Published on May 1st, 2019 by Josh Arnold
Shares of telecommunications giant AT&T Inc. (T) have had a rough ride over the past few years. After peaking at $43 in the summer of 2016, shares have declined to $30 and have underperformed the broader market.
While this sort of performance is undoubtedly disappointing, we also 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 cheap 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.
There are currently 57 Dividend Aristocrats, including AT&T. You can download an Excel spreadsheet of all 57 (with metrics that matter) by clicking the link below:
In this article, 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 think the stock is a strong buy for May 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. The company we know today is the product of a complex web of mergers and spinoffs that have taken place since 1984. That was 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 $223 billion, making it among the largest U.S. stocks.
AT&T reported first quarter earnings on April 24, 2019, and results were largely in line with our expectations. However, given the price of the stock, that was good enough for us to remain bullish on the stock.
The Communications segment is by far the largest in AT&T’s arsenal, containing the core telecommunications and entertainment services businesses. Results in Q1 were largely in-line with last year on the top and bottom lines, but even so, progress is being made.
Source: Investor presentation, page 8
In the Mobility portion of the segment, AT&T continues to make steady progress, 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.
AT&T’s revenue in this space is driven by service and equipment revenue, respectively, and the two are quite different. Service revenue comes from recurring sources like monthly wireless service, which is also high margin.
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.
Last quarter, while total revenue rose only ~$200 million, service revenue rose by double that amount, more than offsetting a ~$200 million decline in equipment revenue. While shareholders would certainly like to see both sub-segments of revenue rising, maintaining service revenue growth will always be preferred.
AT&T was impacted by record-low smartphone upgrades in Q1, which drove the decline 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 very nicely in recent quarters, showing immense improvement from weak results in early 2018. Adding net subscribers is certainly helping, and with AT&T’s 5G FirstNet deployment being more than halfway done at this point, we expect service revenue growth will remain strong for the foreseeable future.
Churn remains low as well, coming in at 0.93%, which is a Q1 record for AT&T. While equipment revenue was weaker-than-expected, this was more than offset by a terrific showing from service revenue, which is where we believe investors should focus.
Source: Investor presentation, page 9
In the Entertainment Group, which is also part of the Communications segment, revenue growth was slightly negative, but margins rose and so did profits. Total revenue declined for the group from $11.4 billion to $11.3 billion year-over-year driven by a small decline in video revenue, as well as a decline in legacy/other revenue, the combination of which 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 Q1.
AT&T saw much stronger ARPU in Q1 for premium video as well as broadband services, as both continue to expand nicely against recent results. Broadband ARPU was up a staggering 8.3% in Q1, 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 grow in the Entertainment Group, once again showing significant progress.
The story was certainly less rosy with Business Wireline, which showed a ~$200 million decline in total revenue year-over-year, falling from $6.7 billion to $6.5 billion. This legacy segment continues to struggle with not only revenue growth, but the negative operating leverage that accompanies revenue losses.
Segment EBITDA also fell ~$200 million, declining 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 is still quite profitable despite recent struggles.
AT&T’s contentious and enormous acquisition of Time Warner has already begun to pay dividends to the parent company, as expected.
Source: Investor presentation, page 10
In Q1, the WarnerMedia segment produced a very strong ~$300 million gain in total revenue, rising from $8.1 billion to $8.4 billion. 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 Q1 and boosting its operating income margin from 11.8% of revenue to 15.3%.
The Turner segment saw its revenues decline slightly, but operating income margin rose significantly, having been boosted from 33.7% to 36.2% year-over-year. Gains were achieved as subscription revenue grew, and despite the shift in NCAA Final Four games to the second quarter of the year, which resulted in a decline in ad revenues for Q1. On the bright side, those revenues should show up as growth in Q2 revenue for this year.
Finally, HBO continues to provide significant profitability despite a small decline in revenue in Q1. The top line fell from $1.6 billion to $1.5 billion, but operating margin income, consistent with the other segments, rose from 33.0% to 37.5%. This helped drive higher operating income year-over-year despite lower revenue. In addition, the company’s hugely popular Game of Thrones franchise debuted to millions of viewers in April, and we expect ongoing revenue and margin gains from subscribers beginning in Q2.
In total, AT&T’s Q1 was largely positive, but the company still has some headwinds to work out, particularly with legacy business lines.
Source: Investor presentation, page 5
Adjusted earnings-per-share came a penny higher than last year at $0.86 on revenue growth of 18%. Importantly, adjusted operating income margin was up 170bps thanks 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 Q1 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 investors 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.
Source: Investor presentation, page 6
Fortunately, AT&T generates excess cash flow, which helps the company steadily pay down debt. In the past twelve months, AT&T has produced more than $25 billion in free cash flow. In Q1 alone, it produced $5.9 billion in free cash flow, using $3.7 billion of that to pay dividends, and using $2.3 billion to deleverage.
In addition to free cash flow, the company is selling off non-core assets like its former stake in the Hulu business, as well as a more recent transaction selling off office space in the Hudson Yards development.
These transactions are providing the company with billions of dollars in additional cash it will use to reduce its ~$170 billion debt load.
Source: Investor presentation, page 12
To that end, the company believes it will pay off ~75% of the 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.
Expected Returns
We see very strong expected 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 income investors.
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 Q1 – as a key driver. In addition, revenue growth from the company’s WarnerMedia in particular, as well as stronger recent 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, for instance. Still, margin expansion was enough to boost earnings in Q1 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.
However, the bulk of total returns will accrue from the combination of the yield and the change in the valuation. The company’s dividend is now $2.04 per share, putting the current yield at 6.5%. 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, and 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. Shares trade today at just 8.5 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.
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 $31, the stock is undervalued.
The low valuation multiple implies an annual tailwind of 7% in the coming years as the valuation returns to a more normalized level.
Given all of this, we see total annual returns in excess of 16%, consisting of the 6.5% dividend yield, 3%+ earnings growth, and a ~7% change in valuation.
Final Thoughts
AT&T 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.
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. The Q1 report supports our bullish view on the stock, and we think the low current share price represents an opportunity to buy a strong franchise at an attractive valuation.
