Undervalued Dividend Growth Stock of the Week: AT&T Inc. (T)

“Life, Liberty, and the pursuit of Happiness” is a phrase that just about every American is familiar with.

Sourced from the United States Declaration of Independence, they’re “unalienable rights” that have been given to every human being.

However, just how much liberty and happiness do we have in our lives?

There are many people who probably feel very little of either one on many days.

I, too, once felt that way.

After all, how much liberty did I really have in my life if I was practically forced to show up to a job I didn’t like for most of my waking hours?

So I decided to do something about it.

That something involved living below my means and investing my excess capital into high-quality dividend growth stocks like those that can be found on David Fish’s Dividend Champions, Contenders, and Challengers list.

In fact, that something involved doing this for years of my life.

And that something meant I was able to quit that job I didn’t like at just 32 years old.

That something also brought about financial freedom in my life at 33 years old, as the dividend growth stock portfolio I had been building all along started generating the five-figure passive dividend income I need to pay my regular bills.

Being free at 33 meant I was able to finally know what true liberty feels like. And it’s allowed me to regularly pursue happiness.

Best of all, there’s nothing stopping you from injecting a lot more liberty and happiness in your life.

That’s what today’s article is all about.

I’m going to reveal and discuss a high-quality dividend growth stock that looks like a compelling long-term investment idea right now, which could allow you to claim more liberty and happiness due to the passive income this investment could provide you.

In fact, this particular dividend growth stock provides a lot more passive income than most other dividend growth stocks out there, which could translate into that much more liberty and happiness.

And it looks particularly appealing in that department right now thanks to what might be undervaluation.

A wonderful business can be a great long-term investment.

However, it can be a fantastic long-term investment when it’s available for a price below its intrinsic value.

An undervalued dividend growth stock should present a higher yield, greater long-term total return potential, and less risk.

That’s all relative to what the same stock would otherwise offer if it were fairly valued or overvalued.

The higher yield should be present because price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield not only means more passive income in your pocket both now and very likely later, but it also means greater long-term total return potential.

Total return is simply comprised of an income component (dividends or distributions) and a capital gain component.

One can see how the former is positively affected by the higher yield. Meanwhile, the latter is potentially positively influenced by the “upside” that exists between the lower price paid and the higher intrinsic value.

This upside is in addition to whatever organic upside exists as a business makes more money and naturally becomes worth more as a result.

All of this works holistically to reduce one’s risk.

If you pay much less than a stock is worth, that “upside” works to simultaneously limit your “downside”.

This is what happens when you introduce a margin of safety, or a “buffer”.

The greater the margin of safety, the greater the buffer.

And that means one has an advantageous situation where the business would have to do a lot wrong and become worth a lot less before the investment becomes worth less than one paid.

Fortunately, it’s not impossible – or even all that difficult, really – to estimate the fair value of just about any dividend growth stock out there, putting an investor in the “driver’s seat” when it comes to making an intelligent investment decision for the long term.

For example, fellow contributor Dave Van Knapp published a valuation guide that’s designed to help an investor roughly gauge the fair value of a dividend growth stock.

With all of this in mind, let’s dig into a high-quality (and well-known) dividend growth stock that, for the first time in a while, appears undervalued right now…

AT&T Inc. (T) is a holding company that provides domestic and international communication and entertainment services.

We all know AT&T as a phone company. It has used humanity’s love of communication to build itself into a $200+ billion behemoth.

Communication is iniquitous. The world as we know it wouldn’t exist without an ability to clearly and quickly communicate across long distances.

This historically meant landline telephone services.

But the AT&T of 2017 is a lot different from the AT&T of even just 10 years ago.

While it still has a massive communication business, its reliance on traditional landline communication services has dwindled considerably.

AT&T now heavily markets, invests in, and relies on wireless voice and data plans. These are perhaps even more ubiquitous and necessary than landline services were in prior generations.

Moreover, AT&T has been heavily investing in entertainment options, building out a television and broadband business. And the recent acquisition of DirecTV has further cemented AT&T’s businesses of the future.

In addition, AT&T is currently aiming to close on the acquisition of Time Warner Inc. (TWX), which will only add to AT&T’s offerings in the digital entertainment space.

While AT&T continues to build out its communication and entertainment empire, the company is paying shareholders a massive dividend.

For perspective on that, consider the stock yields 5.89% right now.

That’s almost three times the broader market.

It’s also almost 70 basis points higher than the stock’s own five-year average yield.

And lest you think this is just a straight income play, AT&T has a very impressive dividend growth history.

They’ve been paying their shareholders an increasing dividend for 33 consecutive years.

If the stock was yielding almost 6% and that’s all you were getting, it would still be somewhat appealing in today’s market.

But you’re also getting a ten-year dividend growth rate of 3.7% on top of that.

So this is a stock that’s paying you a monster dividend, along with growing that dividend at a rate that’s likely just above the rate of inflation (slowly increasing your purchasing power in the process).

That’s far from shabby!

The only thing that might scare prospective (or even current) investors is the fact that the payout ratio is a sky-high 94.2%.

However, AT&T routinely takes large adjustments to GAAP EPS, which may or may not accurately reflect the company’s ability to profit and pay its dividend.

As such, I think using free cash flow is important for a stock like this.

And the most recent quarter showed $5.9 billion in FCF. The dividend, meanwhile, runs the company approximately $3 billion per quarter. So they’re comfortably covering that huge dividend.

Of course, we want the company to not just cover the dividend, but continue growing it.

And in order to get a feel for what kind of future dividend growth to expect, we must first build an expectation of underlying business growth.

Building that expectation will first require us to look at what AT&T has historically done (using the last 10 years as a proxy for the long term). And we’ll then compare that to a near-term forecast for profit growth.

Combined, these numbers should give us a reasonable idea of what kind of growth the company is producing.

And this will also provide valuable help when it comes time to value the business and its stock.

AT&T has increased its revenue from $118.928 billion to $163.786 billion between fiscal years 2007 and 2016. That’s a compound annual growth rate of 3.62%.

That’s about what I’d figure for a mature company like AT&T; however, large-scale acquisitions (as noted prior) cloud the picture here.

The bottom-line growth is considerably less impressive, although one also has to consider that the company’s recent acquisition of DirecTV hasn’t had time to fully materialize.

AT&T’s earnings per share advanced from $1.94 to $2.10 over this same 10-year period, which is a CAGR of 0.88%.

I’d like to see something closer to (or even a bit higher than) the revenue growth rate, but AT&T’s reported GAAP EPS can bounce around a bit from year to year.

That said, the company’s free cash flow should remain strong and grow after its acquisitions start to fully materialize, transforming AT&T into a modern-day vertically integrated entertainment and communication company.

Looking forward, CFRA believes that AT&T will compound its EPS at an annual rate of 3% over the next three years. This expectation models in the strategic acquisition growth opportunities.

I think this is more than reasonable for AT&T – and this kind of platform would allow for like dividend growth moving forward. More recent dividend increases have been a bit muted, but the new structure would seemingly put the company in a position to resume to more historical dividend growth.

One area of the company that I’d personally like to see improved a bit is the balance sheet.

With a long-term debt/equity ratio of 0.92 and an interest coverage ratio of just over 5, the balance sheet is in okay shape.

The company certainly isn’t leveraged the point of immediate concern.

But there’s still a lot of long-term debt (over $113 billion) being carried around. That’s against relatively little cash. And the balance sheet will only be more heavily indebted if/when the Time Warner acquisition closes.

Meanwhile, profitability is robust, especially considering that the mobile communication side of the business is increasingly becoming competitive, saturated, and commoditized.

Over the last five years, AT&T has averaged net margin of 8.32% and return on equity of 11.52%.

There’s a lot to like here.

If you’re a dividend growth investor who prefers a bit more of a bird in the hand (rather than two in the bush), this stock offers one of the biggest safe dividends out there. One can find higher yields, but this often requires speculation. And you might not be getting any dividend growth. AT&T, however, has three decades of proven dividend growth.

The continued transformation of the company bodes well for that historical dividend growth to continue. If anything, a slight acceleration of dividend growth moving forward (relative to where it’s been at over the last few years) seems very plausible.

Meanwhile, mobile phones are almost as ubiquitous as oxygen – and many people might consider the former more important than the latter. As such, people will continue to pay the corresponding monthly fees in order to have the mobile access they need.

However, the core business is still very competitive.

And there’s less growth potential in the mobile communication space moving forward, due to so much saturation in the US mobile market.

This is why AT&T is aiming to become more diverse and integrated across communication and entertainment.

The issue there, though, is that cord cutting could mitigate some or much of AT&T’s success with these moves.

But I think investors have been paying more attention to the company’s challenges than its opportunities recently, with the stock dropping almost 16% over just the last month alone. The stock is now trading for 2015 prices.

This has resulted in what looks like undervaluation for a stock that hasn’t appeared to be undervalued for a long while…

The stock is trading hands for a P/E ratio of 16.01.

That compares very favorably to both the broader market and the stock’s own five-year average P/E ratio of 27.0, but the latter metric shouldn’t really be considered due to numerous adjustments.

The company’s cash flow is a better metric to use for profit and valuation, and investors are paying much less for cash flow now (even though it’s very likely to rise considerably in the near term) than they’ve been paying, on average, for the last three years.

And the yield, as noted earlier, is significantly higher than its own recent historical average.

So it does look relatively cheap here, but how cheap might it be?

I valued shares using a dividend discount model analysis.

I factored in a 8% discount rate (due to the yield) and a long-term dividend growth rate of 3%.

That future DGR is in line with the stock’s 10-year proven DGR. FCF is comfortably covering the dividend, underlying business growth looks set to accelerate, and few companies are more committed to their dividend than AT&T.

I believe this is a reasonable baseline expectation for AT&T’s dividend and dividend growth profile moving forward.

The DDM analysis gives me a fair value of $40.38.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis indicates that the stock is at least moderately undervalued here, but perhaps significantly so. However, my perspective is limited to my own views on the business and its stock, which is why comparing my analysis to what professional analysts conclude adds value and depth.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates T as a 4-star stock, with a fair value estimate of $40.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates T as a 4-star “BUY”, with a fair value calculation of $33.93.

The latter firm has a 12-month target price in line with my fair value calculation, which would make this idea even more compelling. Nonetheless, averaging out the three valuation analyses gives us a final valuation of $38.10, which would indicate the stock is potentially 14% undervalued right now.

Bottom line: AT&T Inc. (T) is a high-quality business with a tremendous record for paying shareholders a huge and growing dividend. Their ability to continue doing that could very well improve moving forward, yet the stock’s recent price action apparently discounts much of this. But short-term volatility is often a long-term opportunity, and this stock has the potential for 14% upside on top of a market-crushing yield of almost 6%. If you like your dividends big, and you want them to get bigger every year, this dividend growth stock should be on your radar.

— Jason Fieber

Note from DTA: How safe is AT&T’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 78. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, AT&T’s dividend appears safe and unlikely to be cut. Learn more about Dividend Safety Scores here.

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