AT&T (NYSE: T) is a telecommunication giant that has been a stable and reliable dividend payer for more than fifty years. In the recent past due to the lack of earnings growth, management has turned to Acquisitions. In 2015 it acquired DirecTV for $49 billion. Recently it concluded the acquisition of Time Warner for $85 billion. With the effort to grow through acquisition the company ended up putting itself in a fragile position. It has accumulated way too much debt, and the dividend might not be safe if earnings decline. Some have questioned if AT&T’s acquisition of DirecTV was a mistake.
The Time Warner acquisition allowed the company to launch its streaming service. Including all of the Time Warner content. The lack of growth strategy the management has used and a large amount of debt has been the main drivers of the stock price. Today it has over $147.2 billion in net debt. This has crippled the free cash flow generation. It is also important to keep in mind that AT&T’s size doesn’t allow the company to grow faster. The company had a little over $189 billion in revenues. Bear in mind that countries like Greece and New Zealand GDP’s are close to that number at around $200 billion.
Q4 and FY20 Results
T financial results in the last quarter of 2020 were surprisingly positive. It managed to grow its post-paid phone customers by 1.5M the most since 2011. Additionally, it added 1M customers to their fiber broadband segment. Finishing the year with 41M US subscribers to its HBO content platform. AT&T ended 4Q with a loss, despite generating $27.5B in FCF in 2020.
A decline in revenues across most segments is a bad signal. It can be attributed to COVID-19, and the challenges it created.
Known in the past for its activist role in many companies. Elliot Management tried to pursue an activist approach, after taking a considerable stake in T. A letter to the board of directors was written, and their intentions of shaking management up were eventually unfruitful. They would divest their initial investment by the end of last year. The fact is that there might be some problems with T, in regards to management and some changes could be made to improve operations. In this case, the company has a considerable size, and it is not so easy to play the activist role. Elliott Management, led by billionaire Paul Singer, perhaps underestimated how difficult it would be to enforce any meaningful change in T.
To prepare for the 5G transition, AT&T will require extensive investments and lots of capital. Given the amount of debt that it has, and the increased CapEx required in future years. It seems that returns in the next years will not be particularly high. Management estimates CapEx of $18B in 2021, some of it will be used for its HBO segment. Time Warner also requires large amounts of CapEx to create its content.
The stock is currently trading slightly over book value, at 1.27x. The current price-to-earnings is a forward P/E under 10. It trades under 4x EBITDA, which given its operating margin close to 15% seems undervalued. The reason is the large amount of debt it carries. It will take quite some time to reduce it meaningfully.
The stock does not trade at a high valuation, but it is not cheap. Especially considering the amount of debt it holds. Until the debt is meaningfully reduced it seems to be you should consider an investment in T as a bond. It generates plenty of FCF and the payout ratio for 2021 is forecasted to be under 50%. The dividend at this point appears to be safe. Yielding over 7%, and a payout ratio of 54.5%.
The risk-free rate is currently very low. Add to that the fact that junk bonds are trading at incredibly high levels. Investors looking to allocate part of their portfolio to bonds, find themselves in a difficult position. T is not a high-growth company, it does have some competitive advantages. The past has shown how acquisition-driven growth might not have been the best solution. It seems at this point that investors in T, are mainly looking at the yield, and the dividend.
It seems like a good play would be to hold the stock and sell covered calls. This ensures that you boost the income you receive on your initial purchase. It should provide investors with a solid dividend, and additional income from the premium of the covered call. In case the stock rises and hits the strike price of the calls you sold, you will book a profit. If it heads lower you still collect the dividend and the premium for the option. At this point and given that it is a large stock, that hardly moves it should be the best way to play and keep this investment nearly risk-free.
T is currently trading around $29. To purchase 100 shares will cost you $2,900, minus commission. You can expect to receive at least $2.08 dividend per share or $208 from your initial investment yearly. The calls with a strike price of $35 are selling for $66. Depending on the commission you basically can expect to earn $208+$66 or $274. Given your initial investment, it translates into a 9.4% gross return.
If the stock goes up and the options you sold get exercised you will make an additional $600. Depending on how much dividends you collect before, the maximum amount you will make is $874, minus commission, capital gains tax, and dividend tax.
If the stock price stays flat you will essentially collect a 9.4% gross return, which is fairly good considering the amount of risk you are taking.
If the stock declines you still collect the return minus any decrease in value. It would have to decline to $26.27 for it to break even. You would still collect the income from the dividend and the premium which is not a bad option.
Given the current market valuations and the mania and folly showcased in stocks like Gamestop (NYSE: GME). AT&T doesn’t seem like a bad place to park some of your money. Especially when considering that some bonds are yielding negative rates. Add to that the fact that some macro forecasters are expecting inflation and that way bonds seem like a bad place to look for a risk-free rate. Unless you are planning on holding TIPS. At the same time given the debt AT&T has it could be a value trap.
AT&T has a large amount of debt and it will take the company a lot of time to reduce it. The acquisition track record is not great, and some of the management’s decisions should be questioned. As Elliott Management has done in the past. Given the stable price action of the stock, and its safe and solid dividend. Our approach to holding T and selling covered calls seems at this point a good play to earn some income, without incurring much risk.
Disclosure: I have no position in any of the stocks mentioned.
Author bio: Value of Stocks is an independent financial information provider. Focused on analyzing stocks with a value investing approach. Our main goal is to help investors make better investment decisions.