AT&T Stock: Undervalued But Uncertainties Remain (NYSE:T) (2024)

A few years ago, I changed my investment strategy. Before, I often used screeners and scanned for companies with the lowest P/E ratio or the highest dividend yield. Now, I try to identify companies according to "quality" - I am searching for high-quality businesses with a wide economic moat and create a watchlist including these companies and then wait for these companies to trade at attractive prices.

But I am sometimes still screening for low P/E ratios and high dividend yields and every now and then I will take a closer look at a company (and stock) when these criteria are meet. AT&T (NYSE:T) is one of the companies, which is certainly interesting due to its extremely high dividend yield. According to market capitalization, AT&T is on the 73rd spot of all companies around the world and without doubt one of the major businesses. And it is certainly the company with the highest dividend yield among the mega cap companies.

AT&T is certainly not only interesting for its dividend, but it is also interesting as it was once one of the companies with the most impressive wide economic moat. And this is reason enough for me to take a closer look at AT&T right now.

Dividend

As the dividend is one of the reasons we got interested in AT&T I will start by looking at the dividend. Although I am a rather young investor (at least in my opinion as I have about 30 years before I retire), I still focus a bit on dividends in my investment decisions. And when looking for high dividend yields one of the most interesting companies right now might be AT&T. When screening on Finviz for companies with a dividend yield above 8%, I only get 214 companies - and one of them is AT&T.

(Source: Author's work based on numbers from AT&T)

Right now, AT&T is paying a quarterly dividend of $0.52, which is leading to an annual dividend of $2.08 and resulting in an impressive dividend yield of 8.43%. Recently, AT&T lost its status as dividend aristocrat. And after AT&T increased its dividend for 34 years in a row it kept its quarterly dividend at $0.52 for eight quarters in a row. And although AT&T was growing its dividend in the last years, dividend growth was only in the very low single digits. In the last five years, dividend grew with a CAGR of 1.61% and in the last ten years dividend grew with a CAGR of 1.91%.

When seeing such high dividend yields, we must look at the payout ratio to determine if the dividend is sustainable. In fiscal 2020, earnings per share were actually a loss of $0.75 per share and we can't calculate a reasonable payout ratio. In the last four quarters, earnings per share were $0.13 leading to a payout ratio of 1,600% (also not a number we can work with and certainly not a number that seems sustainable). Instead, we can compare the dividends paid to the free cash flow. In the last four quarters, AT&T had to pay $15,060 million in dividends and compared to a free cash flow of $25,697 million this leads to a payout ratio of 58.6%, which seems acceptable.

And although AT&T did not announce a dividend cut so far, there are hints and rumors indicating an upcoming dividend cut. In my opinion, a dividend cut would make sense as the dividend hardly seems sustainable right now (despite paying out only 60% of free cash flow last year). Especially when looking at the balance sheet, AT&T should rather focus on reducing its debt.

Balance Sheet

When asking the question, if the dividend is sustainable, we should not just look at payout ratios, but also at the balance sheet. Important for AT&T is the question, if the high dividend yield is sustainable (assuming AT&T is not cutting the dividend).

When looking at the balance sheet on September 30, 2021, we see short-term debt (debt maturing within one year) of $23,755 million and long-term debt of $155,406 million. When comparing total debt of $179,161 million to a total stockholders' equity of $181,303 million, we get a debt-equity ratio of 0.99, which seems acceptable. However, when comparing the total debt to the operating income ($28,375 million in the last four quarters), it would take about 6.3 times operating income to repay the outstanding debt. This is an extremely long time to repay the outstanding debt - especially for a company that has trouble to grow its earnings per share.

AT&T has $21,270 million in cash and cash equivalents, which could be used to repay the outstanding debt, but compared to almost $180 billion in debt, this is not a lot. And additionally, we should mention $133,663 million in goodwill on the balance sheet (24.4% of total assets), which could also be a problem in the years to come - and might lead to goodwill impairments.

Even if AT&T should cut the dividend, the balance sheet is still a problem and with these high levels of debt and goodwill, AT&T could face problems in the years to come. In my opinion, AT&T should clearly focus on reducing the outstanding debt and not so much on dividend payments (or share buybacks).

Growth

The high debt levels might not be so problematic if AT&T could increase net income and especially free cash flow in the years to come. And therefore, we should also look at the growth potential of AT&T in the years to come.

And when looking at the last four decades, net income could grow with a solid pace. It is true that growth was a little choppy in the last decade and especially in the last three years net income declined every single year (and in 2020, AT&T even had to report a loss). But between 1983 and 2019, AT&T could increase net income with a CAGR of 7.92% (we excluded 2020 due to the negative number).

(Source: Own work)

But the picture is deceptive. When just looking at net income, we are ignoring a huge problem for investors. AT&T could not only increase net income over the last few decades, but also increased the number of outstanding shares with a similar pace. The number of outstanding shares increased from 1.17 billion in the 1980s to 7.16 billion right now. These are trends and dynamics we usually know only from rather young companies in desperate need of capital.

When focusing on revenue and free cash flow during the last ten years, we see rather stable growth while earnings per share fluctuated quite heavily. Free cash flow - for example - increased with a CAGR of 7.32% in the last decade, but the increased number of shares is a problem.

(Source: Author's work based on numbers from Morningstar)

When looking at the last decade, the results are certainly not perfect. And in my opinion, there are very few reasons to believe that AT&T will grow with a higher pace in the years to come. It seems reasonable to assume, that AT&T will generate similar amounts of free cash flow per share in the coming years as right now, but I would not calculate with high growth rates (maybe growth in the very low single digits).

Intrinsic Value Calculation

The fact that AT&T could not really grow during the last decade (or in the last two or three decades) must not be problematic as long as the current stock price is reflecting that. Even a business that has trouble to grow can be a great investment as long as it is trading for a low valuation multiple.

And when looking at the price-free-cash-flow ratio, AT&T seems to be extremely cheap, and it is trading for the lowest price-to-free-cash-flow ratio in the last ten years. Aside from one point a few weeks ago, when the P/FCF ratio was even lower (6.69), AT&T is currently trading at the lowest P/FCF ratio in the last ten years. It is also trading way below the average P/FCF ratio of the last ten years (11.93). From this point of view, AT&T seems to be extremely cheap.

Aside from looking at the price-free-cash-flow ratio, we can also determine an intrinsic value by using a discount cash flow calculation. As basis we can take the free cash flow of the last four quarters ($25,697 million), which is also in-line with the free cash flow of the last few years and seems like a realistic basis to use for our calculation. And let's assume that AT&T can keep the current free cash flow stable, which seems like a realistic assumption (despite the troubles to grow). When using these assumptions and use 7,202 million in diluted outstanding shares, we get an intrinsic value of $35.68 for AT&T and the stock is clearly undervalued.

Wide Economic Moat

And although the assumptions used above seem rather cautious, there is one question, which is extremely important for me and which should be answered with a clear "yes" before I invest: Does AT&T have a wide economic moat?

This is certainly not turning into a history lesson but let us take a minute or two to look at the past and the story how AT&T built one of the most impressive economic moats of all time. The Bell Telephone Company was established in 1879 by Alexander Graham Bell - the inventor of the telephone. Bell also founded the American Telephone and Telegraph Company (AT&T) in 1885, which acquired the Bell Telephone Company. The telephone was patent protected until 1893 and AT&T was generating revenue by selling franchise licenses and leasing telephones. Theodore Newton Vail however realized that a patent might be great to ensure growth until 1893, but after patent expiration AT&T would face intense competition. In the end, AT&T's great success came without the patent. Vail realized the value of the physical network and began to establish a powerful network that was the foundation for the success of AT&T over the next decades. Vail resigned due to frustration with the board (that opposed the intense capital expenditures) in 1887 but was president again from 1907 until 1920. In 1908, Vail describe the power of the network effect in the annual report:

A telephone - without a connection at the other end of the line - is not even a toy or a scientific instrument. It is one of the most useless things in the world. Its value depends on the connection with the other telephone - and increases with the number of connections. […] No one has use for two telephone connections if he can reach all with whom he desires connection through one.

Vail not only described why the connections in a network are more important than the nodes, but also mentioned that two parallel networks are useless. Today we associate networks often with social networks and think of companies like Twitter (TWTR), Facebook - now Meta Platforms (FB) - or LinkedIn. But there are many kinds of networks, and the network effect Facebook or LinkedIn is relying on is only one specific type of network effect and there are networks that are much more powerful. As consequence most of these networks are not associated with private companies but are rather owned by the government or are placed at least under government conservatorship. After the Kingsbury Commitment, AT&T became a monopoly that was sanctioned by the US government and was like a national utility and expanded its service to every corner of the union. Today many similar monopolies are much more regulated than AT&T was back then.

AT&T built a powerful monopoly as it was manufacturing the telephone (creating the nodes) and was only leasing the "nodes" to its customers. Additionally, AT&T owned every connection and link, it owned the entire network. Back then, it represented the world's first complex electronic network. Vail's vision was the development of a long-distance telephone service connecting the entire country to a single network as his solution. Vail believed that Bell Telephone's future would be secure if it could build a national network and function as a national utility before exclusivity ran out.

In case of AT&T, we are dealing with a physical network and with a physical infrastructure. When looking at powerful networks like Facebook or Instagram, Meta Platforms is not owning the physical network necessary to provide its service but is using the physical network and infrastructure other companies own (for example AT&T). However, AT&T created a dense and extremely complex physical network with extreme upfront costs and once the network was in place and running, it was almost impossible for a competitor to duplicate the network (and it wouldn't have made much sense).

Looking at AT&T's past and learning how the company generated one of the most powerful economic moats of all time is certainly interesting (at least for me), but for investors today the important question to answer is if AT&T still has a wide economic moat. And I would not argue that AT&T doesn't have any moat at all, but the moat certainly got weaker over time and competition clearly increased. The company today is not the company described above.

Technical Picture

Finally, we can also look the chart of AT&T - and in this case we should really look at the long-term chart as AT&T is in a correction since the Dotcom Bubble peak and hit its all-time highs in 1999/2000. And in the last two decades, AT&T shareholders had not much to celebrate - aside from the dividend, which was increased annually in small steps. In the last twenty years the stock returned only 38.33% and total return (including dividends) was 80.54%. Shareholders did not lose money, but these are certainly not impressive returns and AT&T clearly underperformed the S&P 500 (SPY).

(Source: TradingView)

AT&T is in a huge correction pattern - basically one gigantic symmetric triangle - and such a triangle is usually indicating a continuation of the (in this case bullish) trend. And in the recent past (last two months), the stock broke out of this corrective phase - but to the downside, which could imply even lower prices in the coming weeks and months. And right now, the stock could very well drop to the range of $19 to $21 again. And at least from a technical point of view, even lower stock prices in the coming months seem possible.

Conclusion

AT&T is presenting itself in a mixed way. We can find several arguments, why we should not invest in AT&T right now. Starting with the extremely high debt levels and amounts of goodwill on the balance sheet, which is giving me headaches to the constantly increasing number of outstanding shares or the chart, which seems rather bearish right now, there are several aspects indicating to stay away from AT&T.

But we can also find arguments to invest in AT&T. The high dividend yield is certainly tempting for every income investor, but the risk of a dividend cut is quite high. And of course, AT&T seems to be undervalued when assuming AT&T can keep its free cash flow at least stable in the years to come. And despite a constantly increasing number of outstanding shares, I would consider these assumptions realistic. I personally consider AT&T a great case study on how to build an extremely impressive economic moat (in the past), but do not consider it a great investment at this point.

Daniel Schönberger