward P/E multiple.
To me, I think this is a fair discount to apply to the stock, yet it still represents 11.5% upside from today’s prices. When you factor in the stock’s 5.68% dividend yield into the total return equation here, we arrive at a situation where T could still provide investors with strong double-digit upside even after its recent ~35% rally.
It’s amazing to see a name like T providing such fantastic returns like this. When we are talking about explosive double-digit growth like this, we’re usually focused on disruptive growth names. I think T deserves credit for being a blue chip telecom name, which is a great type of defensive holding, but you’d have a hard time convincing me that this is a growth name (remember, during recent guidance, management said that it expects low single-digit EPS growth).
No, the returns here are simply a product of fear in the market. T never should have traded with an 8x multiple. This was crystal clear to me which is why I never considered selling a share during the recent weakness. It’s why I wrote so many articles about T in a relatively short-period of time. It’s why AT&T has been on my weekly Nick’s Picks list for months now. Finally, investors who ignored the noise and focused on the fundamentals are being paid for their willingness to step in and buy a beaten down stock. And, I don’t think the party is over quite yet.
I wouldn’t blame anyone for taking a few chips off of the table because you know what they say: no one ever went broke taking a profit. Yet, I’m content to stick with this stock. The dividend remains high and safe and I suspect that T will be playing a key role in my passive income stream for years and years to come.
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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.