I suppose there are worse stocks out there to own than AT&T (NYSE:T). AT&T does pay a solid dividend, admittedly. Its 6.7% yield is among the highest in the market among large-market-capitalization stocks. And T stock does benefit from a base of reasonably stable revenues, particularly in the core wireless business (what AT&T calls the Mobility segment).
But real problems exist, too. Putting aside the attractive dividend, the T stock price is headed in the wrong direction. It touched a seven-year low in December. The rally since has underperformed the market as a whole. Over the last five years — even including dividends — AT&T shares have returned just 11% total. On average over that time period, the S&P 500 — again, including dividends — has provided the same amount of return on an annual basis.
And it’s difficult to see how or why that changes. Looking past the headline yield, the news here isn’t good. AT&T’s end markets aren’t attractive. It’s not a leader in its businesses anymore. The company has more debt than any investor should be comfortable with. Indeed, there’s little evidence to suggest that the next five years will look much different than the last five.
The End Markets Problem for AT&T Stock
One obvious issue for AT&T stock is that the underlying telecom firm’s end markets simply aren’t that attractive. Per figures from the 10-Q, nearly half of first-quarter operating income came from the Mobility segment. In the U.S., the wireless industry is marked by low growth and intense competition, which I’ve in the past likened to a circular firing squad. It’s a difficult business, and one that has shown little growth, though AT&T did manage to drive a 7% increase in profit last year (albeit after a decline in 2017).
About 14% of total profit came from the Entertainment Group, the vestige of the company’s disastrous acquisition of DirecTV. The satellite business on the whole is in decline: AT&T’s profits are falling, and rival DISH Network (NASDAQ:DISH) has seen its share price fall by over half from 2015 peaks. Streaming service DirecTV Now already is losing subscribers.
Business wireline services drive over 10% of earnings. Those profits are falling, unsurprisingly, with the declines accelerating in Q1 after a modest compression in 2018. WarnerMedia supported a little over 20% of the bottom line in Q1. Over half of that profit came from Turner networks, which are facing challenges from cord-cutting and the shift to streaming. Latin American operations and Xandr, built through last year’s acquisition of AppNexus, are too small to move the needle yet.
Not one of those markets looks attractive. None has any real growth; Turner and wireline combined produced almost a quarter of profits, but likely are facing declines. Yet those businesses are supporting some $175 billion in debt. On its face, then, T stock is a risky play.
The Competition Problem for T Stock
Making matters worse, AT&T isn’t even a leader in those tough end markets, save perhaps for wireline. In wireless, Verizon Communications (NYSE:VZ) has clearly outperformed it, which has been and still is a much better stock. I’d even include T-Mobile (NASDAQ:TMUS) in the mix.
DirecTV is losing to Hulu, let alone Netflix (NASDAQ:NFLX). The Turner networks aren’t dominating cable. HBO probably is the best business in the portfolio, but it drove about 5% of profit in the first quarter. And its management team already has been decimated under AT&T’s ownership.
This isn’t just a backwards-looking problem. If AT&T can’t win in mobility, is the new WarnerMedia streaming service really going to beat Disney (NYSE:DIS) and Netflix in streaming? Can an investor really trust that the moves at HBO are logical and that the business will be better under AT&T management? Can that same investor trust that the Time Warner deal itself was a smart move, financially and strategically, when DirecTV was such a terrible move?
Ignore the nearly 7% yield. Focus on the fact that an investor in AT&T stock is buying the AT&T business. And then ask, why? This is a company posting middling performance in difficult markets. That’s a combination that is going to create a cheap stock.
The Case for T
To be fair, T already is a cheap stock, and seemingly prices in some, if not all, of those concerns. 2019 EPS estimates of $3.59 suggests a forward price-earnings ratio of about 8.5x. That’s low, and notably lower than ostensible rivals like VZ or DIS.
And so exists a path to upside. Paying down the $175 billion in debt — and the associated interest expense — could help earnings growth over time. Approval of the merger between T-Mobile and Sprint (NYSE:S) could minimize competition — and pricing pressure — in wireless, with 5G another potential catalyst.
A less-leveraged company showing better performance could receive a 10x-plus P/E multiple. EPS could get to, or beyond $4. There’s a “back of the envelope” case that AT&T stock could move to $40 from the current $30 range. This thesis suggests 30%-plus returns on top of the 6.7% dividend (which itself should rise going forward, if modestly so).
But Even the Bull Case Has Big Risks
But there are an awful lot of risks on the way to that upside. If the streaming business fails, AT&T will have essentially no growth drivers left. The balance sheet, growth outlook and debt load look somewhat akin to that of Anheuser-Busch InBev (NYSE:BUD) last year, right before it halved its dividend. As far as the dividend goes, there is little room for error.
Meanwhile, there’s still a risk of another step down in the other businesses. DirecTV is going to hemorrhage subscribers going forward. The Turner networks — based largely on reruns of shows available elsewhere — will be cannibalized by the WarnerMedia streaming service, in addition to other competitors. This still, even with a few breaks, looks like a zero-growth company at best.
And zero-growth companies with enormous debt obligations don’t trade at 15x earnings, or usually even 10x. The valuation assigned to T stock at the moment isn’t the case of the market not paying attention: this is the 25th largest company on U.S. markets by market cap. The Street is paying attention; it just doesn’t like what it sees. Until that changes, T stock isn’t going anywhere.
As of this writing, Vince Martin has no positions in any securities mentioned.
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