Over the past five years, AT&T only managed to grow earnings at 1% per year. You got to collect a 5% or 6% dividend along the way, which was a nice offset, but ultimately core business was not keeping up with inflation. This was due to three things: (1) the company was losing lucrative landline customers at a fast rate; (2) Verizon Wireless was making market share gains in the mobile space; and (3) the company was investing heavily into Mexican infrastructure that had a payoff several years down the line. This slow growth explains why the quarterly dividend has only grown by a penny per share during each year since 2007.
This acquisition of DirecTV is going to add $3 billion in annual profits immediately, and estimated cost savings of $1.5 billion per year for the next four years could make AT&T a company making $20 billion per year in profits by 2020. For a company that was making $13 billion per year in profits between 2010 and 2014, this is quite the uptick.
The deal is also a great example of concurrent benefits. While AT&T is building out wireless platforms in Mexico, it will soon be able to attach video bundles as well thanks to DirecTV. And in Latin America, where DirecTV has a strong presence but AT&T does not, AT&T will have a clear area for future wireless expansion as a place to focus future capital investments once the heavy infrastructure investments in Mexico are completed. In the home market of the United States, AT&T will be able to take advantage of the lucrative proprietary content owned by DirecTV–most notably the NFL Sunday Ticket programming package–to find strong footing in the new world of technological communications.
For the past fifteen years, AT&T was paying out over 70% of its profits as dividends. The low earnings retention has been in element in explaining why earnings growth has been so sluggish during the medium term–there hasn’t been a lot of capital available to invest for growth, and the most lucrative customers of the old business model cancelled their landlines at a quickening pace.
Next year, the AT&T dividend will be in the 60% range, and it may be in the 50% range once the full integration of DirecTV into the A&T umbrella becomes complete. If, a few years from now, AT&T is paying $11 billion in dividends while generating $20 billion in annual profits, the company will find itself able to aggressively fund international expansion into the Latin American countries because it will have the retained earnings on hand to do so. Or, shareholders will get dividend growth at a higher rate than the penny per share that had become recent tradition, and the company will borrow to fund international expansion. The interest rate environment of the next few years will no doubt play a role in determining which strategy is most preferable.
Meanwhile, you are seeing the short-termitis of the stock market participants play out right before your very eyes. The stock is down 1% on the day, to around $33.50, because the management team provided guidance that quarterly estimates for the company are wrong. Analysts are expecting the full month of DirecTV’s July performance to be included in earnings, whereas AT&T pointed out that it will only include earnings from the July 25th date of the acquisition onward. Seems fair to me, but the news has worried some short-term traders that the earnings report from AT&T that comes out at 3:30 tomorrow will be disappointing.
What I do know is this: AT&T is going to make somewhere close to $2.65 per share in profits this year. That is a valuation of under 12.5x earnings. This is a stock that trades between 12x and 16x earnings. Even on a traditional analysis basis, this stock is on the low end of fair value right now.
I would even argue that AT&T is more attractively valued today than during the financial crisis when the stock traded at 11x earnings. Why? Because the growth profile is greater. In 2009 and 2010, you got a 6% dividend attached to 1% annual earnings growth. Now, you get a 5% dividend attached to 4-6% annual earnings growth. If true, we all agree that the latter opportunity is more attractive. And in order to get it, you only have to pay a 13.6% valuation premium compared to what was available during the financial crisis. That, to me, is worth it.
This company is especially attractive on a relative basis to the S&P 500. Earlier this year, we discussed the Dow Jones move to kick AT&T out of the index and insert Apple. Even though it seems counterintuitive, the research of Dr. Jeremy Siegel demonstrates that AT&T actually has a statistical probability of outperforming Apple stock over the next 25 years. Siegel’s argument hinged on the fact that outgoing stocks seem to get too cheap at the time of their exit from the index.
We saw it in 2008 and 2009 with Anheuser-Busch while Inbev was working through the acquisition. The stock traded in the $30s while the company was taking two years to work through the integration process, before shooting up to the $80s thereafter (and the generally rising tide of an improving market also helped.) Berkshire Hathaway goes through this every acquisition–the stock stays stagnant while investors wait for the company to be consumed. Berkshire trades at $133. This time next year, the stock should be around $150 once the earnings power of Precision Castparts is absorbed–if the valuation of the stock remains the same. If there is another Hurricane Katrina to hit the insurance subsidiaries, or the P/E ratio of the S&P 500 fluctuates, then this prediction won’t hold true. But if the market tracks changes in earnings power while maintaining the same valuation, that is what should happen.
And AT&T is no different. It now trades at $33 per share. That’s crazy–that’s the price you could have gotten in 2006, 2007, 2008, 2012, 2013, and 2014. That was during a time when earnings were just moving forward by a smidge. Now, with DirecTV under its belt, earnings per share will be rising and the company has a much more cohesive growth strategy ahead. It’s going to bring video to Mexico, bring wireless to Latin America, and seduce Americans with football. That wasn’t part of the growth profile last year. If you buy today, you get a 5% dividend yield with a high probability of at least tracking the S&P 500 over the long haul and a small but reasonable probability of beating the S&P 500 index. If you like high current income and want near-market average returns, AT&T is a good candidate for consideration right now.