AT&T: A Battleground For Value Investors (And Why I Steer Away) (NYSE:T)

Introduction

AT&T (NYSE:T) was once part of my portfolio. It now is not, nor am I planning on making it part of my holdings anymore. The experience with this stock has made me ponder a few questions that I finally would like to share with SA readers. In fact, my research and thought process has led me to consider AT&T a so-called value trap. Better put, I consider the company at risk of destroying value instead of generating strong returns for the shareholders.

Since on Seeking Alpha the stock enjoys big popularity, with many convinced bulls, I would like to share my thoughts on this investment and see what many sophisticated investors on this site have to say.

The company

AT&T’s business

AT&T is one of the largest companies in the U.S. and as a leading provider of telecommunications, its brand is widely known. With its $120 billion in revenue, it ranks as the 30th largest company in the U.S., beating companies such as Meta (META), Target (TGT) and Lowe’s (LOW).

In North America, its network reaches more than 438 million people with 4G LTE and over 302 million with 5G.

As AT&T explains in its annual report, its reportable segments are two:

1. Communications – providing wireless and wireline telecom and broadband services in the U.S. This segment has three business units: Mobility, Business Wireline, and Consumer Wireline.
2. Latin America – providing wireless services and equipment in Mexico

AT&T’s Catalysts

Among its catalysts, AT&T sees the shift towards 5G and fiber for its connectivity services because bandwidth demand continues growing.

Of course, 5G requires big investments and this catalyst creates thus what can be seen as a big headwind. However, telco companies seem to have reached the peak in their capex, so investors now expect improving free cash flows from the whole industry.

A few months ago, the company announced plans to work together with Ericsson to develop and build the infrastructure for an ORAN (Open Radio Access Network). By late 2026, the company writes that it plans “for about 70% of our wireless network traffic to flow across open-capable platforms, and to have fully-integrated Open RAN sites starting in 2024”.

As AT&T states in its annual report:

We believe the move to an open, agile, programmable wireless network positions us to quickly capitalize on the next generation of wireless technology and spectrum when it becomes available. These innovative technologies are expected to enable lower-power, sustainable networks with higher performance to deliver enhanced user experiences.

AT&T’s Customer Base

Let’s look at AT&T’s customer base. The company reports 242 million Mobility subscribers, it provides broadband and internet services to almost 15 million customer locations, with 8.3 million fiber broadband connections. In Mexico, the company has 22 million subscribers.

As we can see from this slide taken from the last earnings presentation, the company services 71.3 million postpaid phone subscribers, with an ARPU of $56.23, and reports Mobility Service revenues of $16 billion for the quarter, with an EBITDA margin of 52.2%.

Its revenue breakdown sees its Wireless service unit account for over 50% of total operating revenues, while the other two units of its Communications segment – Business service and Equipment – make up 17% each. Latin America makes up only 3% of the company’s operating revenues.

AT&T’s Troubled History

AT&T’s history has faced several hurdles in recent years. Let’s go over the purchase of DirectTV and let’s just look at the Time Warner deal. Its attempt to create an entertainment giant combining WarnerMedia and Discovery was at first welcomed by analysts as a “real blow” to Comcast (CMCSA) and Paramount Global (PARA). But, although the deal can be seen as a quick way to generate cash, it ended up being quite a hit for AT&T. In fact, the acquisition of Time Warner in June 2018 was a deal worth around $100 billion. In just four years, the company retraced its steps and spun off its Warner Media assets, handing them over to Discovery. The issue was that the deal led to a loss of almost $50 billion for the shareholders.

Moreover, AT&T has consistently carried an increasing amount of debt on its balance sheet, making it financially over-leveraged and at risk of seeing its interest expense skyrocket at times of rising rates.

Finally, AT&T has been a real pain in the neck for those investors who expected the company to generate significant results and returns. In the past decade, the company has basically sold off, with only small rallies that were an opportunity for short-term traders rather than investors.

What is actually striking is that the chart above has more or less the same trend the chart below shows, where we see AT&T’s returns on invested capital over the last ten years.

Returns on invested capital rarely over 10% are, indeed, low and at risk of being below the cost of capital. When this happens, that is, when a company’s returns on invested capital are lower than the cost of capital, we have value destruction, which can lead to many unpleasant consequences in case this trend lasts a long time.

Why Investors Love AT&T

Nonetheless, AT&T sees many investors truly convinced the stock is a buy. Let me summarize the main reasons I see among AT&T’s bulls.

1. Low valuation. According to Seeking Alpha’s Quant Ratings, T has an A- as its valuation grade. A fwd PE of 7.9, combined with a fwd EB7EBITDA of 6.5 and a fwd P/FCF of 3.1 make the stock look very cheap. Many believe its valuation is so low that it can’t do anything else but expand.
2. Dividend Yield. Income-oriented investors find here a 6.7% yield supported by a 46% payout ratio and an FCF yield close to 15%. No wonder, its dividend yield grade is an A+. But when we consider its growth, our delight might stop because, in 2022, AT&T had to cut its dividend to have enough cash for its infrastructure investments.
3. Turnaround Play. Though damaged by poor execution in the past, the company’s recent reports showed a declining debt and a growing free cash flow. Thanks to diminishing investments, many investors expect the company’s management to operate a turnaround, which would eventually lead to investors flocking to the stock.

Why I Am Cautious

As I wrote at the beginning of the article, I was once invested in AT&T. In fact, when I started my portfolio, I was particularly attracted by stocks with low valuations and high yields. AT&T seemed the perfect fit. But, as I became more aware of what I had bought and the underlying business, I became less and less attracted by the investment. In truth, I thought HBO Max was the only reason to be long AT&T. But then the deal with Discovery took place and AT&T spun off its media business. At that time, I sold.

Since then, I have thought several times about what value traps are. Usually, they occur when a stock allures investors with a very cheap valuation based on fundamental analysis. However, not always the financials reported by a show those immaterial factors that can lead a company toward prosperity or towards its failure.

For example, the lack of a strong catalyst finds no place in the income statement. However, if this is missing, the company’s financials may be hurt in the upcoming quarters.

A Possible Value Trap

Now, a value trap is there if a company’s returns on invested capital are lower than the cost of capital itself. With interest rates above 5%, a 5% return rate is not enough to create value.

Finally, value traps are often burdened by high debt. All of these factors can create a financial deadlock that can damage a company.

Now, as Martin Fjeldhoj pointed out, AT&T does offer a fat dividend which seems to be paying well to the shareholders, but, in reality, the company has funded its dividend mainly through debt and the issuance of new shares. As a result, Mr. Fjeldhoj states that the shareholders are paying for the dividend themselves.

I like dividends, but I want them to come from excess cash a company has, not from debt or the sale of new shares.

At Odds With High-Debt

I have made it a rule of my portfolio not to own companies whose net debt/EBITDA ratio is above 3. To tell the whole truth, I want to own companies with no debt.

AT&T has seen its debt explode well above $150 billion, although in 2022 it started reducing it. Currently, the company’s total debt is around $137 billion.

In the meantime, the huge amount of debt has led to increasing interest expenses. When in 2014, the company only paid $3.6 billion for this, it now has to pay $6.1 billion.

During the last earnings call, John Stankey, CEO of AT&T, was proud that the company had already achieved its $6 billion plan of cost savings. However, this is extremely needed now that interest expense has rapidly increased. In fact, with pre-tax earnings at $20 billion and interest expense above $6 billion, we have a rather low earning power (pre-tax earnings divided by interest expense) of 3.3.

Since AT&T is showing very little top-line growth, the company needs to reduce its debt to avoid becoming over-leveraged.

This is what the company has been doing for the past two years, reducing its net debt/EBITDA ratio below 3 and targeting a 2.5 by mid-2025.

Possible Turnaround

What seems to me more convincing, rather than the valuation and the dividend, is that AT&T could present in the future a nice turnaround. As we have seen, there are signs of improved execution and more careful financial management compared to the past.

When we look at the company’s guidance, we finally see some top-line growth going along with margin expansion. More interesting, capex should moderate, leading the company to guide for $18 billion in FCF.

Valuation

So, considering what we have seen, how much is AT&T worth? In other words, what kinds of cash flows can the company generate for its investors in the future?

In my DCF model, I assumed the company would be able to grow its FCF at 3% per year for the next 5 years. I then used a very low 1% as its perpetual growth rate. I discounted the future cash flows using a 7.7%. I bet many investors are using a higher discount rate because they perceive AT&T as riskier.

Plugging in the other main financials a DCF needs, I come to the result that the stock is more or less fairly valued right now. But, again, a DCF model doesn’t take into account many qualitative aspects of a company.

Even though in the past two years, its debt has been reduced a bit, I am still quite uncomfortable with its huge size. Even though the yield is tempting, I see little room for fast FCF growth, which should lead to fast dividend growth, too. Finally, the company operates in a market that has been quickly saturated. This makes organic growth more difficult over time.

Since the stock has benefitted from the current bull market and is up 17% over the past 6 months, I would suggest moving out of it and locking it in whatever gains one has earned. The future trajectory of the company seems to me uncertain and, most importantly, the predictability of its future cash flows is low. As a result, my rating is currently a sell.