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What Makes AT&T a Profitable Investment

As the second largest domestic wireless carrier, AT&T (T) provides its services to over 93 million customers and 14 million "connected devices," in addition to operating as a phone company in 22 states (30 million phone lines and 16 million Internet users). The company's scale advantages, and well-developed wireless unit are particularly attractive features, which has helped establish its dominant market position. In fact, today the company shares 60% of the entire domestic communications market with rival Verizon Communications Inc. (VZ)'s Wireless system.

Given the disposable resources, AT&T has been able to consistently invest developments to target customer needs, while generating operating margins of 23.7% and healthy cash flow levels. Furthermore, the company's wireless network has become so massive and gained so much customer loyalty, that smaller competitors like T-Mobile US Inc. (TMUS) or Sprint Corporation (S) have turned to aggressive pricing strategies in order to stay in the race. However, the firm is well set to manage a bidding war, given its cost advantages in providing quality service.

In the article below, I will analyze AT&T's past profitability, capital and operating efficiency, in addition to looking at which institutional investors have recently bought the company's shares. Based on this information, we will get an understanding of the company�s revenues, operating metrics and quality of earnings.

Profitability Analysis

Profitability is a class of financial metric used to analyze a business' ability to generate earnings, compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study the profitability metrics return on assets, quality of earnings, cash flows and revenues, which will help us elucidate if the company is really making money.

ROA - Return On Assets = Net Income/Total Assets

ROA is an indicator of how profitable a company is relative to its total assets. It additionally gives us an idea as to how efficient management is at using its assets to generate earnings. In simple terms, this metric tells you what earnings were generated from invested capital (assets).

I am encouraged by the fact that AT&T's ROA has increased from 1.46% to 6.63% in the past three years, because it indicates that the company is generating more from its assets now, than it did in 2010.

Quality of Earnings

Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies -such as inflation of inventory. In order to assess AT&T's quality of earnings we will compare the level of income with operating cash flows.

The company generated profits growth of 50% over the past two years, surpassing that of the operating cash flow. This implies that earnings could have been created by inventory anomalies, which is somewhat worrisome.

High-end Customers

While Sprint and T-Mobile are popular options in the low-cost wireless segment, AT&T prefers to focus on customers willing to pay higher prices, in return for premium services. Thus, recent changes in the company's pricing strategy, reducing the cost of 2GB data buckets for single and two-line accounts from $55 to $40 per month, are bound to attract more customers, stealing some market share from Verizon.

Working Capital

Working Capital is a measure of both a company's efficiency and its short-term financial health. It indicates whether a company has enough short term assets to cover its short term debt. Since most believe that a ratio between 1.2 and 2.0 is sufficient, anything below 1 will be a negative sign and anything over 2 implies that the company is not investing excess assets.

In order to appreciate a company's working capital structure, we need to analyze its current ratio growth. AT&T's current ratio has decreased from 0.75 in 2010 to 0.66 in 2012, indicating that the company�s balance sheet has lost some strength over the last few years.

Gross Margin: Gross Income/Sales

The gross profit margin measures a company's manufacturing and distribution efficiency during the production process. It also tells investors what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors - and overall industry - is more efficient and investors will pay more for these businesses, given their capacity to make a decent profit as long as overhead costs are controlled.

Over the past three years, AT&T's gross margin has increased. The ratio rose from 54.7% in 2010 to 60.0% in 2012, indicating that the company has, in fact, gained efficiency year over year.

Institutional Investors

I feel encouraged by the fact that investment gurus Jim Simons (Trades, Portfolio) and Paul Tudor Jones (Trades, Portfolio) bought the stock in the past months at an average price of $34.78, because it shows that hedge funds have confidence in AT&T's future profitability.

Analyst Outlook

Currently, many analysts have a good outlook for AT&T. While Analysts at MSN Money are predicting that the firm will retrieve a growing EPS of $2.78 for fiscal year 2014, Bloomberg estimates 2013's revenue of $131.70 billion to continue its 4.5% growth pace and close at $133.57 billion in fiscal year 2014. On Sept. 3, 2014, Macquarie gave AT&T a rating of "Neutral" with a target price of $35.54, which implies significant upside potential from this point.


While some issues remain regarding the company's dependency on iPhone sales (accounting for 80% of its smartphone sales), and low switching costs for unsatisfied customers, I believe AT&T is still a top-notch investment. Given the firm's strong balance sheet, with growing metrics in almost every aspect, I think shareholders are bound to benefit from several factors in the long term. The 5.6% dividend yield, for example, is way above the industry average, as well the as the 20.10% returns on equity and 11.40% EBITDA growth rate.

Furthermore, this may be the perfect time for investors to buy the company's stock, as it is currently trading at a 42% price discount relative the industry median of 16.4x, making it a real bargain. And considering the scale and past profitability of its business model, I feel very bullish about the long term results of AT&T.

Disclosure: Victor Selva holds no position in any stocks mentioned.

This article first appeared on GuruFocus.