Wednesday, May 29, 2019

Why I Bought AT&T Now May 29, 2019 6:45 AM ET






About: AT&T Inc. (T), Includes: CMCSA
Registered investment advisor, REITs, dividend growth investing, portfolio strategy

Summary
AT&T racked up plenty of debt and was exacerbated when it acquired Time Warner.
FCF has been more than enough to cover dividends and the company has never been in danger of not being able to service its debt despite a rating downgrade.
With Q1 results better than expected, management kept 2019 the same, positioning it for an upside surprise later in the year.
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Since we last wrote about AT&T (T), the stock had underperformed Verizon (NYSE:VZ) and the S&P 500 (SPY) over the previous 5-year period by almost 40%. If we look at the 5-year trailing returns now, not much has changed for the better.

In fact, the performance gap has only widened. Throw in Comcast (CMCSA), which we didn't include back in November, and the underperformance is even more pronounced.


Much has changed over the last 6 months, however, and more importantly, I see the potential for several positive surprises in the year ahead that will boost the stock. While most investors have shied away from T because of its mounting debt, I suggest looking out 12-24 months and getting a glimpse of how the company will be positioned financially and how it will begin to leverage its vast content library obtained from Time Warner. In other words, waiting until the end of the year to see how the numbers play out might prove to be too late.

Source: Shutterstock

First Quarter Momentum

The first quarter results were quite positive, suggesting an upward adjustment to guidance for 2019. However, when asked about the possibility of raising guidance by one analyst on the earnings call, CEO Randall Stephenson suggested,

We are not raising our guidance, but as Randall said and I repeated, it's clear that we're on line of sight to not only meet but exceed that target, so we are just being careful with our representations going out.

Got to love it. Keeping expectations in check. Honestly, I prefer that management doesn't raise guidance. The old adage to underpromise and overdeliver is much more preferable than the other way around. Anyone who missed that call and is focused solely on the fact that guidance remained the same might miss out on what's brewing underneath.

Q1 Highlights


Operating revenues increased by almost 18%, while operating contribution was up almost 27%. However, all of this increase was due to the addition of WarnerMedia, which had operating revenues of $8.4 billion and operating contribution of $2.3 billion.

Looking at results at the highest level - with no growth - might look worrisome, but as we get into the details, I hope to shine some light on how some of these evidently negative figures are actually positive.

Take, for example, Communications, which generated $35 billion in revenues and $8 billion in operating profit but was relatively flat compared to Q1 2018.

A look at the underlying details sheds light on how the company is shifting its focus to be smarter about pricing and targeting - driving margins.

The tables below show the revenue categories for each business segment across all types of service revenues. Within Mobility, for example, revenues only slightly increased from $17.4 billion to $17.6 billion, but the shift to more service revenue is a positive development. In fact, it might be a better indicator of the direction of the business as equipment revenue is usually driven by upgrades - which can vary from quarter to quarter - and which had its worse quarter in history.

Wireless revenue increased over $350 million, which was slightly offset by the decrease in equipment revenue.
We can see a similar shift within the Entertainment Group and Business Wireline businesses, where more revenue is being generated by Advanced Data Services and less revenue is being generated by less profitable Legacy Voice & Data services.
So, while the flat revenue growth may have disappointed some investors, the shift to higher margin services is a positive indication of future profitability.
Management was upfront about expectations of further declines in traditional TV subscriptions. The number of customers on a 2-Year price promotion was 2.4 million at the beginning of the year and 700K of those rolled off in Q1. As pricing normalized for these customers, many cancelled their subscriptions. With about 1.6M additional customers still in the lock-up, we could see additional subscribers roll off, but the company is planning on launching a new thin client video product at a lower price point. This should reduce churn from the expiring promotional pricing, particularly for customers looking for lower price points.
The price increases in DirecTV Now also resulted in more customer losses but are expected to be less in Q2 and the rest of the year.
Source: AT&T Q12019 10Q

The impact of this shift in revenue mix can be seen below, where, despite flat revenue growth, segment operating contributions increased in both Mobility and Entertainment.

Business Wireline had the biggest decrease in both revenues and operating profit, but again, this was due to a shift in demand from legacy voice and data services to the more advanced IP-based offerings.

Source: AT&T Q12019 10Q
The shift in revenues within the Entertainment Group is shown below, where High Speed Internet revenues increased by over 10%, and was likely to be the biggest driver of the 13% increase in operating profit.

Source: AT&T Q12019 10Q

One of management's priorities this past quarter was to stabilize profitability in the entertainment group, and that goal was accomplished with a YOY EBITDA change of $181 million, after all 4 quarters in 2018 had negative EBITDA growth compared to the prior year.

The majority of that growth has to do with the increase in Fiber Broadband Connections from just under 2,000 in Q1 2018 to over 3,000 at the end of Q1 2019. (see table below) That is a 56.5% increase in which was consistent with a 31% increase in net Fiber Broadband additions.

DirecTV Now ARPU was also up more than $10, which helped drive an increase in revenue of 2.8%.

Source: AT&T Q12019 10Q

WarnerMedia


The newest addition to the AT&T family has no comps from Q1 2018 but, as I mentioned earlier, contributed over $8 billion in revenue and $2 billion in operating profit in Q1 2019. Revenues were spread across Turner, HBO, and Warner Bros, but the majority of operating profit was generated within the Turner business.

Management stated on the Q1 earnings call that it is on schedule to realize $700 million in annualized cost synergies by the end of the year.

Source: AT&T Q12019 10Q

I also want to point out that while Xandr is still relatively small, it is growing rapidly, and is a key component of AT&T's strategy of providing optimized marketing capabilities to advertisers. Xandr revenue was up over 26%, but it still ramping up and did not generate any operating profit.
Source: AT&T Q12019 10Q

Paying Down Debt


Part of the reason why investors have punished the stock in recent years is the high level of debt taken on by the company, most of which was used in the Time Warner acquisition. The chart below is obviously worrisome, if not for a viable and clear plan to get this debt reduced rather quickly.

Management's goal of reducing the debt/EBITDA ratio to 2.5 might look daunting, and it hasn't been that low since sometime in 2017. However, as I'll go over in the next section, management has a clear path to reaching that goal, and the Q1 results may have accelerated that timeline.

This year alone, there was about $7 billion in debt due as of December 2018, with a weighted average interest rate of 3%.
Source: AT&T Q12019 10Q

That alone would lead to an ongoing savings of $0.03 per share in interest payments, which is about half of what analysts are forecasting in EPS growth for 2020 from 2019. In Q1 alone, the company paid down about $2.3 billion in debt.

Source: AT&T Q12019 Investor Presentation

The plan for debt reduction for the remainder of the year looks as follows.
Source: AT&T Q12019 Investor Presentation

Follow the Cash Flow


As I mentioned in the previous article, the one thing that jumps out at me is how free cash flow for AT&T has continued to grow and yet, the stock price hasn't reflected it. In fact, since November, TTM cash flow has increased to $25.8 billion, and the stock is still in the low 30s.

To put this into context, consider that the highest price the stock has ever reached was around $57 in 1999, and Free Cash Flow was just $3 billion, while FCF per share was $1.17. Free Cash Flow is now $3.64 per share, and the price is $32.42!!

If cash is king, AT&T's stock price certainly isn't reflecting it.

FCF to Dividends


The ratio of FCF to dividends did decrease slightly to 1.6x, but this ratio still covers the current dividend payments.

Net cash provided by operating activities was up over $2 billion driven by higher depreciation and amortization costs and offset by production costs and paying down of accounts payable.
Source: AT&T Q12019 Investor Presentation
Source: AT&T Q12019 10Q

The company also has valuable assets that can be monetized as it has already done with Hulu and Hudson Yards, which generated an additional $3.6 billion of cash. The target of asset monetization for FY 2019 is $6 billion to $8 billion, so the Q1 divestments put the company almost halfway to its top line guidance after just one quarter.

Maintaining the Dividend


When a company becomes highly leveraged, it's only natural to question its ability to maintain its dividend, and/or continue to be a viable business. In AT&T's case, I see a very low probability that the dividend will be cut any time soon and an even lower probability that the company will face imminent financial challenges.

AT&T has increased its dividend slowly and steadily over time and now has a 6% plus dividend yield. It has raised its dividend at least $0.04 per share each year since 2008, when it increased its dividend by $0.18 per share. It's not a torrid dividend growth rate, but at a 6% plus yield and a payout ratio of less than 60%, it looks quite safe for now.

Source: Seeking Alpha

Analysts are forecasting 2019 dividends at $2.05 and 2020 dividends of $2.08. If bullish price targets of $48 are reached, that 6% yield won't be available much longer, and there is a strong possibility that dividend increases will accelerate.

Valuation


If analyst forecasts for $184 billion in revenues (7% growth) and flat EBITDA margins of 33% in 2020 prove to be accurate, then EPS of $3.62 in 2020 seems conservative. With $26 billion in FCF expected for FY 2019, I believe the company will reach its goal of debt/EBITDA of 2.5, and the EPS estimates for both 2019 and 2010 will prove to be too low.

I'm not quite as bullish to warrant a $48 price target as my base case scenario, but I believe the stock can easily get back up to the high 30s or low 40s over the next 12 months as progress on debt reduction and acquisition synergies flow through.

At a PE of 9, I find the stock to be deeply undervalued. Its 5-year average PE ratio is roughly 16.75 and has rarely been below 15. If we apply EPS of $3.62 and apply a 12 multiple (about halfway between the current PE and 15), we arrive at a price of $43. That's more than 30% upside from these levels.

My Take

Companies take on debt all the time, and if I'm an equity investor, I'd much rather a company issue debt than equity - provided it doesn't put the company in a precarious financial position. While debt levels did increase to 'scary' levels, AT&T's ability to service that debt was never in doubt.

It generates $25 billion to $26 billion in free cash flow and has the flexibility to sell several non-core assets for additional cash, if needed. It takes a long time for two very large companies to integrate and create synergies and new growth opportunities, and AT&T is just getting started with the Time Warner merger.

The stock has been unduly punished, and I believe it is too cheap to ignore but won't stay cheap for much longer. Investors waiting for positive news momentum to build up might find themselves buying at much higher prices. And, while I often suggest conservative investor wait for further clarity before investing, in this case, I think there is a large enough margin of safety.


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Disclosure: I am/we are long T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is meant to identify an idea for further research and analysis and should not be taken as a recommendation to invest. It does not provide individualized advice or recommendations for any specific reader. Also note that we may not cover all relevant risks related to the ideas presented in this article. Readers should conduct their own due diligence and carefully consider their own investment objectives, risk tolerance, time horizon, tax situation, liquidity needs, and concentration levels, or contact their advisor to determine if any ideas presented here are appropriate for their unique circumstances. Furthermore, none of the ideas presented here are necessarily related to NFG Wealth Advisors or any portfolio managed by NFG.

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