AT&T; Inc. (T): Although Risky, It Is A Good Bet
Monday, August 16, 2010 5:29 PM

An attractive per-share profit, the possibility of a stock buyback and dividend increase and a relatively inexpensive price gives AT&T a clear advantage over its competitors. AT&T will continue to generate strong wireless sales because of its focus on data--text, email and Internet access. The iPhone has been a huge success and an increasing number of AT&T customers are adding data plans. In the wireline business, meanwhile, the decline in revenue is expected to taper off as the economy recovers and AT&T expands its U-Verse video service. Spending by business customers is likely to rise and U-Verse growth could help offset the loss of local-phone customers.

On the cost side, AT&T has eliminated more than 10,000 jobs since the end of 2009, helping to improve profit margins and AT&T is also expected to generate higher cash flow. Some of that cash almost certainly will be used to fund a dividend increase, with the potential for a stock buyback as well.

The company has boosted its dividend for 26 consecutive years and, based on its strong free cash flow generation, 2010 will be year 27. AT&T's current annual dividend is $1.68 a share.
One potential kink, though, is the possibility of a sharp increase in the federal dividend tax. It is scheduled to rise to 39.6% in 2011 from the current rate of 15%, unless the Obama administration extends a tax cut signed into law by former President George W. Bush. This could more than offset the benefits of an increase to the payout.

The biggest concern among AT&T investors is the loss of exclusive iPhone rights. Rumors persist that Apple will allow Verizon Wireless or other U.S. carriers to sell the iPhone starting in 2011, though the rumors have not been confirmed. The issue has been overblown and most analysts believe that the threat is already priced into AT&T's stock. Most iPhone customers are locked into two-year contracts or have family plans that are not easy to switch, and a small rate of defections are expected once exclusive rights are lost.

AT&T is trading down lately. Investors are no doubt fretting about a slowing economy, but they may have gone too far. Trading below the $27 mark, AT&T could be a good bet as investors seek out AT&T's safe dividend and rethink its prospects in the coming quarters. AT&T's dividend yields a whopping 6.6%, more than three points higher than 10-year Treasury yields, while a free cash flow payment ratio of 60% gives it plenty of cushion to maintain or even raise its dividend. These features will be mighty tempting for investors looking to rotate their holdings in the coming weeks and months.

Admittedly, AT&T is hardly a growth stock. Its revenue declined in 2009, and its earnings have stayed fairly flat since 2007. But new shifts in the telecom market and widespread take-up of the mobile Internet could change things for the telecom giant the coming quarter or two. For years now, big carriers like AT&T and Verizon (VZ) have had to fight for customers on price, which, along with regulatory pressure, put pressure on revenues and forced them to keep cutting costs. But there are emerging signs that customers -- especially the growing ranks of smartphone users -- are starting to care more about network quality than monthly rates, giving AT&T the opportunity to reclaim pricing power. Meanwhile, surging data and Internet traffic is forcing carriers to invest in network upgrades. That should help AT&T, with its high-capacity networks, capture share from "capex-light" carriers that have been competing on price. Smaller carriers, including Sprint Nextel (S) and Deutsche Telekom's (DT) T-Mobile, are feeling the pain as high-value customers move to AT&T for its bigger, more reliable network services. Indeed, these trends are already translating into improved profitability at AT&T. In the first quarter, the telecom giant delivered record EBITDA margins, while revenues and bottom line earnings topped Wall Street analysts' expectations. Despite being positioned to catch the mobile Internet wave, AT&T stock is trading at less than 11 times 2010 earnings, well below the overall market.

The reluctance of analysts to rate AT&T higher is not surprising given a number of potential headwinds, including a weak economy and fading wireline business. Corporate customers have slashed communications spending and millions of local-phone customers have canceled service over the past decade--part of a long-term decline in the traditional phone market. Nor is the company's main jewel, its wireless business, immune from intense pressure. Competition in the mobile industry is fierce, and as the U.S. market matures, there are fewer new subscribers to capture. To protect profits, wireless carriers have to find ways to get customers to maintain current spending levels while whittling down expenses.

However, AT&T deserves a closer look.


AT&T is looking undervalued, according to analysts who think fears of a mass exodus of customers to Verizon are overblown, even though Verizon's network is generally perceived to be better than AT&T's. Many customers who just bought the iPhone 4, for example, are locked into two-year contracts with AT&T.

AT&T shares trade at around 11 times forecast 2010 earnings, compared with Verizon's 12 times multiple, according to Thomson Reuters I/B/E/S. But Verizon's valuation does not yet reflect the recent phone line sale to Frontier Communications Corp , according to analysts. Verizon has said it expects the sale to be "modestly dilutive to earnings in the first full year after closing."

Several analysts also said AT&T's full ownership of its wireless business makes it more attractive than Verizon, which has only a 55% share in its Verizon Wireless venture with Vodafone Group Plc .

Barclays analyst James Ratcliffe estimated that AT&T will report 900,000 net contract customer additions for the second quarter thanks to iPhone. In comparison, he sees 500,000 net Verizon additions of customers who sign long-term contracts. Analysts estimated that about 17 million of AT&T's 87 million cellphone users have iPhones.  Ratcliffe sees between 500,000 and a million consumers switching to Verizon from AT&T because of the change.  "It's 5 or 6 percent of its iPhone base, so it's a sizable number, but it's not a seismic change," said Ratcliffe.



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