(By Bob Ciura)
Shares of telecommunications giant AT&T Inc. (T, Financial) have declined 20% year to date. The good news is the stock could be an attractive income opportunity. On Nov. 6, AT&T’s share price fell to $32.67, which meant the dividend yield had reached 6%.
AT&T is one of 402 high-yielding stocks in Sure Dividend’s database.
The company's dividend yield is currently 5.8% as of this writing. Regardless, it is still a highly attractive dividend payout, especially since AT&T increases its dividend regularly. AT&T is a Dividend Aristocrat, a group of stocks with over 25 consecutive years of dividend increases.
AT&T has a strong brand, growth potential and generates enough cash flow to support its hefty dividend yield. As a result, it appears to be undervalued and a worthy stock pick for dividend investors.
Business overview
AT&T performed well in 2016, with 12% revenue growth and 5% growth of adjusted earnings. Its strong growth was due primarily to the $48.5 billion deal for satellite TV provider DirecTV in 2015.
2017 has been a different story. DirecTV continues to be a positive catalyst—AT&T has racked up 800,000 DirecTV subscribers in less than a year—but the company is battling against cord-cutting, a trend in which consumers cancel high-priced cable bundles in favor of skinny bundles and over-the-top services.
AT&T’s revenue dipped 3% in the most recent quarter, and is down 2.5% over the first three quarters of the fiscal year.
Source: Third-Quarter Earnings Presentation, page 3
AT&T’s total TV subscribers declined by 90,000 last quarter. It is also seeing deterioration in its legacy services. This drove a 220-basis point contraction in its Entertainment Group operating segment.
Fortunately, AT&T is seeing growth in its wireless and video services, which is helping to offset weakness in cable. The company added 1.5 million prepaid phone subscribers and another 600,000 postpaid smartphone subscribers last quarter. It also had its best-ever third-quarter churn of 0.84%.
Source: Third-Quarter Earnings Presentation, page 4
This drove record wireless margins of 42% for AT&T last quarter. Going forward, AT&T has its eye on another huge acquisition to drive growth in the years ahead.
Growth prospects
Normally, investors do not see much growth from telecoms. The U.S. market is saturated and has low growth potential. In situations like this, industries often consolidate, which is what has happened in telecommunications.
AT&T already made one huge acquisition with DirecTV, and now it is trying for another with its pending takeover of Time Warner Inc. (TWX).
Source: Time Warner Acquisition Presentation, page 6
Time Warner has a number of strong media properties, including TBS, TNT, HBO and the Warner Bros. movie studio.
With Time Warner in tow, AT&T would have over 140 million mobile subscribers and another 45 million video subscribers worldwide. AT&T is already growing subscribers organically—it expects 3 million total wireless net adds in 2017. Bringing in Time Warner would allow the company to offer new bundle packages across its services to try to take even more share from competitors.
Plus, owning content and distribution is a huge advantage. AT&T would have leverage over advertisers and would have a way to hedge itself against rising content costs by controlling content. Similar to many large merger and acquisition deals, there would almost certainly be an opportunity to generate cost synergies to boost earnings growth.
There has been the usual uncertainty surrounding AT&T. There is a rumor the company will have to unload CNN from Time Warner to make the deal pass Department of Justice scrutiny. There is also speculation the deal could be slowed by the DOJ. Chief Financial Officer John Stephens had this to say:
"All approvals have been received but for the DOJ. We are in active discussions with the DOJ. I cannot comment on those discussions...
But with those discussions I can now say that the timing of the closing of the deal is now uncertain."
Source: Capital.com weblink
Valuation and expected returns
The bright side of AT&T’s declining stock price is it now trades at a more attractive valuation. The company has a price-earnings (P/E) ratio of 16. This is slightly above its 10-year average P/E ratio of 13.6.
Source: Value Line
At first, it seems that AT&T is overvalued. But the company’s growth prospects are arguably better than at any point in the past 10 years. The company is coming off the successful DirecTV acquisition, which has significantly added growth, particularly in the international markets. While the Time Warner takeover is not yet final, it will likely receive approval. Assuming it goes through, Time Warner will further accelerate AT&T’s earnings growth.
Growth from these acquisitions raises AT&T’s expected returns. The large U.S. telecoms typically grow earnings in the low single digits, near the rate of GDP growth. Growth from acquisitions could fuel earnings growth in the mid-single-digit range. With higher earnings growth, AT&T would justify a slightly above-average valuation.
A potential breakdown of AT&T’s expected returns is below:
- 3% to 4% revenue growth.
- 1% margin expansion.
- 6% dividend yield.
If AT&T can manage 3% to 4% revenue growth and expand profit margins, its earnings growth would reach 4% to 5% per year. Margin expansion is likely as cost synergies are a focal point of large acquisitions, like the DirecTV and Time Warner deals.
Including the hefty 6% dividend yield, AT&T’s total expected returns would reach at least 10% per year. In addition, the dividend should continue to grow going forward. The company is a Dividend Aristocrat, increasing its dividend for 33 years in a row.
The dividend appears secure. AT&T had earnings per share of $1.68 through the first three quarters of 2017. Dividends accounted for $1.47 per share in the same period. This results in a payout ratio of 87%, which is high. While AT&T has incurred significant amortization, merger and integration-related expenses this year, these one-time items are not expected to recur.
Excluding these items, adjusted EPS were $2.27 through the first three quarters of 2017, for a dividend payout ratio of 65%. This is a healthy payout ratio and should leave room for the annual dividend increases to continue.
Final thoughts
AT&T stock has significantly underperformed the S&P 500 this year. The telecom industry is being disrupted by low-cost competitors taking customers by undercutting the giants. 2018 and beyond, however, should be better. New technologies like 5G will help AT&T regain its competitive advantage over smaller service providers undercutting it on price.
Plus, the Time Warner acquisition holds a wealth of opportunities for growth. With Time Warner, AT&T will have greater leverage by owning content and should realize significant cost synergies. At its current valuation, AT&T appears to be an attractive high-yield dividend stock.
Disclosure: I/We are not long any stocks mentioned in the article.
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