AT&T: Still Cheap On Debt Reduction

by The Compound Investor

Depending on how you look at things, AT&T (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 a 50¢ per share 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 back in the 2009/2010 period. Annual shareholder returns do not appear spectacular since then – running 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 $175,000m 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. It is on course to generate something like $40,000m worth of cash from its operating activities this year. However, debt adjusted valuation metrics don’t appear quite so attractive. For instance, the stock’s EV/EBITDA ratio, currently at around 8x, appears to be somewhere in line with its historical average.

Debt Reduction

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 3Q18 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 $6,500m for the quarter. That was around 16% higher than the $5,600m it generated during the equivalent period last year.

For the year as a whole, AT&T should generate something like $21,000m worth of post-CapEx surplus cash. The dividend – currently running at a rate of $2.00 per share per annum – takes up around $13,400m of that. That leaves us with around $7,600m for straight up debt reduction this year.

(Source: AT&T 3Q18 Results Presentation)

That figure doesn’t actually look all that impressive at first glance. After all, net debt is $175,000m, 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 FY18 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, FY19 free cash flow should clock in at around $25,000m. Subtracting dividend commitments means we are looking at something like $11,000m in terms of annual cash left over for debt reduction.

Outlook

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% 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.

The company expects to make adjusted earnings per share of $3.50 this year. 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 to $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, that looks pretty attractive.

Note

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