Back in May, I wrote a series of articles expressing my opinion that AT&T (T) remained a blue-chip, income-oriented stock and that investors were overreacting to the company’s negative price movement surrounding the Time Warner (NYSE:TWX) acquisition drama. At the time, shares were trading down in the $31/$32 area, which I said was essentially in line with a generational low valuation that would likely result in strong support. I also believed that the company’s dividend was safe, despite the high leverage on the balance sheet post the TWX purchase. While others disagreed, calling for calamity, my overarching message was this: focus on the fundamentals and ignore the noise. Well, now six months later, I wanted to re-visit AT&T while still voicing the same opinion.
AT&T is my largest, high-yielding exposure. The vast majority of my holdings leans more towards the “G” in DGI. While I love the passive income that my portfolio generates at the present, I don’t live off of the dividends that I receive, and I’m more interested in watching them compound over time, snowballing towards my long-term financial goals. However, I also like to maintain yield diversity and having a small portion of my portfolio dedicated towards high-yield plays like AT&T, which increases the defensive posture of my portfolio while increasing the purchasing power when it comes to selecting dividend re-investment. With this is mind, AT&T is meeting my expectations quite well. The stock continues to pay out its very high dividend yield, which I deem to be quite safe at the moment.
Now, unfortunately, even after Judge Leon’s decisive announcement, the AT&T/Time Warner saga is still ongoing. AT&T’s management seems confident that the legal system will side with it in the government’s appeals, yet I suppose anything could happen, and it’s never good to count one’s eggs before hatching. I certainly hope this works out in AT&T’s favor because I’ve been very bullish on the Time Warner purchase for years now, even in the face of record-setting debt loads. To me, Time Warner is one of the few blue-chip media/entertainment names. This space is consolidating quickly as the media environment changes, and I think AT&T picked up an absolute gem here. Time Warner’s growth and cash flows should help smooth out T’s balance sheet over time, as well as ensure that dividend growth is viable long-term.
However, I’ve already spoken enough about the benefits of the Time Warner acquisition. If you’re an avid reader of AT&T articles here on SA, I’m sure you’ve seen this discussed more times than you can count. Instead of speculating on the benefits of Time Warner’s assets and the evolution of AT&T’s distribution system, I’d rather take a step back, take a breath, and ignore all of that noise, focusing only on a few simple valuation metrics. I’m sure that some investors may find this approach to be overly simplistic, yet I’ve made good money in the past by focusing on these three things: current P/E, historical P/E, and forward EPS growth expectations. Obviously, my due diligence process covers much more than this, though at the end of the day, I think most of that work can be boiled down into the simple process that I’m about to discuss.
First of all, when it comes to steady-eddy, reliable companies with long profitable histories like AT&T, I like to see what types of premiums the market has assigned to shares historically. Looking at the F.A.S.T. Graphs below, you’ll see that other than the irrational period of exuberance during the dot.com bubble when AT&T traded up to ~26x earnings, during the last 20 years or so, T shares have traded in a fairly strict range between ~16x and ~9x earnings.
Source: F.A.S.T. Graphs
With this in mind, I like to see what sort of growth has supported that long-term average. I averaged out the company’s annual EPS gain/loss during the last 20 years and saw that T has averaged 3.25% growth.
Sure, there are some big up years and some big down years, but when they all evened out, I wasn’t surprised to see T averaging low-single-digit EPS growth. Why wasn’t I surprised? Because over this same period of time, the company’s dividend growth average was 3.9%. That’s pretty darn close to being in line, which is why T’s payout ratio has essentially hovered in the 60s and 70s for over a decade.
Then, I like to look ahead, to see how the foreseeable future compared to the past. Looking forward, analysts expect T’s EPS growth in 2019 and 2020 to be 3% and 2%, respectively.
So, this performance is expected to be slightly less than average, but not terribly so. To me, this means that T’s share price should also be “slightly less than average, but not terribly so.”
I suppose we could use math to come to a more scientific result. Stocks are priced in large part based upon future earnings expectations. T’s future earnings expectations (on average) are 23% below their long-term average. Taking out the artificially inflated dot.com years, we see that T’s long-term average P/E is 14.2x. 77% of 14.2 is 10.9. In other words, in an efficient market, using my admittedly basic P/E focused breakdown, T should trade for 10.9x earnings right now, and not 9.5x. 10.9x T’s TTM earnings of $3.28 is $35.75/share, or 10.86% higher than today’s $32.25 share price.
In other words, I think shares are ~10% undervalued at the moment, which is essentially in line with my prior statements made six months ago. It turns out that the $31/$32 area did serve as very strong support for T shares, yet it’s not magic that I predicted this during the beginning of this downturn. This level has served as support in the past and history tends to repeat itself (especially with regard to reliable companies). T bounced off of this fundamental support level in 2002, 2003, 2008, and thus far in 2018. Shares briefly crossed below 9.5x in 2009, but then again, there were fears that the western world’s financial system was going to crash and burn, and they didn’t trade that low for more than a couple of months during the spring of 2009.
Yes, T has more debt now than it ever had before, so I know the naysayers will say that the stock deserves a new low premium, but I think it’s absurd to say that T is in a worse operational shape now than it was back during the lows of the Great Recession. T’s debt is an issue, but this company has also posted free cash flow of nearly $20b during the TTM, so I can only imagine that management has the capacity to pay down debt over time. However, even though I think T is undervalued, I wouldn’t be surprised to see if it traded at the lows for a while (or at least until all of the TWX loose ends are tied up). Thankfully, even if that is the case, it’s actually not a terrible thing for income-oriented investors.
Since I believe T’s dividend is safe and, therefore, it will continue to meet my expectations as a high-yield/income-oriented investment, I’m totally fine if the debt concerns cause the stock to remain at the low for a while. This consolidation period in the low $30s is really beneficial to investors who’re re-investing their T dividends as it allows them to compound their share count at prices that are more than reasonable. My biggest gripe with automatic DRIPing is that it sometimes forces investors to buy shares of their favorite companies at expensive valuations that they otherwise wouldn’t; however, that certainly isn’t the case with T down here trading with a ~9.5x TTM P/E multiple. And, in this case, it means that every share purchased comes along with a 6.2% yield, which is well above T’s 5-year average yield of 5.32%.
My point with this article/recap is to simply highlight the importance of basic fundamentals in the market. I remember back in May when so many were calling for T to crash to $25/share and cut its dividend. There was fear in the market, so I penned a couple of pieces trying to draw attention to the fact that the market had likely already priced in the worst possible news and further fears were irrational. This piece is a validation of that sentiment. Oftentimes, I think it’s best to ignore a lot of the excess noise in the markets and focus the figures in front of you. That’s relevant right now as well, as the ides of October bring volatility back into the markets.
Keep calm, carry on, and collect your dividends.
Disclosure: I am/we are long T.
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.