Depending on how you look at things AT&T (NYSE: T) stock is either incredibly cheap or really not that cheap at all. Supporting the argument in favor of the former point of view are a couple of undeniable facts. Firstly, the stock’s price-to-earnings ratio is way below its historical average. Based on last year’s normalized profit per share figure ($3.05) and AT&T’s current share price ($30) we get a P/E ratio of just under 10. That’s a good 30% below the fifteen-year average of around 13.5x annual earnings.
Secondly, check out the dividend yield. It’s currently up at around 6.7% based on the $0.50 quarterly distribution. How often does AT&T throw up that kind of yield? Not very. According to my data source the last time it did so was around the 2009/2010 period. Annual shareholder returns since then do not appear spectacular at around 8.5% per annum, but they are hardly catastrophic for a security often touted as a bond proxy.
The thing that is missing from these attractive valuation metrics is the debt load. At $175 billion net of the company’s cash pile it is absolutely gargantuan in nominal terms. Of course, AT&T’s underlying business is pretty big too. After all it is on course to generate something like $40 billion worth of cash from operations this year. However debt adjusted valuation metrics don’t appear to stand out quite so much. For instance the stock’s EV/EBITDA, currently around 8x, appears to be somewhere in line with its historical average.
Fortunately there’s a straightforward way to reconcile these two points: debt reduction. The good news for shareholders and prospective shareholders is that there’s a lot of wiggle room for AT&T to achieve this. When the company reported Q3 2018 results back in October the market responded poorly, possibly because earnings per share came in lower than analysts expected. That said the cash flow figures were actually quite solid. Free cash flow, the stuff that will ultimately fund dividends and debt reduction, clocked in at $6.5 billion in the three months to September. That’s up about 16% on the $5.6 billion generated during the equivalent period 2017.
Now for the year as a whole, AT&T will generate something like $21 billion worth of post-capex free cash flow. The dividend – currently running at a rate of $2 per share per annum – takes up around $13.4 billion of that for FY 2018. That leaves us with around $7.6 billion per annum for straight up net debt reduction this year.
(Source: AT&T Q3 2018 Results Presentation)
At first glance that figure doesn’t actually look all that impressive. After all net debt is $175 billion, roughly 23x our post-dividend free cash flow number. However one of the big reasons for AT&T’s stretched balance sheet was the acquisition of TimeWarner. The deal to acquire the owner of media assets like HBO, Warner Bros., CNN and Cartoon Network closed in June of this year. That means that only half of fiscal year 2018 contains figures that are representative of the newly enlarged AT&T. If we take figures from 2019 onwards as a truer reflection then the situation looks a bit brighter. Indeed in FY 2019 free cash flow should clock in at around $25 billion. Subtracting dividend commitments means we are looking at something like $11-$12 billion in terms of cash left over each year for debt reduction.
What does this all mean from an investment perspective? Well, if your base scenario is that AT&T’s core business is stagnant then you will still make good money here. I mean reduced interest expenses alone could be worth an extra 5-6% in terms of annual earnings per share. The dividend yield is already around 6.7% and fairly secure. I find it quite easy to imagine a scenario under which AT&T stock generates double digit shareholder returns from here on out, even if the majority of that comes from cash dividends. Check out the scenario below as a rough example.
This year the company expects to make adjusted earnings per share of $3.50. Imagine that figure rises to $4.75 over the next decade; not a particularly optimistic scenario in inflation-adjusted terms. Lower debt levels might support a valuation of let’s say 12x annual profits – still a somewhat conservative assumption. That would give us a tentative share price of $52.25. On top of that, cumulative dividend cash could realistically clock in at somewhere around $22-$25 per share. All-in-all let’s call it a total return of around $75 per share. There you have, under a fairly modest set of assumptions, annual returns of nearly 10% per annum. For a bond proxy like AT&T it looks pretty attractive.