The market has been just a little more volatile lately, which has certainly piqued my interest. The energy sector seems to be generating the bulk of that volatility, but with a weighting much higher than I’d like in that particular sector which has been compounded by aggressive investments there over the last few months, I remain hesitant to the idea of constantly buying energy stocks.
Nonetheless, quite a few companies have reported earnings over the last week or so, which has provided some substantial oscillations, some for better and others for worse.
I honestly shouldn’t have even made this purchase from a cash flow perspective, as my cash position is a bit precarious right now due to heavy investing and an upcoming tax bill. But I guess you just can’t hold a dividend growth investor down!
I purchased 50 shares of AT&T Inc. (T) on 1/28/15 for $33.04 per share.
Overview
AT&T is a provider of wireline and wireless telecommunication services, as well as broadband and video services.
With roots dating back to the late 1800s, the company has grown into one of the largest telecommunication companies in the world.
They operate in two segments: Wireless (56% of fiscal year 2014 revenue) and Wireline (44%).
The company supports approximately 120 million wireless subscribers and connections.
Fundamentals
AT&T doesn’t sport massive growth like, say, a Silicon Valley startup, but that’s really not what this investment is for. This investment is all about cash flow in the form of big dividends, as I’ll discuss below. That said, AT&T is growing, albeit slowly.
Revenue has increased from $43.862 billion in FY 2005 to $132.447 billion in FY 2014. That’s a compound annual growth rate of 13.06% over that period, which is obviously impressive. However, this should be taken with a large grain of salt since the company that exists today is a result of a combination of assets of SBC Communications and AT&T as well as the later acquisition of Bell South, all of which occurred during this period.
Earnings per share actually decreased from $1.42 to $1.19 over this period, which is a CAGR of -1.94%. Not even close to spectacular or even passable; however, this, too, should be digested properly. First, the company took multiple adjustments this year, including a large non-cash adjustment of ($0.77) during the fourth quarter, largely due to pension costs. The adjusted EPS for FY 2014 was $2.51, which would show much greater growth. Second, telecommunications companies, like utilities and other companies that routinely record large non-cash charges should probably be evaluated through cash flow, where AT&T is still strong – free cash flow is up from just over $7 billion to just under $10 billion over this period.
S&P Capital IQ is anticipating that EPS will grow at a compound annual rate of 5% over the next three years, which seems reasonable to me. The company is guiding for similar expectations.
But where AT&T shines brightest is with its dividend.
The company has increased its dividend for the past 31 consecutive years, which is fantastic.
The dividend growth itself might leave a bit to be desired, as the 10-year dividend growth rate is only 3.9%. And the most recent raises have slowed as a result of AT&T sticking with a static $0.04/share annual increase to its payout.
However, the current yield of 5.69% should not be overlooked in terms of its potential to increase dividend income output of a portfolio and reinvestment potential.
The payout ratio stands at 74.9% of adjusted EPS, which is high. As such, I don’t see why the $0.04 annual increases will change for the better anytime soon. In addition, FCF just barely covered the dividend last year.
AT&T’s balance sheet is leveraged, with over $76 billion in long-term debt. That compares to $10.5 billion in cash and short-term investments. The long-term debt/equity ratio is 0.87and the interest coverage ratio is 7.48. These numbers are so-so in absolute terms, but actually compare very favorably to the competition.
The company’s profitability metrics also compare extremely well to competitors, with net margin that’s averaged 9.74% over the last five years and return on equity that’s averaged12.32%.
A lot of speculation has been thrown about in regards to a price war among domestic telecoms, but I’m actually not that concerned. If you look at the numbers among smaller players like Sprint Corp. (S) and T-Mobile US Inc. (TMUS), you see contracting (and razor thin) net margins and negative FCF. That’s the kind of business model that just doesn’t work over a long period of time, so it would seem to me that a rational pricing environment will eventually return, probably sooner rather than later.
The company’s much-watched net adds were up substantially year-over-year, with 1.9 million net adds in wireless. That’s more than twice the result of FY 2013. And that’s partially comprised of 854,000 postpaid net adds. Overall, the price war doesn’t seem to be affecting the company as much as some initially thought it would. This is partly why I decided to add to my stake for the first time since initiating a position in the companyback in 2011 for $28.87 per share.
Qualitative Aspects
AT&T has assets that places it in the top tier of telecommunications providers, which drives adds and helps them maintain relationships. They’re constantly improving their network to provide a higher level of service, which cultivates brand equity.
Project VIP is part of this strategy, which is a $14 billion investment in connectivity and reach. This has expanded the company’s 4G LTE network, IP network, fiber deployment, while also increasing the company’s broadband speed. While this spending has come at a cost to FCF, the company’s announced that capital expenditures related to this project have peaked, leading to lower capex guidance for FY 2015. Reading between the lines, that should mean an improvement in FCF and better dividend coverage.
And the company is doing more than just investing in quality. They’re also acquiring additional businesses which fit within their core competencies. AT&T closed the acquisition of Leap Wireless in early 2014, which gives them an increased presence in the prepaid market. And just recently, they announced that they closed the acquisition of Mexican wireless provider lusacell. That gives them access to 9.2 million subscribers and a network that covers approximately 70 percent of Mexico’s population. Finally, just two days ago, the company declared that they will acquire Nextel Mexico. You can see a trend here with the buildout in Latin America.
Of course, there’s also the pending acquisition of DIRECTV (DTV), which would immediately scale AT&T’s business in that market. DTV is Latin America’s is a leading pay TV provider in Latin America as well as the US, and there’s still a lot of growth potential. This move will also give them access to media delivery in a big and immediate way, if the acquisition is approved. The company expects a modest drop in EPS growth in FY 2015, but should be accretive in future years. They’re anticipating substantial cost synergies, which should exceed $1.6 billion on an annual run rate by year three after closing. This could completely change the face of the company and their growth potential, in my opinion. It also gives them a lot of flexibility in terms of bundling and increasing revenue per customer.
Data consumption isn’t going anywhere. Though the penetration rate is high and the low-hanging fruit has been picked – smartphones are 83 percent of the postpaid phone base – the business of providing data to data-hungry consumers is a cash cow business with highly visible recurring revenue. There might not be a lot of organic domestic growth left, but the aforementioned moves should propel the company’s growth at least in line with guidance in the low single digits for the foreseeable future, with some potential additional upside.
I personally like investing in companies that provide products and/or services that are ubiquitous. And I don’t know of many products more ubiquitous than phones (and increasingly smartphones). Communication is becoming more data driven than ever before, meaning network capacity, reach, service, and reliability are differentiating features that should allow entrenched firms like AT&T to continue profiting at a high level.
Risks
The telecommunications business is highly competitive, as shown by recent price wars. In addition, capital expenditures can remain elevated for years in order to expand network reach and capacity. For instance, AT&T’s capital expenditures in FY 2014 was over $21 billion, though the company is guiding for $18 billion in FY 2015. High capital expenditures limits the possible amount of cash flow that can be returned to shareholders.
In addition, technological obsolescence is always a risk in this industry. That obsolescence is leading to falling subscribers in wireline voice connections, which is a risk since the company still generates a lot of revenue from the wireline segment. There is also regulatory risks. Finally, there are risks relating to acquisitions, especially sizable ones like the aforementioned announced acquisition of DTV.
Valuation
The stock is offered for a P/E ratio of 13.61, using adjusted FY 2014 EPS. Their five-year average is 21.3, but numerous adjustments cloud the accuracy and reliability of this metric.
I valued shares using a dividend discount model analysis with an 8% discount rate and a 2.5% long-term growth rate. I’ve decided to start using an 8% discount rate when valuing stocks with a yield above 5% to account for the time value of money. The growth rate is in line with guidance and recent dividend growth, so I think it’s fairly accurate for the foreseeable future. The DDM analysis gives me a fair value of $35.04, indicating that shares are roughly fairly valued here.
Conclusion
AT&T has surprisingly been able to manage its cash flow at an impressive level by targeting multiple uses concurrently: returning substantial cash to shareholders in the form of a big dividend ($9.6 billion in FY 2014), buying back shares, investing in its network, and maintaining healthy margins.
Phones are ubiquitous and that’s unlikely to change any time soon. As communication becomes increasingly based around data and mobile, AT&T benefits through higher revenue opportunities even if some of their wireline business is cannibalized. The company sports an approximate 34% of the market share in wireless (along with major competitor, Verizon Communications Inc. (VZ)) and that huge share of the market brings in steady cash flow while the company diversifies its business offerings and improves its network to maintain that share. I see no reason why the company will not be able to continue paying out its sizable dividend for the foreseeable future. Although, I also don’t anticipate the dividend will grow much or any faster in the near future than it has in the past.
I personally agree with their move into Latin America and more pay TV. This further diversifies the business in a large way in terms of the services they offer as well as their geographical revenue mix.
This purchase adds $94.00 to my annual dividend income, based on the current $0.47 quarterly dividend per share.
I’m going to include current analyst valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates T as a 3/5 star value, with a fair value estimate of $34.00.
S&P Capital IQ rates T as a 4/5 star buy, with a fair value calculation of $33.00.
I’ll update my Freedom Fund in early February to reflect this recent purchase.
Full Disclosure: Long T and VZ.
What do you think of T here? Like the big dividend? Think it’s sustainable?
Thanks for reading.This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]
