AT&T (NYSE: T) is the second-largest U.S. wireless carrier with nearly 100 million customers across a broad mix of telecommunications services. AT&T still offers local phone services in 22 states as well as internet, television, data services and web hosting. The company books 55% of sales from wireless services, followed by wireline data and managed IT services (29%) and 16% from wireline voice services.
The company made a huge announcement in May when it agreed to acquire DirecTV for $48.5 billion to expand AT&T’s reach into pay-television. DirecTV has more than 20 million customers in the U.S. but brings enviable geographic diversification with its 18 million customers in Latin America. The deal would help the company push bundled services, especially across DirecTV’s existing network of retail stores. The deal still needs regulatory approval but AT&T has promised to expand broadband service to 15 million homes if it is approved.
AT&T is also expanding its geographic reach with the recent purchase of Grupo Lusacel SA for $2.5 billion. Lusacel is the third-largest wireless operator in Mexico that has struggled to compete with America Movil (AMOV). A new telecommunications reform law signed four months ago could make it easier for smaller firms to compete and AT&T’s purchase may come at just the right time. The deal is expected to close in the first quarter of 2015.
Sales growth has moderated over the last few years with the U.S. market for wireless services reaching maturity. The company has been expanding into international markets and has had to compete aggressively in the domestic market, which has hit operating income as costs increase.
A current ratio of 0.65, meaning that near-term liabilities far exceed current assets, would normally be a red flag but its not likely to be a problem with AT&T. The company is a cash generating powerhouse with $11.3 billion in free cash flow over the past four quarters and would not have a problem raising money for operational needs. The company has issued more debt than it has repaid in four of the last six fiscal years and funds 45% of its capital structure through debt.
As with other financials, cash flow has been strong over the long-term but has fallen off over the last few years. Besides lower cash flows from operations, due to slightly lower earnings, AT&T increased capital spending by $1.3 billion over the last year which has hit free cash flow.
Dividends and Growth
Shares pay an extremely high 5.2% yield, just slightly lower than the 5.5% average yield over the last five years but well above the market’s current sub-2% yield. AT&T has paid a dividend since 1881 and has increased its dividend for 30 years.
One-time items caused the company’s net income to plummet in 2011 and 2012 and the company paid out more than 100% of earnings in dividends. Excluding the two outlier years, the company’s current payout ratio of 56% is just below the average of 60% since 2009. Dividends have been increased at a compound rate of 2.3% over the last five years.
The company regularly repurchases shares though it has slowed the buyback over the last year to $3.5 billion versus $13.0 billion in fiscal 2013. Cash return to shareholders will likely remain subdued over the next year or two as the company digests its massive acquisition of DirecTV but cash returns could increase substantially afterwards.
Shares of AT&T trade for a relatively inexpensive 10.8 times trailing earnings, well under the average of 16.1 times for the industry. Earnings are expected to increase at a modest 1.1% to $2.60 per share in 2015 on sales growth of 2.4% to $135.77 billion. While the company typically meets expectations pretty closely, I believe there is some upside potential as the company refocuses on cost control after the big DirecTV acquisition. A multiple of 14.5 times on $2.65 per share earnings would bring the stock to $38.42 per share.
Discounting future cash flows confirms a shares being slightly undervalued as well. Assuming a cost of capital of 5.9% and a sustainable dividend growth rate of 2.5% into perpetuity, yields a fair value of $39.65 per share. This growth rate in dividends is only slightly above the average over the last five years and I think there is a good chance the company can beat it over the next several years.
I like the diversification the company gets from its DirecTV acquisition and the stability in sales on other products. The dividend yield on the shares is outstanding, especially considering yields available in the market right now. While dividend growth and the buyback will probably be limited as the company integrates recent acquisitions, cash return to shareholders could jump in later years. I think investors can buy shares now ahead of stronger sales and eventually stronger operational performance.
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