The Key Driver For AT&T's Returns Played Out As Expected

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About: AT&T Inc. (T)
by: Trapping Value
Summary

AT&T has made good progress on its longer-term objectives.

Activist interest might have made the news, but AT&T's performance is still influenced by something else.

We examine the recent results and give our thoughts on what could influence this over the next 12 months.

When we last looked at AT&T (T), things were a bit different than they stand today. The data points in the fourth quarter of 2018 showed us that AT&T was setting up for a good rally. Back then, investors were rushing out of bond funds in a hurry, fearing multiple rate, and we kid you not, hikes. We left then with the conclusion:

We think Q1-2019 will be the point where the brunt of this impact will be seen as purchases and inventory building have been pulled forward into 2018 to avoid potential tariffs. This should bode well for the Treasury bonds. However, how BAA bonds react here will depend largely on the depth of the slowdown. If the yields blow out in 2019 with more recessionary fears, then AT&T will again struggle in 2019. If the slowdown is seen as a mid cycle pause, AT&T should finally move towards our $40 target. We think the latter route is more likely for the first half of 2019.

AT&T has done well since then and outperformed the major indices with far less volatility.

Chart Data by YCharts

We look into drivers of this outperformance and why there are some shorter-term risks.

Q2-2019 results

While AT&T has done a good job integrating Time Warner into its fold, there is something else at play here which has helped deliver the stellar returns. AT&T results continue to have something for both the bulls and the bears. On the positive side, the cash flow continued to be extremely strong and AT&T raised its full-year free cash flow outlook to $28 billion. Operating margins have also been strong and made up for the slightly lighter revenues.

Source: Q2-2019 presentation

Interestingly, AT&T was able to show margin improvement in all subsections of the communication segment, despite flat revenues.

Source: Q2-2019 presentation

In the entertainment group segment, AT&T continued to bleed with premium video and DirecTV NOW losses.

Source: Q2-2019 presentation

Those are paradoxically helping EBITDA margins as they are big money losers. AT&T's expensive purchase price for DirecTV is reflected after the EBITDA margins and shows up in intangible amortizations.

Finally, Warner Media delivered good results which helped management take a victory lap on the acquisition success.

Source: Q2-2019 presentation

Why AT&T has moved up

Back in late 2018, we wanted to bring into focus a key theme for AT&T's next 12-month returns. The idea was that until AT&T was beholden to the 10-year Treasury rates. Back then, we had showed this chart (note the date of December 7, 2018).

Chart

As the chart shows, AT&T's yield moved in sync with the 10-year Treasury Yield. Hence higher yields equaled higher yields for AT&T and hence a lower stock price. Lower yields equaled lower yields for AT&T and hence a higher stock price. We pointed out that we expected 10-year Treasury yields to dip, and that dip should be accompanied by AT&T's stock outperforming.

Chart Data by YCharts

That has played out rather well, and AT&T's stock price has delivered as we expected.

Why we see shorter-term headwinds

We recently posted this chart for our subscribers. Below we plotted the 10-year Treasury yield alongside points where the rate of change over a six-month period reached an extreme.

Source: StockCharts

In each case it "appeared" that the world was ending. Whether it was the global financial crisis in 2008-2009, the 2011-2012 European crisis or the recession that was at the doorstep in 2016. In each case investors were absolutely (wrongly) convinced that the world was ending. In each case, the 10-year yield rebounded and eventually touched the 200-week moving average. That average happens to sit at 2.34% today. While we do not expect a straight line move to that yield target, we think this year's Treasury move has trapped even greater fools holding bonds and in all likelihood we will exceed that target.

This move we expect in yields will create a headwind for AT&T as the stock is still moving with 10-year yields.

Why we expect this correlation to break in the next 12-24 months

Shorter-term weakness aside, we think AT&T's deleveraging is proceeding rather nicely.

Source: Q2-2019 presentation

AT&T is on track for a 2.5X debt to EBITDA target, and somewhere between 2.0X and 2.5X of a debt to EBITDA number is a point where the market will think AT&T has reduced its leverage enough so that it stops acting like a high yield bond proxy. We are not certain exactly where that point is, but we think it is coming and coming within 12-24 months. AT&T has also suggested it will start share repurchases once it meets its target and that too will help put a floor on the stock.

Conclusion

We have ignored the recent activist attempts by Elliott Management, as we think it is nothing more than a distraction. Yes, the fund owns $3.2 billion worth of stock, but that is about 1.2% of the capitalization. AT&T's management is already focusing on the key imperative that is debt reduction and everything else will flow from that. To that point, AT&T's massive debt has been reduced on schedule and its debt maturity profile is so extended at over 14 years that we and bondholders are very comfortable with it. The free cash flow after dividends exceeds the average annual maturing net debt in any single year. The outperformance is well deserved, but was no doubt helped by the big drop in Treasury yields. Investors wanting to hedge should consider selling out-of-the-money calls on AT&T to cushion the volatility, or alternatively a direct short position on bloated Treasury bonds could work just as well. We remain positive on the stock longer term and think fair value is in the $40-42 range, and it remains a core holding in our income portfolio.

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.

Additional disclosure: Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.