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

Marie Antoinette is famous for saying, “Let them eat cake.”

It might not literally translate out that way, but the obliviousness of the statement has a certain staying power throughout history.

Well, if I were ever to be known for a statement, it’d sound more like this:

“Let them collect dividends.”

There’s nothing oblivious about this statement.

Better yet, dividends don’t have any calories!

In a world where there’s an ever-growing gap between the rich and the poor, there’s an easy investment strategy that can be used to bridge the gap.

That investment strategy is dividend growth investing.

This strategy simply involves buying up shares in world-class businesses that share their growing profit with shareholders, via cash dividend payments. As the profit grows, so goes the dividend payments.

There are hundreds of these stocks to choose from, as you can clearly see by perusing the Dividend Champions, Contenders, and Challengers list.

So you’re not lacking in choice.

You’re also not lacking in opportunity, even though you might think you are.

Look, I’m no Marie Antoinette.

I grew up broke. And I stayed broke most of my life.

That is, until I decided I was worth more… until I decided to beak free from the endless loop of working to earn and earning to spend.

That kick-started a six-year journey, where I poured every ounce of my effort into going from below broke at 27 to financially free at 33. 

And I shared that journey via my Early Retirement Blueprint.

Where am I now? 

I’m financially independent and retired early, living off of the five-figure and growing passive dividend income my FIRE Fund generates for me.

And I did this by living below my means and investing in high-quality dividend growth stocks.

It’s an investment strategy that sells itself.

You’re sticking to some of the best companies in the world – blue-chip stocks, if you will.

And you’re collecting growing dividends, all while watching the worth of those stocks rise over time.

Jason Fieber's Dividend Growth PortfolioSo I didn’t start my life or investment journey off as any kind of Marie Antoinette.

And I’m certainly not living in a palace now, either.

But I am financially free in my 30s – because I collect dividends.

And, you know, I even eat cake sometimes.

However, financial independence doesn’t happen for you unless you put in the effort.

We’re here to help with all of that today by providing a compelling long-term dividend growth stock investment idea.

It’s compelling because it’s a high-quality company, and the stock appears to be undervalued right now.

That undervaluation part of the equation is very important.

Price is only what you pay, but it’s value that tells you what you end up getting for your money.

And when buying dividend growth stocks, valuation plays a key role.

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

This is all relative to what the same stock might otherwise offer if it were fairly valued or overvalued.

That first aspect plays out due to the inverse correlation between price and yield; all else equal, a lower price will result in a higher yield.

The higher yield then goes on to positively affect total return, due to the fact that total return is comprised of two components: capital gain and investment income (via dividends or distributions).

So you’re locking in greater long-term total return potential almost right off the bat with a higher yield.

Moreover, total return is given a possible boost through the “upside” that exists between price and value when undervaluation is present.

If there’s an advantageous mispricing (price below intrinsic value) that you can lock up in the short term, the long-term realignment between price and value works in your favor to spit out capital gain.

And that capital gain would be on top of whatever organic capital gain would naturally manifest itself as a company becomes worth more (and sees its stock price rise as a result of the increased value).

This should all go a long way toward reducing risk, too.

After all, it’s obviously less risky to pay less for the same asset (rather than more).

And you’re putting less capital on the table for the same thing.

Plus, you introduce a margin of safety when there’s a favorable gap between price and value.

This protects your downside while simultaneously maximizing upside.

An investor can’t predict the future, and so we need to insulate ourselves (and our capital) from any number of unforeseen events that can cause an investment to become worth less over time.

Even a great business can be a relatively poor investment (especially over the short term) if one buys shares when they’re overvalued.

But undervaluation can take a pretty good business, and turn it into a great investment.

However, if you’re able to invest in a great business when it’s undervalued, you might be looking at a fantastic long-term opportunity.

And that’s what we’re talking about today.

If this valuation stuff seems a little confusing, check out fellow contributor Dave Van Knapp’s great piece on valuation, which is part of an overarching series of articles (which he calls “lessons”) on the strategy of dividend growth investing.

Valuation was discussed here: Lesson 11: Valuation.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

AT&T Inc. (T)

AT&T Inc. (T) is a diversified and vertically integrated media, entertainment, technology, and telecommunications company.

The AT&T of 2018 isn’t the AT&T your parents (or grandparents) might have been familiar with as they were growing up.

This a conglomerate that touches on almost every aspect of communications and media today.

The communications side of the business is dominant through its solidified position as one of the two major wireless carriers (the other being Verizon Communications Inc. (VZ)) in the United States. It’s essentially a duopoly.

And that business is in and of itself quite attractive, mostly because of the way wireless access has become a ubiquitious part of society today.

Wireless communication service may as well be a utility, for it’s arguably just as important to everyday life as electricity. If you don’t believe me, just count how many people you know that don’t have a smartphone and use it countless times per day. There you go.

Indeed, AT&T has for many years now looked a lot like a utility in that aspect: it has been a slower-growing business with stable cash flows and a good chunk of debt.

But this business is set for a revolution of sorts via the rolling out of 5G, which should allow the promise of the Internet of Things to finally materialize: everything from our phones, cars, houses, and even potentially our bodies will be communicating with each other, across networks, in the near future.

That makes wireless service even more ubiquitious and necessary.

However, AT&T further flipped the script a bit with its recent acquisition of Time Warner Inc., which has instantly scaled AT&T into a vertically integrated and faster-growing entertainment player – they now own their distribution (via DirecTV) and content production.

The new Time Warner business means AT&T now controls major cable networks (including the venerable HBO) and one of the largest movie studios in the world.

Plus, the synergies and cross-selling opportunities gives the company fresh opportunities on the wireless side.

This move means the company’s big dividend appears even more sustainable than it was before.

That big dividend is, by the way, really big.

The stock is yielding 5.95% right now, which is approximately three times as high as the broader market.

Furthermore, it’s more than 80 basis points higher than the stock’s own five-year average yield.

So the stock was already a high-yielding security, but it’s now in the stratosphere.

This kind of yield would be great all by itself, but you’re also getting that reliable dividend growth.

AT&T has increased its dividend for 34 consecutive years.

And I don’t see any reason why that’ll stop anytime soon.

Although the 10-year dividend growth rate is low, at 3.3%, you’re combining that with a yield that’s almost at 6%.

Income-hungry investors, especially older investors, should really like these numbers.

Free cash flow is soaring because Time Warner was a FCF machine.

Meanwhile, the payout ratio (using adjusted EPS for Q4 2017 to factor out one-time tax gains) is sitting at 70.4%.

It’s a touch high because they’re paying that big dividend, but it’s more than reasonable when you consider the big picture.

I see AT&T’s big dividend as secure and reliable as it’s ever been, and 2% to 3% annual growth keeps up with US inflation. That means you’re getting a lot of income, but you’re also retaining your purchasing power. You could do a lot worse than this.

We’ll now look at what kind of top-line and bottom-line growth the business has produced over the last decade (using that as a proxy for the long term), which should tell us a lot about just how secure that dividend is, as well as how much it might grow moving forward.

And then we’ll compare that to a near-term professional forecast for profit growth.

These numbers – the known past and estimated future – will aid us later when the time comes to value the business and its stock.

AT&T increased its revenue from $124.028 billion in FY 2008 to $160.546 billion in FY 2017. That’s a compound annual growth rate of 2.91%.

This is more than acceptable for a mature business like this; however, the company’s revenue has been positively impacted by numerous acquisitions over the last decade (with the 2015 acquisition of DirecTV being particularly notable).

Looking at bottom-line growth on a per-share basis should paint a more accurate picture about what the company is doing (and whether or not these acquisitions have been accretive).

Earnings per share grew from $2.16 in FY 2008 to $3.05 in FY 2017 (as adjusted, to factor out one-time gains), which is a CAGR of 3.91%.

We’ve got a slightly higher bottom-line growth rate, which is great to see. I’ll note that AT&T routinely posts GAAP EPS that can be hard to accurately gauge and use for comparison purposes, but this seems to be a good look at what the company has done over the last decade.

Moving forward, CFRA is predicting that AT&T will compound its EPS at an annual rate of 8% over the next three years.

This would obviously be a big jump from what’s transpired over the last decade.

The forecast heavily relies on the Time Warner addition, which has added a faster-growing business, FCF machine, and more bundling opportunities. In addition, DirecTV Now (its streaming platform) is adding more subscribers than it’s losing on the traditional TV side.

My take is that AT&T could come in somewhere between what they’ve historically done and this forecast (say, 6%), yet that would still make for a phenomenal investment.

However, even 6% EPS growth probably wouldn’t allow for 6% dividend growth, because AT&T has to pay down some of the massive debt they’ve taken on in recent years as they’ve built themselves into what they now are.

Still, I see no reason why investors can’t expect that massive yield to be backed up by dividend growth that’s at least in line with inflation. We’re talking low-single-digit dividend growth on top of a 6% dividend. And I don’t see anything wrong with that at all.

The balance sheet, as just foreshadowed, has definitely taken a hit with some of their recent moves.

The long-term debt/equity ratio is sitting at 0.89, with the interest coverage ratio coming in at just over 3.

Both numbers are as of the most recent full fiscal year (2017), but the Time Warner acquisition closed in 2018. As such, these numbers will surely be different this time next year.

The debt was taken on for growth, so I think both numbers will improve in the near term, which is why I noted that I don’t think dividend growth should be expected to keep pace with bottom-line growth (with the difference allocated toward debt servicing).

Profitability is as one would expect for this industry.

Over the last five years, the company has averaged annual net margin of 10.84% and annual return on equity of 14.51%.

There’s a lot to like about AT&T here.

The company has arguably never looked better than it does today, fully integrated across its various platforms. It offers some of the best content out there, along with the distribution model to make that content available on their terms.

5G is finally rolling out, further strengthening their wireless business and the ubiquity of its services. 5G as a solution to Internet at home could end up making traditional broadband solutions obsolete (threatening the entrenched cable companies), which is a massive potential source of additional revenue in the future.

And investors get a big, sustainable, and growing dividend while all of this plays out.

However, the company has taken on a lot of debt in recent years, which was exacerbated by the Time Warner acquisition.

And although the domestic wireless market has limited players, it’s still a very competitive marketplace that competes heavily on price.

At the right valuation, though, this stock is awfully compelling.

Well, it looks like the valuation is attractive right now…

The stock is trading hands for a P/E ratio of 11.83 (using adjusted TTM EPS that factors out one-time gains in Q4 2017).

While the stock deserves a discounted multiple relative to the market because of lower relative growth, we’re talking less than half the market here. And you’re still getting a big part of return coming in the form of that massive cash dividend.

The five-year average P/E ratio for the stock is 21.2, so it looks cheap on that basis, too. However, it’s tough to compare the numbers because AT&T routinely puts up numbers that are heavily skewed by numerous one-time impacts.

But both the P/S and P/CF ratios are lower than their respective recent historical averages.

And the yield, as noted earlier, is substantially higher than its own five-year average.

So the stock does look cheap here across the board. But how cheap might it be? What would a rational estimate of intrinsic value look like?

I valued shares using a dividend discount model analysis.

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

That long-term DGR is in line with what the company has done over the last 10 years, so I’m basically extrapolating that out into the future.

Now, recent dividend increases have come in lower. But the revolutionary changes that have occurred of late should spur a slight acceleration off of the more recent dividend raises.

This is even accounting for a wide gap between EPS growth and dividend growth, as the balance sheet should be (and likely will be) cleaned up.

The DDM analysis gives me a fair value of $41.20.

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.

The analysis I used was, in my opinion, fairly conservative. Yet the stock still looks tremendously cheap.

Of course, my valuation is just one way to look at the stock. Let’s also take a look at where two professional analysis firms have come out with this stock and its valuation, which adds further perspective 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 12-month target price of $35.00.

I came out on the high end, but there’s a consensus across the board that the stock is worth more than its current price. Averaging the three numbers out gives us a final valuation of $38.73, which would indicate the stock is possibly 15% undervalued.

Bottom line: AT&T Inc. (T) is a diversified and vertically integrated juggernaut across communications, entertainment, and media. The business has arguably never looked better. With a ~6% yield, more than 30 consecutive years of dividend raises, dividend growth that’s positioned to accelerate, and the potential that shares are 15% undervalued, this might be one of the best high-yielding dividend growth stocks available.

-Jason Fieber

Note from DTA: How safe is T’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, T’s dividend appears borderline with a low risk of being cut. Learn more about Dividend Safety Scores here.

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