AT&T: Still Cheap On Debt Reduction

by The Compound Investor

AT&T (T) stock looks pretty cheap judging by conventional valuation metrics. Check out the stock’s price-earnings ratio for example, which is way below its historical average. The current figure clocks in at just under 10x earnings – with that number based on the current $30 share price and last year’s normalized EPS of $3.05. A quick look at the stock’s trading history suggests that is a good 30% below the fifteen-year average of circa 13.5.

Secondly, check out the dividend yield, which currently stands at around 6.7% based on the 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 2009/10 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 $175b net of the company’s cash pile, it is absolutely gargantuan in nominal terms. AT&T’s underlying business is pretty big too of course, and should generate something like $40b worth of cashflow this year. Anyway the point is that debt adjusted valuation metrics don’t appear quite so attractive. The stock’s EV/EBITDA ratio, which currently stands at around 8, appears to be somewhere in line with its historical average.

Debt Reduction

Fortunately, there exists a straightforward way to reconcile these two points: debt reduction. The good news for shareholders and prospective shareholders is that there is a lot of wiggle room for AT&T to achieve this. Now, when the company reported Q3 2018 results back in October the market responded poorly, possibly because EPS came in lower than analysts expected. That said, the cash flow figures looked quite solid. Free cash flow, the stuff that will ultimately fund dividends and debt reduction here, clocked in at $6.5b for the quarter. That was around 16% higher than the $5.6b it generated during the equivalent period last year.

For the year as a whole, AT&T should generate something like $21b worth of free cash flow. The dividend – currently running at a rate of $2.00 per share per annum – takes up around $13.4b of that. Quick math therefore leaves us with around $7.6b left over for debt reduction this year.

That figure doesn’t actually look all that impressive, especially compared to the $175b net debt load. 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 $25b. Subtracting dividend commitments means we are looking at something like $11b 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. Reduced interest expenses alone could be worth an extra 5% in terms of annual EPS, while 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 this scenario as to how that might work. This year, the company expects to make adjusted EPS 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 profit, which is 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. Let’s call it a total return of around $75 per share all together. 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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