AT&T: Those Who Misinterpret History Will Have Poor Future Returns (NYSE:T)

AT&T: Those Who Misinterpret History Will Have Poor Future Returns (NYSE:T)

Thesis Summary

AT&T Inc. (NYSE:T) has done a great job of maintaining its dividend and dividend growth over the last 30+ years. However, the same can’t be said of its ability to maintain the value of your principal. With the increased debt burden and uncertainty about the future, is now a good time to invest in AT&T? In this article, I argue that underwhelming HBO and 5G results, lower asset turnover, and the increased debt burden make AT&T a “hold” at best.

Source: Barrons.com



HBO Max and 5G

The HBO Max launch has been widely discussed already, but I will give some background here and share my thoughts. First off, let’s look at the revenue breakdown for the latest quarter:

Source: 10-Q

Above, we can see the revenues and EBITDA for each of the company’s segments. Looking at the bottom line, Segment Contribution, we can see that Communications still accounts for most of the revenues, around 82%, while Warner Media contributes only $1,714 million out of $10,032 million in total. Even accounting for the coronavirus, the quarterly numbers seem quite weak. Compared to the same quarter last year, net income is down 12.39%, and EPS fell by 11.11%. Most notably, though, Time Warner’s Segment Contribution fell by 25.8%. With the cancellation of various sporting events, this segment has been the most affected by the coronavirus, and the HBO Max launch did little to help with this.

There have been many problems with the HBO Max launch from the start. Firstly, AT&T has failed to reach an agreement with Amazon.com (NASDAQ:AMZN) and Roku (ROKU), which are the two largest streaming platforms, accounting for over half the market. Secondly, the company’s marketing efforts have failed to create any real traction around the service. But, most importantly, the whole thing is being managed wrong. HBO has the highest price of all the streaming services, the payment plan is confusing, and it seems to be unclear to customers what they are getting. With stiff competition from Netflix (NFLX) and Amazon, it is also hard to see how the segment will maintain its profitability in the future. Even in a best-case scenario, Warner Media still represents significantly less in terms of revenue and profit than the communication sector, which takes me to my next point.

AT&T’s main line of business, communications, has been significantly underperforming in the last few years. Since 2017, when the segment produced $149 billion, revenues have been falling and, in 2019, stood at $142 billion. Now, with the rollout of 5G technology, many think this will give this segment a boost, but past evidence doesn’t show this. During the 2010-2014 period, when AT&T was rolling out 4G and 4G LTE, revenues stayed flat. On top of that, 5G seems to represent higher costs and competition, with T-Mobile US Inc. (NASDAQ:TMUS) and Sprint’s recent merger.

In reality, revenues didn’t start to pick up until 2015, which was after the Times Warner acquisition. This leaves me thinking that the company can only grow through new acquisitions, and this will become a problem as asset turnover continues to decline.

Asset Turnover

Without a doubt, one of the most important measures we need to look at when analyzing a company like T is asset turnover. This ratio is obtained by dividing revenues by assets. This means, the higher the ratio, the more revenue each dollar in asset produces. Generally speaking, we want a higher asset turnover ratio.

Source: Author’s work

As we can see, AT&T’s asset turnover has been steadily declining since 2010. Even after the acquisition of Time Warner and Xandr. This means the company continues to require more assets to produce the same amount of revenue. Now, one could argue that, if properly leveraged, HBO could help improve this ratio, but there has been no evidence of this happening so far, and the company has had HBO for over 4 years.

This means AT&T will have to continue to expand its balance sheet to continue to grow revenues and, by extension, the dividend. Can the company keep leveraging itself? Sure, it can, but with these fundamentals, one has to wonder whether this is a wise move.

Debt Burden and Dividend

AT&T recently reached a maximum level of debt of around $190 billion, giving it the title of most indebted company in the world. Many have applauded AT&T’s “financial wizardry”. Of course, leveraging can be great for shareholders, as long as the debt burden doesn’t become too much.

So, is AT&T’s debt burden manageable? In and of itself, I believe it is. Is it possible for AT&T to maintain its current dividend and dividend growth? Again, I believe the company can do this. But, can the company maintain both investors and creditors happy, reducing its debt burden while paying out consistently higher dividends? This will be a lot harder.

Given what we have mentioned before, it is reasonable to believe that AT&T will be forced to cut the dividend or take its debt levels to new highs. With asset turnover at the current level, the company will be forced to further expand its balance sheet. The result is more debt and less profitable assets. Does that sound like a recipe for success?

AT&T is caught between the sword and the wall, these being creditors and investors. I expect that AT&T will do anything to avoid cutting the dividend. While you could arguably make returns of near 10%, thanks to the dividend, protecting your principal should be your biggest priority.

Valuation

We have used a trendline analysis to forecast cash flow and derive an expected return based on today’s price for AT&T. Below, we can see a simplified balance sheet, income statement, and some growth ratios for the forecasted period as well as a target price/return based on the discount applied. The B/S and income statement shown here are for the next 10 years (2021-2030), but the forecasted period and target price/return are reached through a full forecast ending in 2050. Bear in mind, this forecast assumes that debt is repaid as quickly as possible to maximize cash flows.

Source: Author’s work

Our model predicts revenues will be quite stable at around 4%. Having said this, the company doesn’t begin to produce cash flow until 2036. In other words, according to our forecast, and assuming this is the company’s only obligation, the company would need until 2036 to pay down all of its debt.

At today’s price, this would imply an 8.1% return. This doesn’t sound bad, but it must be put into context with financial risk. In our recent study of the airline industry, we determined that Southwest Airlines Co. (LUV) offered the best risk-reward ratio, with an expected return of 8.4% and a “debt coefficient” of 23%. The debt coefficient can be seen as a measure of financial “safety”, and it is derived by adding the Net Debt to revenue over the years. In other words, it is a measure of how long it would take the company to repay all of its debt.

AT&T’s debt coefficient is around 826.5%. This means, compared to Southwest, the company offers a worse return and a higher financial risk.

Takeaway

To justify investing in AT&T, the company would have to prove that it can fundamentally change its business. This would mean achieving a higher asset turnover. AT&T can still do this, but the company has put all its eggs in the HBO basket, and if things go south, there’s not much room for AT&T to do anything else. At today’s price, I would rate AT&T a “hold” because of the dividend.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.


Originally published on Seeking Alpha

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