AT&T Inc. (T, Financial) shares have rallied sharply over the past six months and have delivered a total return of nearly 30%.
Despite this rally, the stock remains cheap based on most conventional measures. The stock trades at approximately 8 times consensus 2024 earnings per share and at a forward enterprise value/Ebitda ratio of approximately 6.10.
Mature, capital-intensive business with low returns on capital
Telecommunications is a mature, low-growth business. Market penetration for the service offered by AT&T is high and thus subscriber growth for the company's offerings is fairly low. The company's fiber offering is its fastest-growing segment, while the wireless business is growing more slowly and the wireline voice business is in decline. Competition across service offerings is fairly intense, which limits pricing power for industry players. For 2023, AT&T reported revenue growth of 1.40% versus 2022. For 2024, the company expects wireless services growth in the 3% range, broadband revenue growth of 7% and adjusted Ebitda growth in the 3% range.
In addition to being a low-growth, relatively mature business, the telecommunications company is highly capital intensive. Over the past 10 years, AT&T has spent an average of 13% of revenue each year on capital expenditures. For 2024, it expects to spend $21 billion to $22 billion on capital investments, which represents roughly 17% of consensus analyst estimates for 2024 revenue. The company's capital expenditures are focused on 5G and fiber, which are required to stay competitive with peers.
The wireless telecommunications business has historically been dominated by three players: AT&T, Verizon (VZ, Financial) and T-Mobile (TMUS, Financial). However, the space has gotten more competitive with players such as Comcast (CMCSA, Financial), Charter Communications (CHTR, Financial) and Altice USA (ATUS, Financial) now offering wireless phone services by operating mobile virtual networks. AT&T's fiber offering typically competes with fiber offerings from these cable companies as well.
The combination of low growth, high capital intensity and a robust competitive landscape have resulted in fairly low returns on invested capital. I do not believe any of these factors are likely to change in the near future and thus expect the company to continue to be a low return on invested capital business, posing a key headwind for shareholders.
Balance sheet and lead liabilities pose challenges
As of the fourth quarter of 2023, AT&T had a net leverage ratio of 2.97. While this marks an improvement from recent quarters, it remains fairly high. Comparably, Verizon has a net leverage ratio of 2.60 and T-Mobile has a net leverage ratio of 2.50. Thus, AT&T remains somewhat more levered than its rivals and has a stated objective to bring net leverage down to 2.50 by the first half of 2025. While AT&T has a well laddered debt maturity profile, the company is exposed to potential increases in interest expense if interest rates remain elevated or increase from current levels. As of Sept. 30, the company had a weighted average interest rate of 4.20% for its long-term debt portfolio. Thus, even if interest rates remain at current levels, AT&T is likely to experience rising interest costs as debt must be refinanced at higher rates, which will result in a headwind to profitability.
Another challenge currently facing the company is its exposure to potential lead liabilities. In July, the Wall Street Journal reported that AT&T, Verizon and other telecom companies have left behind a network of cables covered in toxic lead. The U.S. Environmental Protection Agency has been conducting an investigation and is now seeking meetings with both companies to discuss the issue. Results of testing thus far appears to show the lead cables pose no significant health risk, but it is difficult to predict the ultimate outcome of the investigation and what, if any, liabilities the company may be on the hook for. Another key potential cost related to the lead liabilities would be a potential cost related to remove the lead-covered cables. Some estimates have put this figure for the industry as high as $21 billion, though the total cost is uncertain.
Valuation is not highly compelling versus historical norms
Currently, AT&T trades at roughly 8 times consensus 2024 earnings per share. While this valuation represents a significant discount to the S&P 500, which trades at approximately 22 times consensus 2024 earnings. The discount is warranted given the historically challenging nature of AT&T's business and limited grwoth prospects.
Over the past three years, the stock has traded at an average normalized price-earnings ratio of 8.50. On an enterprise value/Ebitbda basis, the company has traded at an average forward multiple of 6.60 over the past several years. Currently, the company trades at a forward multiple of 6.10.
While AT&T appears to be trading at modest discount to its recent historical average valuation, I view this discount as appropriate given the risks related to the company's highly levered balance sheet and potential lead cable liabilities.
Potential upside catalyst
One key potential upside catalyst for AT&T shares would be a decrease in interest rates. Given the company's high leverage levels, investors would likely feel more comfortable owning the stock if risks related to increasing interest expenses were to decrease. Additionally, the company has a fairly high dividend yield of roughly 6.20%, which would become more attractive relative to bonds in a lower interest rate environment as investors are currently able to earn close to 5.50% annual interest rates in U.S. government T-bills.
However, given the recent strength in economic data, it seems unlikely the Federal Reserve will get extremely aggressive in terms of cutting rates in the near term and the market has already priced in a number of rate cuts later in the year.
Conclusion
AT&T is cheap for a reason. The company operates in a mature industry characterized by a high degree of capital intensity and fairly robust competition. For these reasons, the company has historically struggled to generate strong returns on invested capital. I expect this trend to continue going forward.
Key risks facing the company include a highly levered balance sheet and potential liabilities related to the recently discovered lead cables.
AT&T currently trades at a modest discount to its recent average historical valuation based on key metrics such as the price-earnings and EV/Ebitda ratios. However, this discount seems appropriate given the challenges facing the company.
I view AT&T as a value trap and do not find shares attractive at current levels versus the broader market.
