AT&T (NYSE:T) has been embroiled in a fierce battle among investors, with bears gaining the upper hand in recent times. However, the significant decline in AT&T’s stock price has presented an opportunity for attractive total returns, even in the face of modest growth. Investors seeking a telecom stock may find it worthwhile to seize this buying opportunity, benefiting from a high yield and a remarkably low valuation.
Recent AT&T Stock Performance
The recent performance of AT&T Inc. reflects its underperformance compared to the broader market. There has been accelerated selling pressure on AT&T while the S&P 500 has experienced a 3% increase over the last month, translating to an annualized growth rate of over 30%. Conversely, AT&T has witnessed a 14% decline within the same period. Although the market’s interest in AI-themed stocks contributed to AT&T’s underperformance to some extent, it also fell behind other stable blue-chip stocks. Several factors fueled the selling pressure, including AT&T’s CEO acknowledging that subscriber additions during the second quarter might fall short of estimates, as revealed at a Bank of America (NYSE:BAC) conference in June. Furthermore, downgrades by analysts, such as JPMorgan (NYSE:JPM) downgrading from Buy to Neutral and Citi (NYSE:C) downgrading AT&T along with other telecom companies, further influenced the weakened share price performance.
It is worth noting that the downgrades from these banks occurred when AT&T’s shares had already experienced a substantial decline from their recent highs of around $20. As a result, these downgrades did not provide significant assistance and instead added to the selling pressure. Paradoxically, these downgrades contribute to an even more enticing buying opportunity.
Cash flow is a critical aspect to consider when evaluating AT&T. As a telecom company, it is not primarily focused on growth but rather serves as an income investment for many and a value investment for others. When the stock is undervalued and this undervaluation diminishes over time, investors can benefit from share price appreciation, even without substantial underlying business growth. Additionally, AT&T is undergoing a deleveraging process, aiming to reduce its high debt load. As debt is paid down, value is transferred from debt holders to equity investors, assuming the enterprise value remains relatively stable.
Cash flows hold tremendous importance for income investors, value investors, and those interested in the deleveraging story of AT&T. Cash flows are required to finance dividends, repay debt, and play a pivotal role in valuing the company, often employing free cash flow yield or multiple approaches.
In the past, concerns have arisen regarding AT&T’s ability to generate cash flows, particularly in terms of generating free cash flows. Free cash flow represents the portion of a company’s cash flows available for debt reduction, dividends, share buybacks, and acquisitions after accounting for organic capital expenditures. Given the heavy investments AT&T has made in its asset base to support technologies like 5G, with capital expenditures totaling $19 billion over the past year, questions have arisen about its cash flow generation ability. Although AT&T has maintained a strong free cash flow generation guidance, the company has had to revise its free cash flow projections downward in the past.
Some investors harbor worries that AT&T’s free cash flows for this year may fall short, particularly since the company’s free cash flows in the first quarter were relatively weak. AT&T had projected at least $16 billion in free cash generation for 2023 but only generated $1 billion during the first quarter, significantly below the forecasted average for the year. Nevertheless, AT&T’s management has maintained its free cash flow guidance, expecting a meaningful improvement throughout the year and a favorable shift in working capital, thereby boosting free cash flow for the remaining quarters. However, for AT&T to meet its FY 2023 guidance, a significant improvement in cash generation is required, with approximately $5 billion of free cash per quarter from Q2 to Q4.
AT&T is due to report its second-quarter earnings results soon, and delivering robust free cash flow numbers will be crucial. Market sentiment may be negatively impacted if AT&T’s free cash flow falls below $4 billion, as it would cast doubt on the company’s ability to reach $16 billion in free cash flow for the year. Since AT&T has not provided new guidance at recent conferences, it can be assumed that management still believes in its forecast. Consequently, the absence of revised guidance would be an imprudent move.
Adopting a conservative approach, let’s assume AT&T falls short of its guidance, generating $15 billion of free cash flow this year. At the current dividend level of $1.11 per share per year, the dividend consumes $7.9 billion annually. Thus, the dividend would be well-covered with a rate of 1.90 or a payout ratio of 53%. This payout ratio is significantly lower than many well-liked income stocks, such as Coca-Cola (NYSE:KO) with a 64% payout ratio, or AT&T’s peer Verizon Communications (NYSE:VZ), which distributed approximately 80% of its free cash flows over the last year. Simultaneously, AT&T’s annual dividend of $1.11 translates to an impressive dividend yield of 8.2%, making it highly attractive. A company that offers an 8% plus yield, covered almost two times by post-capex free cash flows, is indeed rare. It is important to note that this estimate assumes AT&T will miss its free cash flow guidance for the current year.
In this scenario, AT&T will have approximately $7 billion of free cash remaining after paying its dividend. This surplus can be utilized for various purposes, including debt reduction and acquisitions. Admittedly, AT&T’s debt load exceeds $100 billion, making it unlikely to repay a significant portion of its debt within a short period. However, the debt is well-laddered, meaning there is not a substantial amount maturing each year. This is advantageous during periods of rising interest rates, as the company does not face the pressure of refinancing large amounts of debt at significantly higher rates. Additionally, with relatively low annual debt maturities, AT&T can allocate a significant portion of its organic cash flows to debt repayment, further reducing its obligations.
Turning to AT&T’s growth and valuation, the company has forecasted a slowdown in growth for its mobility segment, projecting 2% to 3% this year compared to 5% and 4% in 2021 and 2022, respectively. While slower growth is not ideal, it is not necessarily catastrophic. In fact, AT&T’s current valuation suggests that the market perceives the company as being in a state of perpetual decline. Consequently, even a low single-digit growth rate would be considered favorable. At its present price, AT&T trades at a mere 5.6x EBITDA, representing a notable discount compared to the 5-year and 10-year median EBITDA multiples of 6.4 and 6.2, respectively. Although one might anticipate approximately 15% upside potential to reach the longer-term valuation average, the possibilities for AT&T’s shares are much more substantial. Since enterprise value includes net debt, it significantly influences AT&T. Should AT&T’s enterprise value to EBITDA multiple reach 6.2, the stock would surge by 26% to approximately $17.00. Moreover, a reversion to the 5-year median of 6.2 would result in a 35% rally to $18.20. This analysis demonstrates that a return to the longer-term average valuation could yield significant share price gains for investors who purchase AT&T at its current price. Furthermore, these calculations do not account for the added value that will be transferred from debt investors to equity investors through deleveraging efforts over time.
Alternatively, another valuable perspective is AT&T’s earnings multiple, which presently stands at a modest 5.6. This translates into a remarkably high earnings yield of 18%. Investing in a company with an 18% earnings yield implies that little to no growth is required for the investment to be successful. In fact, no growth is necessary at all. Assuming AT&T achieves the projected $2.43 in earnings for 2023 and subsequent years, a higher share price than $13.50 would be justified. AT&T could continue paying its current dividend indefinitely while progressively eliminating all of its debt, effectively reducing the investment risk associated with the company. This reduction in risk would likely result in increased demand for AT&T shares and subsequent share price gains.
In conclusion, while AT&T has not been an exceptional investment for long-term holders, its shares have exhibited considerable volatility in the past, affording investors who purchased at low points the opportunity for substantial gains. The current ultra-low valuation of AT&T stock presents a favorable buying opportunity. The dividend appears sustainable, there is ample free cash for deleveraging, and the discount compared to AT&T’s historical valuation implies substantial upside potential for shares. Is AT&T an extraordinary company? No. However, it is priced so attractively that it requires relatively few positive outcomes to provide compelling total returns, particularly considering its high yield.
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