Bonds used to offer risk-free return.

Warren Buffett is famous for saying that they offer “return-free risk”.

With rates rising, that quip seems more accurate than ever.

As an investor who’s always favored stocks over bonds, my bias is clear.

However, choosing stocks over bonds doesn’t mean you have to sacrifice income.

Jason Fieber's Dividend Growth PortfolioIn fact, it’s often quite the opposite: Many high-quality stocks offer bond-busting yields.

Especially when you’re looking at the right set of stocks.

I favor and personally use the dividend growth investing strategy.

I’ve used this strategy to great effect, building a six-figure portfolio I call the FIRE Fund in the process.

This dividend growth stock portfolio produces enough five-figure passive dividend income for me to live off.

I’m not exactly at retirement age, either.

Truth be told, I was able to retire in my early 30s.

And I lay out in my Early Retirement Blueprint exactly how I was able to accomplish that.

Dividend growth investing is a strategy that advocates buying and holding shares in world-class businesses that pay reliable, rising dividends.

You can find hundreds of these stocks by perusing the Dividend Champions, Contenders, and Challengers list.

If you take a quick look at that list, you’ll notice dozens of household names – the businesses that make the world go round.

However, as great as many of these businesses can be and have been, how much you pay for stock matters very much.

Price is only what you pay, but it’s value that you actually get.

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

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

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value. And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Buying a high-quality dividend growth stock when it’s undervalued can provide the foundation for excellent long-term total return and income.

Certainly much better than you’d get with a fixed-income instrument.

Fortunately, undervaluation isn’t super difficult to spot.

Fellow contributor Dave Van Knapp has made it a lot easier via Lesson 11: Valuation.

Part of an overarching series of “lessons” on DGI, its easy-to-follow valuation model can be applied to almost any dividend growth stock out there.

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 multinational media conglomerate that provides communications and digital entertainment services in the US and internationally.

Co-founded by Alexander Graham Bell in 1885, AT&T is now a $216 billion (by market cap) media juggernaut that employs almost 250,000 people.

FY 2020 operating revenue breaks down across the following reportable segments: Communications, 79%; WarnerMedia, 17%; and Latin America, 3%.

Their largest segment, Communications, provides wireless and wireline telecom, video, and broadband services to millions of consumers.

They’re one of the largest telecom companies in the world.

If that’s all they were, it’d be impressive – smartphones are almost an additional appendage at this point, and mobile communications/data is practically as important as electricity now.

But they have a very significant media business on top of it.

WarnerMedia, through major properties Turner, Home Box Office, and Warner Bros., develops, produces, and distributes feature films, television content, and other digital content across a variety of platforms.

AT&T is vertically integrated with their media content, acting as both a major producer and distributor of content. The distribution side of the business has been amplified of late, as AT&T recently fully launched their much-anticipated HBO Max streaming service.

AT&T’s debt-fueled foray into media, through their $85 billion Time Warner acquisition in 2018, has generated more questions than answers thus far.

However, the timing might have been fortuitous.

Streaming has never been more important for both companies and consumers than it is now, especially after the pandemic struck in 2020.

More people than ever before are streaming content.

That bodes well for AT&T in two ways.

First, there’s the increased demand for broadband, which they offer across both wireless and wired connections.

Broadband demand is growing, particularly with more decentralized work after the work-from-home theme developed. Streaming only serves to bolster that demand. And with 5G just now rolling out and AT&T set to become a major 5G provider, AT&T’s position will strengthen.

Second, now acting as a major streaming player, they have a growing audience and huge addressable market for content production and distribution.

If there was ever a time to jump into streaming with full force, it’s now. That’s exactly what AT&T is doing.

This one-two punch should translate to growing profit and dividends over the long run.

Dividend Growth, Growth Rate, Payout Ratio and Yield

AT&T has already increased its dividend for 36 consecutive years, making them a Dividend Aristocrat.

And while the 10-year dividend growth rate of 2.2% is nothing to write home about, you have to consider that this stock offers a market-smashing yield of 6.87%.

That’s more than four times higher than the broader market’s yield.

It’s also more than 100 basis points higher than the stock’s own five-year average yield.

Oftentimes, a yield this high indicates an unsafe dividend.

However, I would argue that this is an exception.

The payout ratio is only 65.4%, using FY 2020 adjusted EPS.

Moreover, the FCF payout ratio for the full year came in at only 55%.

I see the dividend as safe.

That said, AT&T has missed its recent schedule for normal dividend increases. They’ve been focusing on their HBO Max launch, 5G rollout, and balance sheet deleveraging efforts.

But I suspect that AT&T will make good on this within the next quarter or two and hand out their usual $0.04/year dividend increase.

This is a slow-growth, high-yield stock that might be perfect for retirees, income investors, or investors who want to amplify the overall yield of their portfolio.

Revenue and Earnings Growth

As enticing as these dividend metrics might be, they’re looking at what’s already transpired.

However, investors risk today’s capital for tomorrow’s rewards.

Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us to estimate the stock’s intrinsic value.

I’ll first show you what AT&T has done over the last decade in terms of its top-line and bottom-line growth.

I’ll then compare to that to a near-term professional prognostication for profit growth.

Combining the proven past with a future forecast in this way should reveal a reasonable growth path for the business.

AT&T grew its revenue from $126.723 billion in FY 2011 to $171.760 billion in FY 2020.

That’s a compound annual growth rate of 3.44%.

This is actually not bad top-line growth for a mature business.

But the aforementioned Time Warner acquisition drove much of this. So this was far from being totally organic.

Meanwhile, earnings per share advanced from $0.66 to $3.18 (adjusted) over this 10-year period, which is a CAGR of 19.09%.

While exceptional, I think this is also misleading.

AT&T routinely adjusts its EPS up and down to account for a number of items that impact GAAP EPS. Many of these items cloud the earnings power of the company.

The growth can look good or bad depending on what period you’re looking at and what adjustments were taken.

If we move past EPS and go straight to cash flow, FCF/share went from $2.44 to $3.82 over this period – a CAGR of 5.11%.

That would be a more accurate view of the growth profile.

Looking forward, CFRA believes that that AT&T will compound its EPS at an annual rate of 3% over the next three years.

I think CFRA’s forecast is perfectly reasonable.

On one hand, AT&T has a lot going for it.

They’re at the center of two megatrends: 5G, and streaming content. Regarding the latter, they now have more than 41 million total HBO and HBO Max subscribers, which is running far ahead of initial company expectations. HBO Max goes international in June.

On the other hand, their large size, debt load, and questionable management choices have worked against them.

All in all, AT&T doesn’t need to produce blockbuster growth in order to be a suitable long-term investment.

It’s basically a bond proxy, except the yield is much higher than you’d get with almost any bond. Plus, there’s a small growth kicker.

It is what it is, and you know what you’re getting here. It’s an income play. And there’s nothing wrong with that.

I think AT&T will continue to produce low-single-digit business growth, which should translate into like dividend growth. It’s not hard to like that when you combine this dividend growth with a near-7% yield.

Financial Position

Moving over to the balance sheet, this is the worst part of the business.

The long-term debt/equity ratio is 0.95.

There is currently a N/A interest coverage ratio, as AT&T took a GAAP loss for FY 2020. However, the interest coverage ratio for FY 2019 was just over 3.

It’s worth pointing out that the company is attempting to deleverage the balance sheet.

Net debt dropped by $3.5 billion for FY 2020.

Furthermore, they announced a spin-off of their video business unit (comprised of DirecTV, AT&T TV and U-verse), which will be 30% owned by private-equity firm TPG Capital. AT&T will own the other 70%.

This deal, which is expected to close in the second half of 2021, will provide AT&T with almost $8 billion in cash. The company plans to use this capital to reduce debt.

I’d very much like to see them continue to chip away at their ~$150 billion debt load. And with their significant FCF, they can afford to do so. They’ll simply have to manage the business properly, grow the sub base, and be prudent with spectrum auctions.

Profitability is relatively robust for the business model.

Over the last five years, the firm has averaged annual net margin of 10.13% and annual return on equity of 11.73%.

If you’re looking for a stock to safely juice the yield of your portfolio, I think AT&T should be top of mind.

And the company’s durable competitive advantages include scale, vertical integration, and key mobile technology.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

AT&T’s maturity and size will naturally limit growth.

The balance sheet’s leverage has created inflexibility. Paying down debt will divert cash flow and stifle future M&A opportunities.

Rising interest rates would make the debt less manageable and the stock’s yield less relatively attractive.

Their streaming efforts are off to a great start, but this is still unproven in terms of long-term profitability. Also, streaming moves consumers away from the legacy cable bundle.

And any kind of major technological change in the way people communicate on devices would have implications for the company.

Overall, I see AT&T as an appealing dividend growth stock for income.

And with the valuation being undemanding, it’s made to be that much more appealing…

Stock Price Valuation

The stock trades hands for a P/E ratio of 9.52, based on TTM adjusted EPS.

That’s obviously much lower than the broader market.

Some of that discount seems appropriate. But the expectations are very low here. It wouldn’t take much for the company to surprise to the upside.

The P/S ratio of 1.3 is also slightly off of its five-year average of 1.4.

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

So the stock looks cheap when looking at basic valuation metrics. 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 2%.

This DGR is slightly below the company’s own demonstrated long-term DGR. It’s also slightly below CFRA’s near-term EPS growth rate forecast.

Assuming AT&T keeps up with its recent trend of a $0.04/year dividend increase, that would represent a ~2% dividend increase off of the current $2.08 annual dividend. And that’s where I believe AT&T will go.

I don’t see the company knocking it out of the park. These are low expectations. And I’m not aware of any reason why they can’t at least meet these low expectations.

The DDM analysis gives me a fair value of $35.36.

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.

Even with low expectations, the stock still looks cheap.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

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 $36.00.

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 3-star “HOLD”, with a 12-month target price of $35.00.

We have a super tight consensus here. Averaging the three numbers out gives us a final valuation of $35.45, which would indicate the stock is possibly 17% undervalued.

Bottom line: AT&T Inc. (T) has built an impressive telecom and media conglomerate that’s vertically integrated and positioned at the center of two megatrends. With a market-smashing yield of near 7%, more than 35 consecutive years of dividend increases, a well-covered dividend, and the potential that shares are 17% undervalued, this Dividend Aristocrat might be perfect for dividend growth investors looking for income.

-Jason Fieber

P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.

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 60. 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 Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

This article first appeared on Dividends & Income

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