AT&T: Missteps And Pessimism Lead To An Attractive Entry Point

Summary

• The market is viewing AT&T with a healthy amount of pessimism which has brought the valuation to an attractive level.
• The company can surprise investors by seizing the giant opportunities coming with the 5G rollout and evolution of its streaming business.
• While waiting for AT&T to deliver on these enormous opportunities, investors will collect a seven-plus percent dividend yield.

The telecommunications, media and technology giant, AT&T (NYSE:T), is currently an attractive and underappreciated investment opportunity. The market is currently having a pessimistic view of its prospects as evidenced by its low valuation and a dividend yield or over 7%. This is a result of many factors including a saturated wireless market with aggressive pricing by competitors, fierce competition in streaming, and the associated need for substantial capital investments.

Business Basics

AT&T's three reportable segments are Communications, Warner Media, and Latin America.

Segment	Percent of 2020 operating revenues
Communications	79%
Warner Media	17%
Latin America	3%

Click to enlarge

Table 1: Data from 2020 Annual Report

At the end of last year, the company had 183 million wireless subscribers which will continue to transition more to 5G. The communications segment also sells equipment including handsets, wirelessly enabled computers and wireless data cards for use with its voice and data services. Surprisingly, the contribution from this Equipment class of the segment was a meaningful 10% of 2020 revenue. The video segment had 17 million subscribers with premium TV and streaming services at the end of 2020. Broadband and internet services were provided to over 14 million customer locations 2020.

The Warner Media segment consists of Turner, HBO Max, and Warner Bros. The streaming platform HBO Max was launched in May of 2020 and ended the year with 41 million subscribers. As a result of the pandemic 2021 Warner Bros. films will be released simultaneously in theaters and HBO Max.

The Latin America segment serves about 11 million video subscribers in Argentina, Brazil, Chile, Colombia, Ecuador, Peru, Uruguay and parts of the Caribbean.

Source: Gadgets360

Risks

There are multiple wireless competitors in every one of AT&T's service areas. The company itself acknowledges that market saturation will continue which will slow the customer growth rate. Its market share could fall with aggressive pricing by T-Mobile and other competitors which of course is a positive for consumers.

Continued changes in the television industry and consumer viewing patters also pose challenges as well as opportunities. AT&T is addressing this challenge with its launch of the HBO Max direct-to-consumer streaming platform. Clearly the competition in this segment is fierce and there is no guarantee that the company's investments will be rewarded. Success of streaming platforms is dependent on the ability to balance the need to constrain costs while delivering content desired by customers. The company has to deploy capital on all fronts of its growth initiatives including ongoing deployment of 5G, fiber and its HBO Max platform.

Is the Dividend Safe?

A dividend yield of over 7% is a red flag, potentially indicating a value trap. Revenues have been fairly stable over the last several years. However, AT&T reported a loss in 2020 for the first time since 2008. The company ended the year with $153,775 million in long term debt compared to total assets of $525,761. Critically, the company has produced reliable free cash flow. Cash flow from operations always exceeds capital expenditures. Cash flows from operations even usually do a good job of covering the dividend payments and acquisitions. It appears that AT&T will be able to continue its hefty payouts per Table 2 provided below. Obviously, the loss reported in 2020 results in a meaningless payout ratio and indicates that a dividend cut is not out of the question if its growth initiatives do not bear fruit.

Table 2: Cash Flow Data collected from barchart

How have investors fared recently?

The answer is actually quite poor. This alone could be enough for some investors to take a pass on AT&T. Per Morningstar data, AT&T had a total return of -14.74% over the last year compared to 32.25% for U.S. equities. The five year annualized return is only 0.9% compared to 16.6% for U.S. equities. Only the 10 year annualized returns paint a slightly better picture coming in at 5.72% compared to 13.57% for U.S. equities as a whole.

Financials including the impact of the recent DIRECTV transaction

The balance sheet is leveraged but manageable given the company's fairly stable free cash flow. The need to invest in growth will need to be weighed with the equally critical need to deleverage. Long term debt to equity is high at 0.95. Moody's views the sale of 30% of its stake in DIRECTV as credit positive given that it will provide about $7.8 billion in proceeds to offset the company's C-band auction cost obligation. Anything that helps reduce leverage helps from a credit perspective. However, the transaction values DIRECTV at about $16 billion which pales in comparison to the $67 billion AT&T paid in 2015. It highlights the risks of acquisitions when management fails to properly evaluate opportunities or integrate the acquired business.

AT&T's bonds should also be considered as they actually offer attractive yields currently. Consider CUSIP 00206RHK1, maturing in March of 2039 which currently trades at a yield to maturity of about 3.7%. This indicates that bond investors have similar concerns as equity investors about the company's future prospects.

Valuation

AT&T's EV/EBITDA is currently 11.34 which compares unfavorably to Verizon's (VZ) 8.01. Both of these companies dominated that recent C-Band auction. Verizon spent $45.5 billion while AT&T spent $23.4billion. A discounted cash flow model shows that AT&T is currently trading at about fair value if you use the meager average EPS growth estimate for the next five years of about 1.36%. The DCF model starts off year one with the average annual EPS of the last five years, $2.17, and did not assume any change in the dividend or outstanding share count. A 10% discount rate was used.

Per Reuters, AT&T has averaged 6.37% return on equity over the last five years and has a five year EBITDA CAGR of 3.1. Obviously, these figures leave a lot to be desired. However, we consider the current valuation attractive with a lot of the headwinds priced in and large opportunities lying ahead for both wireless and the media and entertainment business. Investors may consider initiating a position leaving room to average down if a substantial discount becomes available in the future.

Does the company have a competitive advantage?

The telecommunications industry is an oligopoly. New entrants require a tremendous amount of capital and would face an immense challenge to compete with the giants. That said, growth forecasts are meager and the competitors that do exist are pricing more aggressively pressuring margins. Management has hopefully learned a lesson from the DIRECTV acquisition and will be more careful evaluating future opportunities. AT&T is the second largest U.S. wireless carrier and is very likely to remain one of the key players in the industry going forward.

Opportunities

AT&T has the potential to surprise in a positive way, especially given the market's current pessimistic view. To address consumers concerns about the cost of streaming services, AT&T plans to launch an ad-supported version of HBO Max in 2021. This can help the streaming service appeal to a wider range of viewers and really improve its competitiveness. The company should also benefit as a greater portion of the population becomes vaccinated so that it can more fully return to the production of content for theaters and HBO Max. The CEO of WarnerMedia, Jason Killar, recently discussed the potential to scale HBO Max globally with plans to go to 39 countries in June.

To spur real growth, the company needs to benefit from the rollout of 5G wireless technology which will begin to gain more traction among businesses and consumers. AT&T has to find ways to help its business customers gain a first mover advantage by embracing advanced wireless technologies. A recent Deloitte telecommunications reports cites an estimate by the Global System for Mobile Communications Association that 5G will generate $700 billion in economic value. Enterprises represent 68% of the market.

Final Thoughts

We believe that there is a lot of pessimism in the market about AT&T's prospects going forward. The headwinds and obstacles have been widely reported and estimates are overly dire such that the shares have now been revalued providing a decent entry point. The current valuation and diminished expectations increase the probability that AT&T can surprise to the upside. Even just meeting analyst consensus estimates may be enough to provide a much needed boost to the share price. Meanwhile investors can collect a hefty yield while they wait for the benefits of 5G and the company's M&E initiatives to materialize.

Analyst’s 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.

This article is provided for informational and educational purposes and should not be considered as personalized investment advice. Perform your own due diligence and make your own decisions. Be advised and aware that buying and selling financial instruments involves risk.