T shares have rallied hard from recent lows, where I thought they were irrationally valued.
Q3 numbers were solid, showing continued debt reduction and strong FCF coverage of the dividend.
Management provided a 3-year capital allocation plan that inspired buyers to rush into the stock.
For over a year now, I’ve been saying that AT&T (T) has been priced way too cheaply. I’ve written numerous articles expressing this opinion, AT&T has been a mainstay on my weekly “Nick’s Picks” list for subscribers, and I’ve put my money where my mouth is, maintaining a heavily overweight position in the name for quite some time. In short, I thought the market was placing an irrationally large discount on shares due to fears surrounding the increased debt load, the strength of the balance sheet, and the sustainability of the dividend. Instead of focusing on debt, I’ve maintained a strict focus on cash flows and the dividend yield, which gave me peace of mind at night when I laid my head down to rest with AT&T as a top 5 position within my personal portfolio.
I began buying AT&T heavily when the company made the Time Warner deal. I’ve added several times during the recent pullback. In short, I couldn’t believe that the market was willing to place a single-digit price-to-earnings multiple on these shares. At T’s recent lows, the dividend yield was above 7%. Give me a safe, 7% yield and I’ll be happy every day of the week. But give me a safe, 7% yield with strong, double-digit capital gains potential due to a discount multiple and I’m going to be ecstatic.
At the recent lows, I couldn’t believe how cheaply the market was willing to price T. Interest rates have been falling, and to me, a single-digit P/E ratio on a Dividend Aristocrat like T implied one of two things (if not both): the market thought that either T was at risk of going out of business or the dividend was at risk of being slashed. However, when I looked at the fundamentals, I didn’t see either of these two scenarios as being likely. Sure, T’s debt load increased significantly after M&A moves in recent years, but the company has always been a cash flow machine. The cash flow generation never stopped, and with that in mind, I was about as certain as you can be in the equity arena that T was being priced irrationally.
(Source: F.A.S.T. Graphs)
Admittedly, T's 20-year average P/E is elevated due to the stock's spike during the dot-com boom. I generally like looking at the largest data set available when attempting to use the past to help establish historical fair value, but I'm also happy to include a 10-year chart which shows that T's current valuation is still trading at a double-digit discount to historical averages.
(Source: F.A.S.T. Graphs)
This is why I’ve been so adamant on my bullish position in AT&T. Thankfully, for my reputation as a stock picker and for the sake of my financial well-being, with T representing ~4.5% of my portfolio, the stock has rallied nicely throughout 2019. It is now trading nearly 44% off of its 52-week lows. The stock is at 52-week highs currently and isn’t far off from the $40 level that served as resistance a few years back. If the bulls manage to push T past this $40 level, I think we could finally revert towards historical norms in terms of the stock’s TTM P/E ratio, which would imply a price of ~52/share. Only time will tell if we’ll get there, but I think the company’s recent Q3 report could be a catalyst for further upside.
AT&T began its Q3 earnings report with this list of highlights:
- Delivering on all 2019 commitments and guidance; share retirement begins 4Q19
- Diluted EPS: $0.50 as reported compared to $0.65 in the year-ago quarter
- Adjusted EPS: $0.94 compared to $0.90 in the year-ago quarter
- Consolidated revenues: $44.6 billion
- Cash from operations: $11.4 billion
- Capital expenditures: $5.2 billion
- Free cash flow: $6.2 billion
Other than the diluted EPS regression, that’s all really bullish. Revenues were down 2.5% y/y, which was a bit of a disappointment as well, though when it comes to T, my primary focus remains on the bottom line/free cash flows because that is what is going to support the dividend and allow management to pay down debt in the short term.
Operating income was $7.9 billion during the quarter, up from $7.3 billion in Q3 a year ago. The increased income in the face of falling revenues was due to increased margins. Operating income margin was 17.7% in Q3 versus just 15.9% a year ago.
When factoring amortization and merger/integration-related expenses, operating income was $9.9 billion in Q3 versus $10 billion a year ago. The adjusted margin was still higher year over year (22.2% versus 21.9%), but this figure still isn’t quite as impressive.
AT&T's Mobile segment continued to perform well. Mobility revenues were up 0.7% y/y during Q3 and up 1.9% year to date. The company posted 255,000 net phone adds during the quarter and has now posted 780,000 net phone adds year to date. And lastly, management highlighted the fact that its network is the fastest (based on analysis regarding average data download speeds performed by Ookla) and the best (based upon GWS OneScore’s September report). Granted, I’m sure that both Verizon (VZ) and T-Mobile (TMUS) can find data that corroborates their view that their network is the fastest and best. Regardless, I think the mobility numbers during Q3 for T look solid, and I suspect that bulls will continue to use the reliable cash flows generated by these operations as an anchor point in their thesis moving forward.
Unfortunately, the Entertainment Group doesn’t appear to be doing as well. Year to date, T is still posting positive revenue growth, operating income, and EBITDA coming from this segment, but in Q3, segment revenues and EBITDA were negative y/y. T is reporting operating income up 4.8% during the quarter, sparked by higher ARPU. The company has been seen raising prices in recent months, and this appears to be trickling down to the bottom line. Yet, many investors and analysts (including myself) have concerns about the sustainability of this growth due to the fact that the company continues to post net losses of paid subscribers to its premium TV services as well as the recently rebranded AT&T Now OTT service. While I remain bullish on T at large due to its low valuation, I have been disappointed with management’s execution in the content distribution space. As T continues to shed subscribers, the DIRECTV acquisition and even the Time Warner acquisition (to a lower extent due to its content production capabilities) begin to look like losing deals.
Speaking of Time Warner, T highlighted Warner Media’s performance during Q3 starting off with HBO’s sales, which were up 10.6% during the quarter. The company mentioned that HBO’s subscriber base was stable during the quarter, seemingly taking a veiled shot at Netflix (NFLX). It also noted that HBO's operating income was up 13.7% y/y. It earned an industry-leading 39 Primetime Emmy Awards and 15 News and Documentary Awards. In short, HBO continues to be the company’s crown jewel in the media/entertainment space, and while I have been disappointed in the DIRECTV/AT&T Now performance, I have no complaints when it comes to T’s stewardship of the HBO brand.
And most importantly, management closed the Q3 report by highlighting asset sales and debt reduction. During Q3, T continued to shed non-core assets, raising $3.5 billion. The company reduced net debt by $3.6 billion in Q3 and has now reduced net debt by $12.7 billion year to date.
Right now, near 52-week highs, T yields 5.36%. This company is a Dividend Champion with a 35-year annual dividend increase streak. T isn’t known for dividend growth. The company typically provides annual increases in the 2% range. In other words, the company protects the purchasing power of the shareholder dividend by growing it at a rate that essentially matches inflation. Historically, T has provided dividend growth well above that 2% range, though moving forward, with plenty of balance sheet repairs still left on the to-do list, I don’t think investors should expect much higher dividend growth than this. However, when we’re talking about a 5%+ yield in a T.I.N.A. environment, I’m totally fine collecting a safe, high yield that still grows a bit year in and year out.
As I mentioned earlier in the valuation section, during T’s recent lows, it appeared as though the stock was being priced for a potential dividend cut. The way I see it, in a low-rate world, there is no other reason for an equity with such a high yield to be priced so low. I understand that T’s massive debt load has been a concern for conservative, income-oriented investors, but throughout this entire bought of weakness, I’ve always felt as though the company’s cash flows fully support the dividend.
A year ago, T’s free cash flow payout ratio was 56.1%. The company’s free cash flow has fallen roughly 4.2% since then, and dividend payments have increased by ~2.6%, resulting in the free cash flow payout ratio rising to 60.1%. Obviously, I’d rather see this figure decrease over time, with FCF growth exceeding dividend growth; however, a ~60% payout ratio still represents a safe dividend situation to me.
T shares popped some 4% in response to the Q3 report, but it wasn’t the Q3 numbers that sparked the increased bullish sentiment, but instead, the future guidance that management provided.
Here’s the 2020 guidance that management provided during Q3:
- Revenue growth: of 1-2%;
- Adjusted EPS growth: $3.60-3.70, including HBO Max investment;
- Adjusted EBITDA margin: Stable with 2019;
- Free cash flow: Stable in the $28 billion range;
- Dividend payout ratio: In the low 50s% range4;
- Gross capital investment: In the $20 billion range6;
- Monetization of assets: $5-10 billion
To me, this all looks great. Slow but steady revenue growth. Steady margins. Stable free cash flow nearing $30 billion. Plans to continue to sell non-core assets and reduce debt. And a dividend payout ratio that is in the low 50s. What’s not to like there?
And on top of that, management gave investors a 3-year capital allocation plan:
- Dividend Growth & Payout Ratio: Continued modest annual dividend growth; dividends as percent of free cash flow of less than 50% in 2022;
- Share Retirement: 50-70% of post-dividend free cash flow being used to retire about 70% of the shares issued for the Time Warner deal;
- Debt Reduction: Retiring 100% of the acquisition debt from the Time Warner deal; a net-debt-to-adjusted EBITDA ratio between 2.0x and 2.25x by 2022;
- Portfolio Review: Continued disciplined review of portfolio; no major acquisitions.
This 3-year plan helped to put investors’ minds even further at ease. Getting the net debt-to-adjusted EBITDA down to the 2x area would be amazing. That would put any credit issue fears totally at rest, in my opinion. And management’s confidence regarding share repurchases really shows the progress that they’re making on the balance sheet. Using the free cash flows generated by the company to reduce the outstanding share dilution created by the Time Warner deal is like to result in strong EPS growth over time. And the fact that management was willing to say that they had no plans to make “major acquisitions” probably also led to a sigh of relief for many investors who have lost a bit of faith in T’s ability to spend billions effectively outside of its core competency. With the 5G revolution likely to begin in the coming years, the company will have to invest heavily in its communications infrastructure. I’m sure that many love to hear that T will be focusing on this rather than attempting to integrate another major company into the fold.
All in all, I liked just about everything that I saw in the Q3 report. I wasn’t surprised to see a pop, and I won’t be surprised if the rally has legs. I know that certain investors will look at this report and ask themselves, “Why’s this guy so excited about such low growth?” Well, it’s all about expectations. When the market prices a company for ~10x earnings, representing a steep, double-digit discount to historical averages, the company doesn’t have to produce amazing growth to generate strong, double-digit upside. All it really has to do is prove that the business is stable and continues to pay a high yield. I don’t think that we’ll see the ~40% gains that we’ve witnessed thus far throughout 2019 in 2020, 2021, and 2022, but these two things alone have the potential to result in a double-digit total return CAGR moving forward, which is amazing for such a defensive, low-risk equity investment.
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Disclosure: I am/we are long T, VZ. 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.