Updated on June 13th, 2019 by Nate Parsh
Shares of telecommunications giant AT&T Inc. (T) have had a difficult time over the past few years. After peaking at $43 in the summer of 2016, shares have declined to ~$33 and have underperformed the broader market. Shares are roughly flat over the last 12 months, while the S&P 500 has returned 4% during that time.
While this sort of performance is undoubtedly disappointing for those looking for capital gains, we continue to believe it has created an opportunity for long-term investors to own a piece of a world-class franchise with an outstanding yield, and a very attractive valuation.
AT&T’s appeal doesn’t stop there. It is a member of the prestigious Dividend Aristocrats, a group of S&P 500 stocks with at least 25 consecutive years of dividend increases.
Including AT&T, there are currently 57 Dividend Aristocrats. You can download an Excel spreadsheet of all 57 (with metrics that matter) by clicking the link below:
In this update, we’ll take a look at AT&T’s recent developments as well as the value proposition the stock offers, as determined by our Sure Analysis Research Database, where we rank stocks based upon total expected returns.
AT&T continues to rank highly among the hundreds of stocks in our coverage universe, and we continue to believe that the stock is a strong buy for June 2019 due to its high expected returns.
Company Overview and Recent Events
AT&T traces its roots back to 1876 when Alexander Graham Bell invented the first version of the telephone. In its current form, AT&T is the result of a tangled web of mergers and spinoffs that have taken place since 1984, when the former AT&T spun off its local telephone operations but retained its long distance, R&D and manufacturing segments. SBC Communications was born from this and with it, the modern AT&T was as well.
SBC acquired several smaller telecommunications players, including what was left of AT&T in 2005, creating the company we know today. Since then, AT&T has purchased Cingular Wireless, Cricket Wireless, lusacell and Nextel Mexico, respectively, to add to its core business. In addition, it has diversified away from phone service with its DirecTV acquisition in 2015, and the 2018 acquisitions of AppNexus and Time Warner Inc.
Today, AT&T competes in four business lines: Communications, Entertainment, WarnerMedia, and AT&T Latin America. The company employs more than 260,000 people and generates roughly $170 billion in annual revenue. The stock’s market capitalization today is nearly $240 billion, making it among the largest U.S. stocks. The company is also a member of the Dow Jones Industrial Average.
AT&T reported first quarter earnings on April 24, 2019. The company’s results were largely in line with our expectations, but because of the share price, we remain bullish on the stock.
The Communications segment, which is by far the largest in AT&T’s arsenal, contains the core telecommunications and entertainment services businesses. Results in the first quarter were largely in-line with last year on the top and bottom lines. Despite flat revenue and earnings growth, we feel that the company continues to make progress.
Source: Investor Presentation
In the Mobility portion of the segment, AT&T continues to see incremental gains, as expected. Total revenue rose from $17.4 billion to $17.6 billion year-over-year for Mobility, but more importantly, service revenue continues to climb higher.
AT&T’s revenue in this space is driven by two distinct areas: service and equipment revenue. Service revenue comes from recurring sources like monthly wireless service. This source of revenue also happens to produce high margins.
Equipment revenue, on the other hand, is transactional and driven by things like consumers upgrading their phones. While this is an important source of revenue, it is more akin to retail revenue and is less desirable than service revenue as it is not recurring.
While total revenue rose only ~$200 million for the Mobility segment, service revenue rose by double that amount, more than offsetting a ~$200 million decline in equipment revenue. While shareholders would undoubtedly like to see revenue growth from both sub-segments, maintaining service revenue growth is preferred as this is a source of recurring revenue.
AT&T was impacted by record-low smartphone upgrades in the first quarter, which was the primary reason for declines in equipment revenue. However, strong service revenue should be the focus of investors as the top line grew 2.9%, and as EBITDA service margin reached 53.6%. That helped improve segment EBITDA margin from 41.8% to 42.0% year-over-year, and in dollar terms, EBITDA rose from $7.3 billion to $7.4 billion.
Service revenue has grown at a very solid pace in recent quarters, showing immense improvement from weak results in early 2018. The company has been able to add net subscribers during this time, and with AT&T’s 5G FirstNet deployment being more than halfway done at this point, we expect service revenue growth to remain strong for the foreseeable future. Churn remains low as well, at 0.93%, which is a first quarter record for AT&T.
Source: Investor Presentation
In the Entertainment Group, which is also part of the Communications segment, revenue growth was slightly negative, but margins and profits rose. Total revenue for the group declined from $11.4 billion to $11.3 billion year-over-year driven by a small decline in video revenue and a decline in legacy/other revenue. The combined decline was partially offset by a significant gain in high-speed internet service revenue.
Indeed, the company lost 544,000 net subscribers in its premium TV segment, but ended the quarter with 22.4 million subscribers. Its over-the-top service had 1.5 million subscribers at the end of the quarter, but that, too, was 83,000 subscribers fewer year-over-year.
However, despite the somewhat dreary top line performance of the segment, AT&T’s focus on average revenue per user, or ARPU, in addition to declining operating costs, helped drive margins significantly higher in the first quarter.
AT&T saw much stronger ARPU in the quarter for premium video and broadband services, as both continue to expand nicely against recent results. Broadband ARPU was up a staggering 8.3% in the first quarter, while premium video ARPU was positive for the first time in several quarters.
This, combined with a 3.2% decline in cash operating expenses, was good enough to send EBITDA margin from 22.9% to 24.7% year-over-year, a terrific showing of +180bps. This helped EBITDA grow from $2.6 billion to $2.8 billion in Q1 despite lower revenue. Last quarter was the first in several that AT&T produced year-over-year EBITDA growth in the Entertainment Group, once again showing significant progress.
Cord cutting amongst consumers has impacted most TV providers in recent years and AT&T was no different in the last quarter. On Friday June 7th, it was announced that both AT&T and Dish Network Corp (DISH) could be interested in merging their satellite TV businesses. Dish and DirecTV lost a combined 2.75 subscribers over the last year.
With the high number of new competitors in the TV space, Dish and DirecTV might be able to gain regulatory approval for the merger. This remains speculative as both companies denied that they had engaged in talks.
On the other hand, Business Wireline performance was underwhelming. This segment showed a ~$200 million decline in total revenue year-over-year, from $6.7 billion to $6.5 billion. This legacy segment continues to struggle with both revenue growth and with negative operating leverage that accompanies revenue losses.
Business Wireline EBITDA also fell ~$200 million, from $2.7 billion to $2.5 billion year-over-year. This was due to revenue losses and a decline in EBITDA margin of 270bps, from 40.5% to 37.8%. Certainly, this is AT&T’s least attractive business segment, but importantly, it remains quite profitable.
As many expected, AT&T’s contentious and enormous acquisition of Time Warner has already begun to pay dividends for the parent company.
In the first quarter, the WarnerMedia segment produced $8.4 billion in total revenue, a very strong ~$300 million gain from the previous year. The segment’s strength came from theatrical and television gains, although the Warner Bros. portion of the business was responsible for the entirety of the revenue gain. That segment saw a huge gain in revenue, rising from $3.2 billion to $3.5 billion in the quarter and boosting its operating income margin from 11.8% of revenue to 15.3%.
The Turner segment saw a slight decline in revenues, but operating income margin rose significantly, from 33.7% to 36.2% year-over-year. Subscription revenues also improved. The shift in NCAA Final Four games to the second quarter of the year caused a decline in ad revenues for the first quarter. On the bright side, those revenues should show up as growth in second quarter revenue.
Lastly, HBO continues to provide significant profitability despite a small decline in revenue in the first quarter. The top line fell from $1.6 billion to $1.5 billion, but operating margin income, as seen with the other segments of the company, increased from 33.0% to 37.5%. This improvement drove higher operating income despite a lower revenue result. In addition, the company’s immensely popular Game of Thrones franchise debuted to millions of viewers in April, and we expect ongoing revenue and margin gains from subscribers beginning in the second quarter.
In conclusion, AT&T’s first quarter was very sound, though the company’s legacy business lines remain a headwind to overall results.
Source: Investor Presentation
Adjusted earnings-per-share improved by a penny over last year to $0.86 on revenue growth of 18%. Importantly, adjusted operating income margin increased 170bps due to broad-based strength in margins across its segments, irrespective of revenue change.
We think this is key for AT&T’s profitability and growth moving forward, and the first quarter shows not only that AT&T’s focus on costs is working, but also that its newer lines of business are driving growth.
Balance Sheet Analysis
One potential concern for AT&T that investors should be aware of is the impact of the company’s increasing debt, particularly in a rising interest rate environment. AT&T’s balance sheet has become stretched, due to the major acquisitions of DirecTV and Time Warner in recent years.
Fortunately, AT&T generates high levels of excess cash flow each quarter, which should help the company steadily pay down debt. In the past year, AT&T has produced more than $25 billion in free cash flow. In the first quarter alone, it produced $5.9 billion in free cash flow, using $3.7 billion of that to pay dividends, and using the remaining $2.3 billion to deleverage its balance sheet.
These transactions, which resulted in $3.6 billion in additional cash for AT&T, are providing the company with billions of dollars in additional capital that it will use to reduce its ~$170 billion debt load.
Source: Investor Presentation
To that end, the company believes it will pay off ~75% of the $40 billion in debt it issued to buy Time Warner by the end of the year, an extraordinary feat in our view.
Paying debt down this quickly should help assuage any fears investors may have about AT&T’s debt, as its leverage will be down to ~2.5X EBITDA by the end of 2019. This is a healthy leverage ratio.
We continue to expect very strong returns for AT&T in the coming years due to a variety of factors. We compute total expected returns in our Sure Analysis Research Database using the sum of dividend yield, valuation change, and earnings-per-share growth. Using these criteria, AT&T is among the most attractive stocks in our coverage universe today, particularly for those investors desiring income.
Beginning with growth, we’re forecasting 3.1% annual expansion in the bottom line on a per-share basis for the next five years. We see the company’s focus on cutting costs to boost margins – as it did with great effect in the first quarter– as a key driver. In addition, we expect revenue growth from WarnerMedia, as well as stronger performance from the wireless business’ service revenue.
However, we believe these factors will be partially offset by continued, slow declines in legacy businesses like business wireline. Still, margin expansion was enough to boost earnings in the first quarter despite some less-than-inspiring top line performances from the various segments, and we think AT&T’s growth looks decent enough in the years to come.
While bottom line growth is important, we believe that the bulk of total returns will accrue from the combination of the stock’s yield and the change in the valuation. The company’s dividend is now $2.04 per share, putting the current yield at 6.3%. That makes AT&T a premier income stock in just about any context, particularly outside of traditional income stocks like REITs.
In addition, the payout ratio is less than 60% of earnings for 2019 so it is very safe. For context, the company had an average dividend payout ratio of 71% from 2009 through 2018. Combined with a 35-year dividend increase streak, we see the payout as having a lot of room to run in the coming years.
You can watch a video further detailing AT&T’s dividend safety below:
The final component of total returns is change in the valuation, which we also see as a significant tailwind for AT&T. Shares trade today at just 9 times our 2019 earnings-per-share estimate of $3.60. That is the lowest price-to-earnings ratio the stock has seen in the past decade. For comparison purposes, the S&P 500 index has an average price-to-earnings ratio of more than 21.
Our fair value estimate is a price-to-earnings ratio of 12. We believe AT&T stock is a buy under $43. With a current share price of $32.50, the stock is trading at just 77% of our fair value estimate. This makes the stock undervalued in our opinion.
The low valuation multiple implies an annual tailwind of 5.9% over the next five years as the valuation returns to a more normalized level.
Given all of this, we see total annual returns in excess of 15%, consisting of the 6.3% dividend yield, 3%+ earnings growth, and a ~6% change in valuation.
Consistent with our previous review of AT&T, we believe that the stock offers investors the chance to own a piece of a dominant wireless business that also has several growth levers it can pull in the coming years, particularly with recently acquired businesses. Debt remains a concern for investors, but the company’s immense free cash flow, in our view, diminishes the importance of this concern. Non-core asset sales will also aid in deleveraging.
Given this, and very high expected total returns, not the least of which is the company’s enormous dividend yield, we rate AT&T a strong buy for the month of June. The first quarter report reinforces our bullish view on the stock. We think that the low current share price offers investors an attractive entry point into a strong franchise trading at a very low valuation.