AT&T (NYSE:T) was a difficult title to own. Even dividend champions, who only focused on incoming quarterly payments, found themselves with lower income after Warner Bros. was discovered. (WBD) spin off. These events, however, often mark the end of long declines. There’s one last round of selling as the company’s biggest supporters end up “vomiting” and throwing in the towel. Have we reached this inflection point for AT&T?
Large Base Numbers
Through all the chaos surrounding the spin-off and the dividend cut, one thing remains abundantly clear. AT&T is cheap. The company trades at approximately 6X EV to EBITDA and 7.5X price to free cash flow. Here we rely on 2023 numbers, which are clean and easier to compare with other telecom giants. Verizon (VZ), another stock we like, is trading at nearly 7.0X EV to EBITDA and 10X to free cash flow. The 1x multiple difference on EBITDA is quite significant for companies in this space and you can tell by the difference it makes between the price and the free cash flow multiple. The differences become even more absurd if you look at other North American comparisons. TELUS Corporation (TU) and BCE Inc. (BCE), both sport a multiple of around 9.0X EV to EBITDA on 2023 figures and a price of around 17X-18X to free cash flow multiples. AT&T also has the highest dividend yield of all with a payout ratio of 50%. BCE is the second closest, but has a dividend payout ratio of 120% (based on earnings). On the raw numbers, AT&T continues to look compelling.
Assess the threat of inflation
We’ve been talking about it for a while now, so it won’t come as a surprise to our regular readers. The inflationary threat is real. It is so real that we have seen companies with extraordinary assets succumb to its pressures.
In the case of AT&T, there is a strong advantage in the form that most of its infrastructure is already in place. In any given year, only modest amounts of replacements and repairs are carried out. This insulates it from rapidly increasing cost pressures. But this isolation is only partial. There are still three ways in which this is impacted.
Although the daily repair numbers are small compared to the value of the network, capital expenditures are another matter. The company is already planning a 20% increase in capital spending and we are sure there is a strong inflationary component there.
It forecasts EBITDA of $41-42 billion in 2022 (vs. $40.3 billion pro forma), benefiting not only from revenue growth but also from “incremental cost transformation savings” of around $1. billion dollars. And earnings per share are expected to be between $2.42 and $2.46, compared to $2.41 pro forma for 2021, with capital investments of up to $24 billion, compared to $20.1 billion pro forma .
Source: AT&T via Seeking Alpha
This is a big deal and so one has to be careful in slapping very high multiples on equities when inflation is so rampant.
At the last check, wages were 6% year-on-year.
This is an incredible number and one that we don’t see anywhere else in this chart. AT&T will only be able to withstand this pressure for a while before being forced to lower wages to retain its talent. On the other hand, let’s note that AT&T is finally starting to raise the prices of a few of its plans. But the extent and effectiveness of these increases remains to be seen. Our view here is that there will be margin compression on the operating side and we view that as modest. But in combination with higher capital spending, we consider the risks to free cash flow to be more serious.
The revaluation of debt as the bond bubble imploded was one we happily applauded from behind the scenes. The decline in BAA bond yields has been nothing short of dramatic.
This destroyed all debt instruments, including closed-end funds and baby bonds. AT&T has not been immune to this either. AT&T Inc. 5.625% NT 67 (NYSE: to be confirmed) are down 12% from their 52-week highs, or two years of payouts.
Preferred shares were even more damaged. AT&T Inc. 4.7 DP SHS PFD C (NYSE: TPC) were down more than 30% from recent 52-week low highs of $18.49.
As AT&T refinances its existing debt, especially amounts issued over the past two years, expect earnings headwinds. The good news here is that while some future debt will be refinanced upwards, there is also plenty of debt that has been issued at even higher rates in the past.
AT&T may also be able to issue more debt in Europe at relatively more attractive rates, as this central bank still appears to be stuck in a coma.
Although inflation has increased massively over the past two years, we have been flabbergasted by the magnitude of its impact on earnings. From Walmart Inc. (WMT) to Target Corporation (TGT) and everything in between, there is a very serious inflation headwind. AT&T looks isolated in the very near term, but we’re not underestimating the potential here to tighten the noose around free cash flow. We still view this as a buy and expect the exceptional valuation and modest pricing power to see AT&T through the day. However, due to the forces mentioned above, our price target is only $24-$25 or 9X-10X potential free cash flow in 2023.
Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.