Market sentiment occasionally creates absurd situations, especially at its greed or fear extreme. AT&T (NYSE:NYSE:T ) is currently at the fear extreme, and its FY PE of 6.7x is so compressed that it is lower than its TTM dividend yield of 7.87 percent as you can see from the following chart.
To broaden the viewpoint a bit more, let's compare it against its closest peer Verizon (VZ). As seen, its current TTM dividend yield of 7.87% is also above its 4-year average yield of 6.91% by 100 basis points (or almost 14% in relative terms), and above its peer VZ's 6.06% by a whopping 181 bps (or almost 30% in relative terms). In terms of valuation metrics, its FY PE of 6.71x is discounted by 24% compared to VZ's 8.16x PE. Admittedly, T is more leveraged than VZ and its PE should be discounted, and a leverage-adjusted valuation metric may be more meaningful. Except that, as you can see below, once such an adjustment is made, the valuation gap becomes even wider, not narrower. Its EV/EBITDA ratio is at a 32% discount from VZ. And finally, in terms of the price-to-cash flow ratio, it's only trading at 3.2x times its cash flow.
Of course, there are some good reasons behind such seemingly absurd numbers, which we will elaborate immediately below. However, the overall thesis of this article is that these reasons are overblown, and the severe mispricing of T creates an investment opportunity for outsized potential returns.
Source: author based on Seeking Alpha data.
Source: author based on Seeking Alpha data.
Undoubtedly, there are headwinds and restructuring uncertainties ahead as the company streamlines its operation post the WarnerMedia spinoff. My estimate is that the divestiture of Warner Media would shave about $45 billion from its top line for the full year of 2022. Furthermore, Warner's revenue growth potential is better than the other business segments retained in T. As a result, the divestiture will very likely also slow down T's revenues going forward.
Even in the immediate near terms, there are strong headwinds with the overall slowdown of the economy and also the renormalization of post-pandemic consumer spending. The chart below shows such a slowdown clearly. As seen from the top panel (which shows the inventory on a quarterly basis), the inventory is within its historical average. Its current inventory stands at $3.24B, essentially on par with the average of $3.25B in the past few quarters. However, in terms of the days of inventory outstanding on a quarterly basis (shown in the bottom panel), the picture is completely different. Its inventory currently stands at 23.6 days, completely off the chart compared to the 15 to 17 days a few quarters ago. It is expensive to maintain a large inventory, especially considering the heavy CAPEX requirements that its needs to build out its 5G and fiber capabilities.
Next, we will see if the potential reward can properly compensate for such risks.
The above risks are capsulated in the following projection of slow growth and also the large variance in the consensus forecasts. As seen, the consensus forecasts imply an annual growth rate of only 0.9% CAGR in the next few years. The variance between the optimistic and pessimistic forecasts is quite large too: more than a factor of 1.26x for 2025 ($2.27 EPS vs $2.87 EPS). In terms of annual rate, the low-end forecasts predict a contraction of EPS between 2022 and 2025 (from an EPS of $2.38 to $2.27).
Source: author based on Seeking Alpha data.
Source: author based on Seeking Alpha data.
However, my view is that the above projections are too pessimistic. My analysis of its ROCE (return on capital employed) is about 30% as detailed in my earlier articles. In terms of reinvestment, it is planning $24B in CAPEX Investment in the next few years (2022 and 2023 at least) and then gradually taper down from there. Assuming an aggregated average of 10% reinvestment rate, the organic growth rate would be 3% (organic growth rate = ROCE * reinvestment rate = 30% * 10%). Given the long-term pricing power that T has demonstrated, adding 1% or 2% of inflation escalation would easily bring the growth rate to the mid-single-digit range (say 4% to 5%).
In my mind, such a growth rate is on the conservative side for a few reasons. First, I expect the margins to be higher now than prior to the Warner divestiture. My analysis shows that a 250 basis points margin expansion is feasible going forward. The lower interest expense alone, thanks to the lower debt after the spinoff, will contribute to a margin improvement by about 115 bps. Second, the company is in the process of expanding its 5G network and also its fiber network. The spinoff and the lower debt also enable AT&T to better focus on its 5G and fiber ramp-up. Once the main infrastructure is laid out, the cost will remain approximately fixed and profitability accelerates. As just mentioned, my projection is that capital expenditures will increase first, and then gradually begin to taper down starting ~2024.
The valuation compression is so extreme that even a moderate growth could deliver large returns. As aforementioned, T is substantially undervalued in both absolute and relative terms. Even compared to its own historical track record, the valuation discount is about 14% in terms of dividend yield and 41% in terms of price-to-cash flow ratio.
With such a compressed valuation, a healthy projected return can be expected even assuming a conservative growth rate of 4%. As shown, for the next 3~5 years, the total return is projected to be in a range of 33% (the low-end projection) to about 99% (the high-end projection), translating into an annual return of 7.4%to 18.8%. A highly asymmetric opportunity in my view even after adjusting for the above-mentioned risks and its relatively weaker financial strength (B+ compared to A+ from VZ).
Source: author based on Seeking Alpha data.
Source: author based on Seeking Alpha data.
Besides the above asymmetric return profile, I also feel T is beginning to pass our patience test as the dust of its spinoff keeps settling. The current situation T is facing is not unlike those we've observed in our other past investments such as LMT and BTI, as detailed in our blog article:
The stock market is a place where people with patience trade their patience for money, and people without patience pay money to learn to be patient. It is absolutely true. And we use the so-called consolidate window as a simple test of patience to screen for stocks ideas. We've had many successes with this test (more than failures anyway) including Lockheed Martin, British American Tobacco, et al.
And now we see the stock prices of T have been trapped in a consolidation window between $17 and $21 for almost a year by now, as you can see from the orange box below. The market seems not sure what to do with it. We love seeing quality stocks like T stuck in such windows for at least a year (but really, the longer the better) while we monitor the fundamentals. And currently, we are not seeing any substantial deterioration in its fundamentals. I see the operation challenges discussed in the 2nd section either as temporary or as uncertainties (which are different from deteriorations).
Source: author based on Yahoo Finance data.
Source: author based on Yahoo Finance data.
Finally, risks. Besides the risks aforementioned (operation challenges, higher leverage, relatively weaker financial strengths compared to VZ), investors also need a stronger nerve to tolerate T's price volatility. As seen in the chart above, T's beta has been about 1.5x higher than VZ in the past 24 months (0.36 vs 0.22) and about 2x higher in the past 60 months (0.61 vs 0.34). Moreover, I think the use of beta underestimates its true volatility. As aforementioned, T's valuation in terms of price-to-cash flow is discounted from its historical average by 41% and from VZ's by 31%. And its peak price-to-cash flow ratio has been almost 6.2x in the past 5 years, almost 2x higher than its current value. Such large discounts, while making its valuation attractive, provide more insights into the magnitude of its true volatility.
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This article was written by
** Disclosure: I am associated with Sensor Unlimited.
** Master of Science, 2004, Stanford University, Stanford, CA
Department of Management Science and Engineering, with concentration in quantitative investment
** PhD, 2006, Stanford University, Stanford, CA
Department of Mechanical Engineering, with concentration in advanced and renewable energy solutions
** 15 years of investment management experiences
Since 2006, have been actively analyzing stocks and the overall market, managing various portfolios and accounts and providing investment counseling to many relatives and friends.
** Diverse background and holistic approach
Combined with Sensor Unlimited, we provide more than 3 decades of hands-on experience in high-tech R&D and consulting, housing market, credit market, and actual portfolio management. We monitor several asset classes for tactical opportunities. Examples include less-covered stocks ideas (such as our past holdings like CRUS and FL), the credit and REIT market, short-term and long-term bond trade opportunities, and gold-silver trade opportunities.
I also take a holistic view and watch out on aspects (both dangers and opportunities) often neglected – such as tax considerations (always a large chunk of return), fitness with the rest of holdings (no holding is good or bad until it is examined under the context of what we already hold), and allocation across asset classes.
Above all, like many SA readers and writers, I am a curious investor – I look forward to constantly learn, re-learn, and de-learn with this wonderful community.
Disclosure: I/we have a beneficial long position in the shares of VZ either through stock ownership, options, or other derivatives. 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.