Justin Sullivan
It has been a tough year for AT&T (NYSE:T), with the stock trading near historical lows. Despite its 7.1% annualized dividend yield, the stock’s staggered valuation today suggests that its income-focused investor base are not pleased with the company’s progress. The company’s full divestiture from its failed dabble in media and entertainment has also shown little payoff, as investors remain skeptical over whether the company could right its course – especially ahead of a shaky macroeconomic backdrop that had management slashing AT&T’s free cash flow guidance for the year during the 2Q22 earnings call.
Specifically, management’s decision to cut its original free cash flow guidance of $16 billion by $2 billion, with lengthening customer payment collection cycles observed during 2Q22 contributing to a $1 billion headwind, have only increased investors’ angst over the sustainability of AT&T’s dividend yield given its highly leveraged balance sheet harbingers significant long-term financial obligations still.
However, beneath all of the ugly challenges lie robust fundamental performance by the telco giant. The company’s 3Q22 sales and earnings beat, accompanied by an upward revision to its full-year EPS guidance from the previous $2.42 to $2.46 range to now above $2.50 is also consistent with our earlier expectations for an earnings surprise:
In the latest turn of events, CFO Desroches had recently shared that “AT&T is not seeing any material incremental shift in its cash collection cycles, which are within the company’s expectations and largely consistent with normal pre-pandemic levels”. This provides grounds that while the earlier decision to slash free cash flow guidance for the year may have been appropriately conservative, an earnings surprise could still be within reach for AT&T later this year.
The optimism is further corroborated by the company’s expectations for a back-end weighted year, as mobility contract pricing increases implemented in May start to reflect in its fundamentals, driving sustained growth from its existing and still-growing postpaid customer base.
Source: “AT&T: Fundamentals May Compensate for the Low Multiple”
AT&T’s market leading resilience demonstrated in 2Q22 has carried through 3Q22, with 708,000 post-paid phone adds in the three months through September and 338,000 fiber adds over the same period. Delays in customer payment collection cycles have not deteriorated further since earlier warning signs communicated in April, which is consistent with observations mentioned in our previous coverage that any related losses would not be permanent and the situation would improve ahead of a back-end weighted year:
In the latest turn of events, CFO Desroches had recently shared that “AT&T is not seeing any material incremental shift in its cash collection cycles, which are within the company’s expectations and largely consistent with normal pre-pandemic levels”. This provides grounds that while the earlier decision to slash free cash flow guidance for the year may have been appropriately conservative, an earnings surprise could still be within reach for AT&T later this year.
The optimism is further corroborated by the company’s expectations for a back-end weighted year, as mobility contract pricing increases implemented in May start to reflect in its fundamentals, driving sustained growth from its existing and still-growing postpaid customer base.
Source: “AT&T: Fundamentals May Compensate for the Low Multiple”
Achieving $14 billion in free cash flows by the end of the year is likely already in the bag for AT&T given its demonstration of continued resilience in 3Q22 with a double beat, and expectations for sustained demand through 4Q22 based on robust take-rates observed in recent weeks ahead of an anticipated seasonality-driven surge in end-of-year sign-ups. This largely safeguards AT&T’s ability to fulfil its ~$8 billion annualized dividend pay-out, with excess to further reduce leverage, which is consistent with management’s “focus on paying down debt”. AT&T’s robust 3Q22 performance also reinforces its credibility as a safe long-term investment with industry-leading dividend yield backed by strong fundamentals and a resilient business. As the company strengthens its focus on growing its broadband and wireless mobility business ahead of a digital era underpinned by connectivity, its free cash flows – and inadvertently, dividend pay-out – are expected to expand further, creating a compelling risk/reward opportunity at current levels that point to greater yields ahead.
Dividends are Safe
The continuation of AT&T’s market share gains through 3Q22 and optimistic commentary provided by management on the company’s near-term forward outlook given its decision to raise this year’s earnings guidance continues to support robust free cash flow generation.
The company benefited from post-paid phone net adds of 708,000 during the third quarter, complementing the 813,000 post-paid phone net adds in the second quarter to support rising momentum in market share gains. Despite waning consumer confidence ahead of rising inflationary pressures in everything from food and gasoline to housing loan payments, AT&T’s third quarter post-paid phone net adds continue to underscore its resilience. Its churn rates remained within low levels (~1%) as expected given its outstanding 3Q22 results, despite price hikes implemented in May to compensate for inflationary headwinds. This implies continued customer support for its value proposition, which is further corroborated by AT&T’s expanded 5G network coverage to “100 million people” as of September with a “target to more than 130 million people” by the end of the year. The company has likely benefited from promotion-driven demand as well given the earlier-than-expected iPhone 14 release this year. As discussed in our previous coverage, AT&T has been prudent and purposeful in the implementation of promotional activity and discounts, which is consistent with the company’s sustained profit margins alongside improved ARPU reported for the third quarter:
With AT&T offering the most attractive iPhone 14 phone plan ahead of the U.S. telco trio’s annual promotions arms race, the company is well-poised to benefit from greater consumer demand. And past performance indicates that the company has continued to benefit from discount offerings, turning them into a positive value-adding strategy that locks in greater long-term visibility into both revenue growth and margin expansion through scale, which assuages concerns that AT&T’s attractive iPhone 14 promotion might impact its near-term profitability.
Source: “AT&T: Fundamentals May Compensate for the Low Multiple”
The results also support gradual market share gains for AT&T, which defies an increasingly competitive landscape in the telco business, while also benefiting from its recent price hike’s favourable impact on profit margins, hence the increased EPS guidance for 2022.
The company’s heightened focus on expanding its fiber broadband business is also gaining momentum, with net adds growing 7% q/q from 316,000 in the second quarter to 338,000 in the third quarter. Related revenues also grew more than 30% y/y (or 6.1% for the broader Broadband segment), with total Consumer Wireline operating income margins expanding by an eye-popping 470 bps y/y from 5.7% in 3Q21 to 10.4% in 3Q22 as take-rates scale up alongside other realized cost efficiencies.
Pricing has been a critical “profit factor” this year, as companies across all industries have pulled the lever as a mean to compensate for near-term inflationary pressures. And based on AT&T’s robust results discussed in earlier sections, the company has definitely benefited from the pricing lever. But the company has also made meaningful inroads on the cost factor in the profit formula, remaining on track towards realizing $4 billion of its “$6 billion transformation cost savings run rate target by the end of this year”. This, again, makes a favourable contribution to AT&T’s full-year free cash flow target, and support its earlier claims in the year to navigate through the “difficult reality [of] real-time cost pressures in [its] business” effectively:
As we shared before, we’ve initially reinvested these savings to fuel growth in our core connectivity businesses. However, as we enter the back half of this year, we expect these savings to start to contribute to the bottom line.
As you’re likely aware, we’re taking proactive measures, such as selective pricing adjustments, to address as much of the very real inflationary pressures that are clearly impacting all parts of our economy…Still, we’re confident in our ability to emerge in this chapter, a stronger company, thanks to our position as one of the world’s largest-scaled telecom operators, our improved underlying financial flexibility, the cost reduction initiatives we have in place, the essential nature of the services we provide and our pricing actions that help partially offset these impacts.
Source: AT&T 2Q22 Earnings Call
And circling back to management’s commitment to deleveraging AT&T’s balance sheet, the company is expected to benefit from lower capital costs going forward as a result, which is favourable to improving its bottom-line. As discussed in one of our previous coverages on Warner Bros. Discovery (WBD), the media giant had inherited a significant portion of AT&T’s debt associated with its original acquisition of Time Warner in 2018 following the blockbuster WarnerMedia-Discovery merger in April, and much of it came at a fixed rate of about 4%, which provides visibility over the company’s long-term borrowing costs and shields it from material exposure to rapidly rising interest rates. And a similar cost structure comes with AT&T’s existing debt profile today – in other words, interest expenses are expected to come down over time as AT&T continues to pay down its outstanding borrowings, which will then contribute back to improved free cash flow margins that can further help towards the company’s deleveraging goals, while it also benefits from relatively lower costs of capital on fixed-rate debt compared to peers like T-Mobile (TMUS) that are looking to borrow today.
AT&T’s free cash flows are also expected to improve further ahead of an anticipated moderation in capex spend after an aggressive build-out of its 5G network over the past several years. The company is now focused on generating returns on its investment, as it focuses on transitioning legacy phone plans to 5G unlimited plans, alongside the roll-out of attractive sign-up incentives with a new slate of 5G-enabled devices. Meanwhile, 3G shutdown costs that will be completely rolled off by 2023 will also make a favourable contribution to AT&T’s forward free cash flow margins. The recent roll-out of federal funding totalling at least $95 billion towards supporting the build-out of high-speed internet connectivity across the U.S. also makes a favourable tailwind for AT&T’s push towards its fiber broadband ambitions without adding incremental pressure on its capital outlay requirements. This accordingly allows the company to further improve its free cash flows over the longer-term without stifling its growth trajectory. We view AT&T’s recent consideration of entering into joint ventures to fund its multi-year fiber aspirations as another prudent strategy that will allow it to capitalize on long-term growth stemming from increasing connectivity demand across the U.S. without adding pressure on its long-term free cash flow prospects.
Valuations are Attractive
The AT&T stock has remained rangebound in the low-teens, as it struggles to sustain any uptrend momentum since slashing its free cash flow guidance a few months back. The stock now trades at a forward P/E ratio of under 7x, which is a significant discount to the S&P 500’s average of about 17x to 18x even after the first-half wipe-out. Yet, AT&T’s fundamentals remain strong and the company continues to demonstrate resilience against looming macroeconomic uncertainties, with robust free cash flows backed by improving business growth and profitability, reduced expenses, and prudent capex spend.
Considering the steady-state P/E ratio computed based on the formula “1 divided by cost of equity”, which measures a company’s estimated intrinsic value when incremental investments neither contribute to growth nor declines, AT&T should trade closer to 12x forward earnings based on an 8% cost of equity which is consistent with the average U.S. cost of equity capital estimate. As mentioned in our previous coverage, we believe AT&T also demonstrates an ability to maintain growth at a five-year CAGR in the 2% to 3% range given managed visibility into its forward market share gains. Now trading at under 7x forward earnings, AT&T’s current value is not reflective of its growth prospects on a relative basis to peers (VZ: 7.2x forward P/E, 1% to 2% range forward growth; TMUS: 30.5x forward P/E, 2% to 3% range forward growth). Together, AT&T makes a favourable case for further upside potential over the longer-term as it continues to materialize on its long-term business plan.
Final Thoughts
The combination of AT&T’s dividend yield of 7.1% today, plus anticipated valuation upsides creates a compelling risk/reward opportunity at current levels. AT&T currently services more than 40% of American wireless connections, as it slowly captures share from previous industry leaders like Verizon which has been struggling to regain momentum amid intensifying competition. This continues to build a favourable case to support the sustainability of AT&T’s annual shareholder returns.
Looking ahead, the critical nature of connectivity will continue to buoy AT&T’s recurring revenue growth. Meanwhile, price increases implemented earlier on in the year are also expected to have a more evident impact on its fundamental over coming months, overshadowing any nominal churn as a result of inflationary headwinds. With previous warnings of lengthening customer payment cycles now also under control, AT&T continues to present itself as a safe income investment.
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