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Buy AT&T for the Free Cash Flow and Possible Multiple Expansion

AT&T Inc. (NYSE:T) is one of the most well-known stocks among dividend growth investors. With a yield above 5%, AT&T is also one of the highest yielding stocks in the S&P 500 index. The company has more than three decades of dividend growth, qualifying it as a Dividend Aristocrat.

AT&T has long been seen by many investors to be just a dividend. After the stock spent several years of offering very little share price appreciation, that type of thinking might be changing. Shares of AT&T increased more than 32% in value in 2019, edging out the 30% return of the S&P 500.

So, what's changed in the view of investors? The company has, at best, a very anemic expectation of revenue growth over the next few years. The difference is that the market is starting to realize AT&T's free cash flow situation. To me, AT&T is a free cash flow giant that is just beginning to roar. Not only that, but shares of AT&T are currently very cheap.

Recent earnings

AT&T reported third quarter earnings at the end of October, and the results were not especially inspiring. Revenue declined 2.4% to $44.6 billion, net income dropped by $1 billion to $3.7 billion and EPS of $0.50 was lower by 23% year-over-year. Adjusted EPS did improve by $0.04 to $0.94, but this was mostly due to a lower effective tax rate compared to 2018. Not exactly the best way to grow profitability.

Wireless revenues were up just 0.7% in the quarter, but AT&T did have smart phone net adds of 317,000 and a postpaid churn rate (meaning the number of customers who dropped plans) of just 0.95%. The Entertainment Group had a revenue decline of 3.4% due to weakness in IP Broadband. The company lost more than 1.1 million premium video subscribers due to a reduction in heavily discounted plans. Revenues of the Business Wireline segment were off by 3% due to continued weakness in the company's legacy wirelines services.

AT&T offered a three-year outlook for its business. The company expects revenue to grow in a range of 1% to 2% for the current year and a similar rate of growth for 2021 and 2022 as well.

While revenue growth is anemic and likely to continue to be so, AT&T has set a fairly ambitious plan to become more profitable.

AT&T has a midpoint for adjusted EPS for 2019 of $3.56. Guidance for adjusted EPS for 2020 is expected to fall in a range of $3.60 to $3.70 before growing to $4.50 to $4.80 in 2022.

Some of this growth in adjusted EPS is due to share repurchases. AT&T is scheduled to retire much of the shares issued to acquire Time Warner in 2018 over the next few years. A combination of cost reductions and synergies from WarnerMedia will also help the bottom line. Growth in wireless, WarnerMedia and Advertising are seen as contributing as much 40% of adjusted EPS growth between 2020 and 2022. From this guidance, it is clear that AT&T has multiple levers to pull to hep grow the company's adjusted EPS even as revenue is only projected to increase by a small percentage.

With mixed results, why did shares of AT&T deliver a better performance compared to the market index? In my opinion, the primary reason is because the company is in the early stages of delivering a significant amount of free cash flow.

All about the free cash flow

The addition of TimeWarner has only added to what was already a robust free cash flow. Listed below are the annual amounts of free cash flow for AT&T dating back to 2013:

  • 2013 free cash flow: $13.9 billion
  • 2014 free cash flow: $16.7 billion (20% increase)
  • 2015 free cash flow: $10.1 billion (40% decrease)
  • 2016 free cash flow: $17.8 billion (43% increase)
  • 2017 free cash flow: $18.5 billion (3.9% increase)
  • 2018 free cash flow: $22.8 billion (23% increase)

AT&T expects free cash flow of approximately $28 billion for all of 2019, above its previous forecast of $26 billion. Achieving this new goal would be a 23% improvement from the total from 2018.

The company has been able to use this cash to help pay down debt. AT&T ended the third quarter with ~$154 billion of long-term debt. This is no small amount, but the company has reduced its long-term debt by about $12.6 billion, or 7.6%, since the start of 2019. AT&T remains saddled with a massive amount of debt, but the company will be able to manage this due to the amount of cash that it generates.

The improvements in cash flow mean that the generous dividend is well supported.

Dividend analysis

AT&T is just one of three communications companies with at least five years of dividend growth. The company has increased its dividend for 35 consecutive years, which is a full two decades longer than Verizon Communications (NYSE:VZ).

AT&T has increased its dividend by an average of:

  • 2.1% per year over the past three years.
  • 2.1 per year over the past five years.
  • 2.3% per year over the past 10 years.

Investors know at this point what to expect with regards to AT&T's dividend increases as the company has raised its dividend by $0.01 per quarter for more than a decade. Like clockwork, the company declared a dividend increase of 2% for the Feb. 3 payment.

The lack of a high dividend growth is a tradeoff for what amounts to a dividend yield of 5.4% at the moment, which is three times the average yield of the S&P 500. The current yield is just under the 10-year average dividend yield of 5.6% even after the recent share price appreciation.

While dividend growth isn't expected to accelerate, shareholders can rest easily knowing that the dividend is very safe. AT&T distributed $3.7 billion of dividends in the third quarter. Free cash flow totaled $6.25 billion during this time, which equates to a free cash flow payout ratio of 59% for the quarter.

Year-to-date, the company has paid out $11.2 billion of dividends while generating $21 billion of free cash flow for a payout ratio of 53%.

Going back further, AT&T distributed $37.2 billion of dividends from 2015 through 2018 while producing $59.2 billion of free cash flow. This gives the company an average payout ratio of 63% during this period of time.

These payout ratios are all within a very safe range, and the company has a target payout ratio of 50% in the coming years. AT&T should get closer to such a level as shares are retired and free cash flows continues to grow over the next few years.

Many high yields are often a warning sign to investors of trouble within the company or that the dividend is at risk for a cut. Looking at AT&T's cash generation and the recent payout ratios should reassure investors that the stock's high yield is very well protected.

The market undervalues AT&T

Using the most recent closing price of $38.52 and expected adjusted EPS of $3.56 for the year, AT&T's stock has a price-earnings ratio of 10.8. This compares very favorably to the stock's 10-year average price-earnings ratio of 12.8. A price-earnings ratio of somewhere between 12 to 14 seems appropriate due to the company's prospects for increases in profitability and free cash flow offset even if revenue growth will be stagnant.

Using estimates for 2019, shares are worth approximately $43 to $50, which would represent growth of 12% to 30% using the most recent price.

Looking out a few years, the possibility of even further gains seems likely. Using the midpoint of the company's guidance for 2022 of $4.65, shares could be worth $56 to $65. Investors buying AT&T today could see returns of 45% to 69% over the next three years, and that is before you add in the dividend. Not bad for a stock many consider to be just a dividend story.

Final thoughts

AT&T's most recent quarter showed weakness in several business segments. Revenue, net income and reported EPS were lower than the prior year while adjusted EPS did show growth. The company doesn't expect much revenue growth over the next three years, but share repurchases, cost cuts and growth in key areas is expected to add a $1 to adjusted EPS over this period of time.

The real story to me is the company's free cash flow, which, if the guidance is correct, could be $10 billion higher in 2019 than it was just two years prior. This free cash flow will be used to maintain and grow the dividend while also buying back stock and retiring debt.

In addition, shares trades at a very low valuation. If AT&T can reach its targets over the next few years then the multiple is likely to expand. This would make shares of the company an excellent combination of growth and income.

Disclosure: Long AT&T, Verizon

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This article first appeared on GuruFocus.