Growth is not normally a word associated with AT&T (T). I mean, earnings per share (“EPS”) came in at around $2.75 in 2007 – with that figure only growing to about $3.05 as of last year. For many folks, that statistic alone marks the end of any consideration of the stock as an investment. Young investors in particular fall for this ‘growth trap’ – the idea that high earnings growth automatically equals high shareholder returns. It does not, at least not necessarily anyhow.
At this point I will give another shoutout to Dr Jeremey Siegel and his book – The Future For Investors: Why The Tried And The True Triumphs Over The Bold And The New – because the growth trap is really counterintuitive until you see an example. A good one is Royal Dutch Shell. Shell stock compounded at an average rate of around 13.5% per annum between the late-1950s and the early-2000s. It did so despite average annual of EPS growth of just 6.65%. How? Well, the stock’s average dividend yield clocked in at 5.25% over that time.
Sticking with the oil patch, how about another example? Between 1950 and 2003, Standard Oil Of New Jersey, which went on to become the “Exxon” part of Exxon Mobil, grew its EPS at an average annual rate of approximately 7.5%. Total shareholder returns, however, outpaced that by a whopping 6.9 percentage points per annum.
This is the blueprint for AT&T going forward. As it stands, the stock is trading at just under 9x prospective 2018 net profit. Put another way, that is an earnings yield of over 11% straight off the bat. You don’t even need any organic growth here to make very tidy returns for a stodgy blue chip stock. It just has to keep doing what it is currently doing. Oh, and the dividend yield is currently around 6.6%.
Okay, so what gives? An earnings yield that is over 11% – essentially implying we don’t need any organic growth to lock in double digit compound annual returns – is too good to be true, right? To answer that question, most folks would point you towards the balance sheet. One of the consequences of acquiring both Time Warner and DirecTV in the space of a few years is whopping levels of debt. The headline figure is around $175b net of cash right now. If we divide that by the 7.3b shares of AT&T currently in existence, then we get a per-share net debt figure of around $24. Suffice to say that is pretty high.
The above notwithstanding, I remain optimistic. Debt reduction is a prize in itself given the annual interest bill and current valuation, something I have said before. I mean, the firm is paying something like 4.5% per year on its debt load. Let’s call that $8b per year in cash terms. It will also throw off free cash flow in the $21b region. That is a company estimate and probably fairly accurate. Anyway, an amount equal to 40% of annual free cash flow is going to bondholders rather than shareholders.
The good news is the cash flow situation is fairly solid. That was covered about a month ago – the bottom line being that there should be around $7b per year for debt reduction. Let’s suppose AT&T can reduce its interest bill by 40% within a decade without a dividend cut. That seems like a realistic proposition given its rate of cash generation. On its own, that would be worth around 45¢ per share, and roughly equal to a 13% boost to current annual EPS. Spread over a decade, it equates to around 1.25% per year on average. Now that may not sound like much, but remember that is on top of an earnings yield in excess of 11%. So don’t be put off by the low growth prospects, there is more than enough value to make things work out very well for those buying today.
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