AT&T Cruises Into The Buy Zone

Summary:

• AT&T recently released its third quarter earnings. It easily beat estimates on revenue and adjusted EPS.
• When I last covered AT&T, I rated it a ‘hold’ on the grounds that its interest expenses were rising too rapidly. Today I think differently.
• AT&T stock has a high dividend yield of 7.4% and positive free cash flow growth, making it appealing for dividend investors.
• The stock is trading at a cheap valuation of six times earnings, providing a margin of safety for investors.
• AT&T’s latest earnings release showed solid FCF growth and profitability, suggesting that the company may survive and thrive in the future.

AT&T (NYSE:T) stock is one of the highest yielding telco stocks on the planet. With a 7.4% yield, it throws off buckets of income. True, its dividend has been cut in recent quarters. However, with the company having returned to positive free cash flow (“FCF”) growth in the second quarter, and continued the growth in Q3, T’s dividend may not have to be cut further. So, investors who buy AT&T for the dividend are likely to at least collect the payout they expected.

Indeed, AT&T is starting to look fairly appealing today, not only in terms of the dividend, but in general. The company’s stock is among the cheapest of all large caps, trading at a mere six times earnings and 1.09 times book value. This cheap valuation gives AT&T a “margin of safety” of sorts, as the company could likely be liquidated and sold for not much less than it currently trades for.

When I last wrote about AT&T stock, I rated it a ‘hold’ on the grounds that interest expenses on its massive amount of debt could become a problem. Interest expense is still a problem for AT&T, but the company is doing better than expected. Its most recent quarterly earnings release beat analyst expectations, delivering $0.64 in adjusted earnings per share (“EPS”) and $30.4 billion in total revenue. The company’s earnings increased, which suggests that it may no longer be “collapsing” like it once looked it was.

Granted, we need to assume a few things in order to confidently assert that AT&T will continue on the same path it was on in the last two quarters. The company has a lot of variable rate debt, so we need to assume that interest rates will continue to weigh on earnings. That is the case even if rates stay about where they are; if rates rise, then the problem will get worse.

With that being said, AT&T’s latest earnings release merits a close look. Not only did AT&T experience solid growth in the quarter, it was also highly profitable, with a 17% free cash flow margin. High FCF growth and high margins are not the kinds of characteristics you’d expect to see side by side in a dying company. Therefore, there are grounds to think that AT&T will survive–if not thrive–in the years ahead.

Nevertheless, real risks remain. Treasury yields are rising. Smartphone sales are declining. The industry as a whole remains very competitive. These are serious challenges for Telcos like AT&T. On the other hand, T stock is truly outrageously cheap today, “pricing in” much of the pain. Trading at a mere six times earnings, it is in deep value territory. In my previous article on the stock, I advised caution despite the cheapness, as I wasn’t sure whether the company would be able to outgrow its rising interest expense. Now, however, with Q3 earnings in the bag, it’s become clear that AT&T is not in clear and present danger. In this article I will explain why I consider AT&T a mild buy at today’s unquestionably cheap prices.

Competitive Landscape

In order to assess AT&T’s potential, we need to look at its competitive position. I already showed that the company booked two quarters of positive FCF growth, but that alone doesn’t say much. You can never simply assume that a trend will continue, you need to know the reasons why the trend is as it is. When it comes to corporate earnings, the main “reason” for an upward trend is a strong competitive position in a growing industry. So, we need to know how AT&T stacks up compared to its competitors.

As mentioned previously, the telco industry is a competitive one. According to Deloitte, the industry features “strong competition,” characterized by:

• Bundling, whereby customers can lock in lower prices-per-service by signing up for several of them.

• A race to build the fastest 5G network.

• Significant price competition.

These characteristics don’t make for a lot of pricing power. However, there are some areas where competition other than price competition is beginning to emerge in the telecommunications industry. For example, 5G networks. Many new mobile applications, such as online games, require fast 5G speeds in order to run smoothly. AT&T has gamers covered with one of the biggest 5G networks in the United States. Verizon (VZ) has AT&T beaten on “ultra fast” 5G, but its coverage is much less complete than AT&T’s is.

AT&T is currently the largest telco in the United States. Fully 44% of Americans rely on T for their cellular, cable and/or internet service. Sometimes companies trade places in market share rankings, but AT&T’s advantage in 5G deployment tends to argue that it will stay on top.

Profitability and Growth

Having explored AT&T’s competitive position, we can now look at its profitability and growth.

In the most recent quarter, AT&T delivered:

• $30.4 billion in revenue, up 1.2%.

• $10.2 billion in cash from operations, up 2.4%.

• $5.2 billion in free cash flow, up 33%.

• $5.7 billion in operating income, down 3.8%.

• $3.8 billion in net income, down 40%.

From these figures, we get:

• An 18.75% operating margin.

• An 18% FCF margin.

• A 12.5% net margin.

Pretty healthy margins, suggesting that AT&T is very profitable.

Now let’s look at the trailing 12 month profitability ratios from Seeking Alpha Quant:

• EBIT margin: 25.7%.

• 19.1% FCF margin.

• -9% net margin.

Apart from the net margin, these figures are healthy as well. For the trailing 12 month period, T’s earnings were in the red, although the last two quarters showed an admirable reversal of this trend. The picture on growth isn’t as pretty, with Seeking Alpha Quant showing a 21% decline in revenue and negative earnings in the trailing 12 month period. That’s not great, but again, the previous two quarters were much better than the ones that preceded them. Should this trend continue, then AT&T may fare well.

Risks and Challenges

As we’ve seen, AT&T stock has many things going for it that make it a tempting buy today. Indeed, over a long enough time horizon, its stock will probably perform pretty well starting from today’s prices. Nevertheless, there are many risks and challenges that investors will want to keep in mind. These include:

• Rising interest rates. AT&T has $138 billion in total debt and $128 billion in net debt. Some of that debt is variable rate. The higher interest rates go, the higher the interest expense on that debt goes. In its most recent quarter, AT&T’s interest expenses increased 6.5%. That’s the effect of higher rates in action. Should the Fed hike rates again, then AT&T’s interest rates will go higher still. With that said, the company’s EBIT interest coverage ratio is 2.3, so a few more rate hikes won’t drive it into bankruptcy court, or anything like that.

• Declining smartphone sales. Multiple industry reports have shown smartphone sales declining this year. This is a big problem for smartphone manufacturers, and a minor problem for telcos like AT&T. In addition to selling cell phone and internet plans, AT&T also sells smartphones. Smartphone sales are a source of revenue for AT&T in themselves. In addition, discounts on such phones serve as an inducement for customers to upgrade to more expensive cellular plans. For example, AT&T currently offers a $349 iPhone 15–provided you sign up for one of the company’s most expensive plans. Such discounts are great tools to drive signups, but unfortunately, not many people want to upgrade to the latest smartphones this year.

• Price competition. Telecommunication companies’ subscription fees have basically flatlined for a decade. There are so many competitors in the market that they’ve had to compete on price. There aren’t many catalysts on the horizon suggesting that these companies will regain pricing power, so the market will ultimately go to whoever signs up the most customers. AT&T has the greatest number of customers for now, but things could change in the future.

These risks and challenges are serious ones. My ‘buy’ rating on this stock is not with extraordinarily high conviction: I think that waiting for a slightly lower price might be a good idea here. Nevertheless, we’ve got a company trading at six times earnings while its free cash flow grows at a rapid pace. It is not a bankruptcy risk, based on its interest coverage ratio. I’d say investors could do worse than to take a small position in AT&T, though it’s not a stock I’d “go all in” on.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.

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