Although Warren Buffett’s personal conglomerate Berkshire Hathaway has eschewed paying dividends since the “bathroom dividend” of 1967, the Omaha legend’s personal management style tends to seek out recurring and growing streams of income as surely as Captain Ahab sought to stick a spear in Moby Dick. Today, the investor community learned that Berkshire Hathaway chose to convert its DirecTV holdings into 59 million shares of AT&T stock rather than cash out. This move will have AT&T pumping out $275,000 in cash dividends per day on behalf of Berkshire for an annual total of $100 million.
There are five points worth considering in response to this move:
Point #1: The seeds of this move were likely planted by Weschler or Combs, but the decision to harvest AT&T stock after this merger is a reflection of Buffett’s desire to give Berkshire some utility-like components. Berkshire owns Burlington Northern Santa Fe. It owns MidAmerican Energy. It now owns AT&T. The reason why these firms find their way onto the Noah’s Ark of 82 subsidiaries and 52 common stock investments is because Buffett likes things that churn out lots of fresh cash to be deployed into higher growth initiatives, and there is always something attractive about businesses that still churn out substantial free cash flow during recessions.
The value of AT&T isn’t just AT&T itself, but rather, the fact that it facilitates ownership in things like Precision Castparts, Lubrizol, and the 3G partnership with Kraft-Heinz.
Point #2: This move seems to project that future interest rate increases will have a slow slope upward. With low to moderate growth companies, you tend to experience significant P/E compression if interest rates rise quickly (or at least more quickly than expected.) The valuation of AT&T in the low $30s is especially attractive if interest rates remain low or exhibit a slow creep forward over time. The valuation is not attractive if Treasuries start paying out 5.5% this time next year.
Point #3: It looks like someone at Berkshire Hathaway has been reading Professor Jeremy Siegel’s “Stocks for the Long Run.” In March, AT&T got kicked out of the Dow Jones and Apple entered it. Most analysts interpret moves like these in the intuitively obvious way–the added company has a bright future, the removed company not so much. But Siegel’s research showed that the removed companies tend to outperform the new ones, and are even statistically likely to outperform the market as a whole. It’s a product of expectations being too low, and the valuation being so depressed for the exiting company that moderate subsequent success leads to a higher P/E ratio that helps drive the future outperformance.
Point #4: The addition of DirecTV to the AT&T fold brightens the prospects of the parent entity. Although the loss of lucrative landline customers is a real headwind for AT&T, the combined company will have greatly complementing features. AT&T is building heavily in Mexico, and will be able to combine DirecTV with its offerings there. DirecTV has a strong Latin American presence, and AT&T will be able to introduce wireless/video bundles there. The Sunday Ticket Package of NFL programming will enhance AT&T’s bargaining power. The DirecTV division has been growing so fast that the five-year earnings growth rate of 1.0% at AT&T ought to climb to a range of around 5%. For a company with $150 billion in annual revenue, that is a monstrous achievement looming.
At $33 per share, the future profile of AT&T has changed. You get a dividend of 5.8% plus 5% potential growth plus the potential for a bit of capital appreciation. In 2007, you had a company offering a 3.8% yield with 1% earnings per share growth looming. The P/E ratio was over 15. Now, the valuation is 12x earnings, the dividend is two percentage points higher, and the future earnings growth is about four percentage points higher.
Point #5: The yield-on-cost for this investment is outrageous. When Berkshire originally added DirecTV to its portfolio in 2011, it paid an average of $43 per share. The cash component of the deal granted $28.50 per share for every DirecTV share owned, and also stood to receive 1.892 shares of AT&T stock for each share of DirecTV. The consummation of the deal already returned 66% of the purchase price as part of the cash component of the deal, and the remainder is paying out $100 million per year in dividends.
Of the $2.2 billion cumulative investment, $1.45 billion has already been returned as cash. Berkshire only has $750 million of its original contributory capital at risk in AT&T, and that is now collecting a little over $100 million in annual dividends. That’s a 13.3% yield-on-cost in just four years, and within five years, Berkshire will have extracted the entirety of its investment from the cash portion of the merger and dividends alone. At that point, it will own a $2 billion stake in something pumping out more than $100 million in annual dividends “free” in a sense.