Barring a last minute catastrophe, AT&T (T) looks set to post a strong 2019. Shares in the Dallas-based telecom giant are currently up around 40% this year, inclusive of dividend cash, and comfortably ahead of relevant blue chip benchmarks like the S&P 500. Pretty good, right? Taken in isolation I guess the answer to that question is yes. Shift to a slightly longer-term perspective, and the answer is a bit less clear.
I mean, I have total returns at around 8.6% per annum over the past five years. Note that this figure includes reinvested dividend cash too. Given the stock is up 40% this year, that means most of the wealth creation that took place over the past five years occurred very recently. It says a lot about how beaten up the stock was that a 40% gain in twelve months might not represent meaningful long-term progress depending on your exact starting point.
So what is going on here? Two things standout to me in particular. First, AT&T has diluted its shareholders significantly in the intervening period. The 5.2b shares outstanding at the end of 2014 had ballooned to circa 7.3b by the end of 3Q19. Second, AT&T has taken on a lot more debt over the same timeframe. The balance sheet now sports around $85b in additional net debt compared to this point five years ago.
Debt Induced Hangover
Of course, both points stem from the big ticket acquisitions of pay-TV company DirecTV and media giant Time Warner. Indeed, the ongoing hangover associated with those deals partly explains why activist investors Elliott Management recently took a stake here with a view to shaking things up.
Now, the thing with hangovers is that they tend to incapacitate you until they finally wear off. In AT&T’s case, that takes the form of being committed entirely to debt reduction. I think the company has somewhere in the vicinity of $60b due over the next five years. Post-dividend, the company generates somewhere in the region of $12b per year in excess cash. Back of the envelope math suggests AT&T is essentially tied up for the foreseeable future.
Of course, the company can, and probably will, end up refinancing a chunk of that debt. But there doesn’t appear much room for discussion given its current credit rating. Debt reduction appears mandatory right now rather than an optional capital allocation decision.
On that note, we have both good news and bad news. The bad news is that debt reduction in itself is an inherently low returning activity. Just to illustrate that point, consider the interest bill on its $160b worth of net financial debt. This costs the company around 4.4% as things stand, or circa $7b per year. (Note that the $8.4b bill shown on the income statement includes other interest expenses not linked to financial debt).
Based on current cash generation, plus future growth from saved interest payments, it would take AT&T around thirteen years to completely wipe out its debt load. (I’m not saying the company should do this, it is just to illustrate a point). Run the numbers on what an extra $7b in pre-tax income looks like and you should get a tailwind of 2.5% per annum to AT&T’s bottom line.
Now compare that to the impact of stock buybacks. At its current share price, AT&T could retire around 315m shares with that $12b annual post-dividend cash flow figure. I make that equivalent to a circa 5% boost to the bottom line in ‘per-share’ terms.
On the flip side, the good news is probably twofold at this point. Firstly, AT&T stock is still reasonably valued to the extent that debt reduction can generate high single-digit returns. Indeed, quick math suggests returns of 8% per annum, consisting of a 5.2% current dividend yield and 2.5% annual growth from saved interest payments, all other things being equal. This is probably why the stock is up 40% this year. Back in January you could lock in 10% annual returns simply from the dividend and debt reduction.
Secondly, I would expect the share price to follow suit as debt reduction gathers pace. Eventually the company will be in position to throw north of $14b per annum at stock buybacks. As mentioned above, the net result would be a circa 5% boost to per-share profit metrics, all other things being equal.
Or put another way, AT&T could be in position to self fund dividend growth in the 5% per year region on top of a starting 5.2% yield – with both those figures based on its current stock price. Bear in mind that the company also expects earnings growth from a mixture of cost reductions, organic growth and synergies from the Time Warner deal. To me, that looks pretty attractive. The only significant assumption you have to make is that the profit engine from the day-to-day activities of selling cell phone plans, pay-TV and media content from WarnerMedia remains stable.
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