The telecommunications industry is closely tied to the government, for better or worse. This results in intense lobbying. AT&T is one of the country’s biggest spenders on lobbying.
This should appeal to shareholders, as some studies show lobbying spending has one of the highest ROIs of any investment. The ethics of lobbying is left to the reader’s discretion. The image below shows AT&T’s lobbying spending by year:
Source: Open Secrets
AT&T’s strong competitive advantage helps to insulate profits from recessions. The company typically locks consumers and businesses into long-term contracts which create smooth, utility like cash flows.
The company’s cash flows per share through the Great Recession are shown below:
– 2007 Cash flows per share of $5.36
– 2008 Cash flows per share of $5.56
– 2009 Cash flows per share of $5.46
As you can see, the recession barely dented the company’s stable (but slowly growing) cash flows per share. AT&T maintains a reasonable payout ratio of around 70% of earnings. This is prudent given the company’s stable cash flows.
Valuation & Expected Total Returns
AT&T stock is currently trading for an adjusted price-to-earnings multiple of 14.1. There are two ways to value AT&T.
– Relative to today’s elevated valuation
– Relative to the S&P 500’s historical average valuation
AT&T has traded for a 0.75x multiple to the S&P 500’s price-to-earnings ratio over the last decade, on average.
The S&P 500 is currently trading for a price-to-earnings ratio of 24.8. This implies a fair price-to-earnings ratio of 18.6 for AT&T. Based on current market levels, AT&T appears undervalued.
Based on the S&P 500’s historical average price-to-earnings ratio of 15.6, AT&T should trade for a price-to-earnings ratio of 11.7.
If you factor in interest rates, the S&P 500 is trading around what one would expect for fair value. Of course, interest rates are widely expected to rise somewhat over the next several years.
Let’s look at 2 scenarios:
Scenario 1: In 5 years, the S&P 500 is still trading for a 24.8 price-to-earnings multiple, and AT&T has ‘caught up’ to its historical average 0.75x multiple to the market. This would boost returns by 5.7 percentage points a year.
Scenario 2: Interest rates rise, and the S&P 500 goes into a recession. Five years from now, the S&P 500 is at its historical average price-to-earnings ratio of 15.6. AT&T follows suite and trades for a price-to-earnings ratio of 11.7 (0.75x the S&P 500’s). This would drag down returns by 3.7 percentage points a year.
I expected earnings-per-share growth of 4% to 6% a year from AT&T (as discussed in the growth section of this article). The company is currently yielding nearly 5%. This gives expected total returns of 9% to 11% before changes in the valuation multiple.
Using ‘scenario 1’, this implies expected total returns of 14.7% to 16.7% a year. Using ‘scenario 2’, this implies total returns of 5.3% to 7.3% a year.
Of course, there are a near infinite number of valuation multiple scenarios that could play out over the next several years. At current prices, AT&T looks undervalued relative to the market today.
Final Thoughts
AT&T Inc. (NYSE:T) is a high yielding dividend growth stock with a strong competitive advantage. The company has an above average rank using The 8 Rules of Dividend Investing due to its strong yield, lower than average volatility, and reasonable price-to-earnings ratio.
AT&T will likely make a good addition to conservative income investor accounts looking for stable dividend income that grows in excess of inflation.
Note: This article is written by Ben Reynolds and originally published at Sure Dividend.
