Google+ Followers

Thursday, March 28, 2013

AT&T: A Toxic Aristocrat - Seeking Alpha

I have always considered T to be one of the safest investments in the world.  This article points out some real issues between free cash flow and operating earnings.

A TRAP????

AT&T: A Toxic Aristocrat

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
AT&T (T) has raised its dividend every year since 1985. It's also the 13th largest S&P 500 company by market capitalization. This means that it should be a relatively safe stock. These two things combine to make a compelling case for buying AT&T if you want a nice safe dividend paying stock. So why am I calling it a toxic aristocrat and recommending you avoid it?
The dividend payout ratio is 144%. This is simply not sustainable. The good news is that the dividend is well covered by free cash flow. This means the risk is not as immediate as the payout ratio suggests. The difference between earnings and FCF is being made up by recognizing actuarial gains on pensions and post-retirement benefits (as it was last year) rather than being from business-related activities. However, there are only so many improvements you can make in your pension arrangements.
Gross profit margin is 56.7%, which is impressive but not surprising when you consider the lines of business AT&T are in - phone calls do not cost much to "produce" once you have the infrastructure in place. However, they have high expenses - especially selling, general and administrative (56.9% of gross profit) - that reduce their net margin to just 5.7%. This is better than most of their competitors but that says more about the competitiveness of the communications industry than the quality of AT&T. Their net margin also seems to be in a fairly steady downtrend over the last 10 years (with 2011 as a notable outlier).
Debt is growing in both absolute terms (8% increase in long-term debt last year) and compared to treasury share adjusted shareholder equity (10% increase from 1.3:1 to 1.43:1). While now is a pretty good time to be borrowing as interest rates are low this will not last forever. Interest expenses are currently 4.8% of revenue. This is down slightly from 4.9% last year thanks to borrowing at lower interest rates and repaying some higher rate debt. Currently it would take AT&T 9 years of net earnings to repay their long-term debts.
AT&T is improving their receivables both as a percentage of revenue (10.7% of revenue down from 11.6% in 2011 and 11.9% in 2010) and in absolute terms. This is a sign of operating efficiency and a boost to earnings although it will obviously get harder to continue to do this. It does suggest the company is being competently managed though.
The return on total assets is very low at 2.7% and even with gearing AT&T is only providing 7.3% on return on equity. This just is not good enough to guarantee that they will continue to be able to provide an attractive dividend.
This analysis of AT&T's financials suggest that the current 4.9% dividend yield is a trap. The dividend is currently being kept afloat by accounting improvements. At some point this will end. They may be able to continue their record of dividend increases but it will come at a cost to the balance sheet. The less quantifiable attributes don't look particularly favorable either.
The telecommunications market, or at least AT&T's share of it seems to be stagnating. The two main segments of the business are wireless (cellular) and wired (landline) telecommunications services. Both are about half of the company's business (52% and 47% respectively).
Wireless gross customer acquisition has slowed by 13% over the last year while customer losses have increased to the point wireless net customer acquisition (acquisition minus losses) slowed by 52%. One very simple model (assuming gross acquisition stays constant and losses remain at their current rate) suggests that we may have reached an equilibrium in the AT&T wireless customer base. This trend is also playing out in the wireless market generally with the number of new subscribers each quarter dropping from 5 million in 2011 to an estimated <2 107="" 2013.="" amp="" at="" b="" comparison="" for="" have="" in="" million="" subscribers.="">
The wired side of the business is in worse shape - they posted just a 1% increase in revenue which was merely a partial reverse of a 4.7% loss in 2010. The only sub-segment to grow revenues last year was data. It seems likely this flat or slightly downward trend will continue as traditional phone lines become less and less popular.
While AT&T do have a significant market share in their two main market segments (which is good) the overall customer bases are not growing (or even shrinking) so the marketplace will get more competitive. The unfortunate fact is that telecommunications services are very close to being a commodity business. More customers are realizing this and either switching providers or threatening to do so in order to receive improved pricing.
Overall, I think AT&T is an average company that is trading at inflated levels at the moment due to its superficially attractive yield and strong reputation. A nearly 5% yield is very tempting in a low yield environment, especially from a dividend aristocrat. However, AT&T has a relatively poor financial performance and is in a difficult industry. They may be able to weather the storm and continue paying and (maybe even raising) the dividend but it will be challenging. My belief is that future increases would be at or below the 2.4% average from the last three years (which barely beats inflation) and would probably come at further expense to the solidity of the balance sheet.

No comments:

Post a Comment