AT&T is in trouble. The company's wireline business is declining, and the wireless business cannot grow quickly enough to offset the losses. To make matters worse, the company's defined benefit pension plan is a ticking time bomb. And to top it off, Ma Bell will soon lack the free cash flow to maintain her sacred, near 5%, dividend yield. So what's a company like this to do? Management has elected to kick the can down the road by using financial shenanigans to delay the inevitable.
The wireline segment accounts for roughly 47% of the company’s total revenues (annual report, p33), and is steadily declining. From 2008 to 2012, the segment’s revenues declined from $67.9 billion to $63.5 billion to $61.2 billion to $60.1 billion to $59.6 billion, respectively (2012 annual report p37, 2010 annual report p37). It’s declining because the entire wireline industry is declining as more people give up landlines in favor of wireless connections, and because competition from non-traditional providers (e.g. cable and VolP providers) are becoming increasingly competitive with regards to cost. AT&T management acknowledges the declines in this business segment as a problem on page 43 and page 41 of their 20120annual report in saying such things as “economic pressures are forcing customers to terminate their traditional local wireline service,” and “[w]hether, or the extent to which, growth in these areas [wireless and new services] will offset declines in other areas of our business [wireline] is not known.” In a nutshell, management knows their wireline business is declining, and it scares them.
AT&T’s wireless business is growing, but it cannot grow enough to offset declines in the wireline business. Growth in wireless is apparent from the firm’s financial statements, which show revenue from the segment increased from $49.1 billion to $53.5 billion to $58.5 billion to $63.2 billion to $66.8 billion from 2008 to 2012, respectively (2010 annual report p37, 2012 annual report p34). However, management acknowledges the rate of growth is slowing in wireless. For example, page 35 of the 2012 annual report says “We continue to see a declining rate of growth in the [wireless] industry’s subscriber base compared to prior years, as reflected in a 13.0% decrease in gross subscriber additions.” Also, the rate of growth in revenue from the segment has declined in the last two years. Reasons for the decline in growth rate include competition, regulation, spectrum constraints, and simply because there are a lot less people in the world that haven’t already gone wireless.
- Competition: Competition in the telecommunication services industry is fierce and increasing. In addition to competition from traditional telecommunication providers, AT&T faces competition from alternative providers (e.g., cable and VoIP). Alternative providers often face less regulation (see regulation, below), resulting in lower costs, and increased competition to AT&T’s traditional business. AT&T also faces increased pressure from competitors such as Verizon and Sprint. For example, Verizon and Sprint are both now selling the Apple iPhone following the expiration of AT&T exclusivity deal. The iPhone was a huge sources of growth for AT&T over the last four years, and now that exclusivity advantage has ended. Additionally, AT&T faces competition from technology and services that are still being developed, but present a threat to AT&T’s future business.
- Regulation is another significant challenge for AT&T’s growth and profitability. For example, AT&T believes the Telecommunications Act of 1996 (Telecom Act) is outdated and imposes unfair regulations on AT&T that newer competitors are not subject to (see page 41 of the 2012 Annual Report for additional details). Also, international regulation is a challenge. AT&T is engaged in multiple efforts with foreign regulators to open markets to competition, reduce network costs and increase their scope of fully authorized network services and products (Annual Report, p42).
- Spectrum (the airwaves that carry mobile data) is another challenge for AT&T. One of AT&T’s top priorities in recent years has been to add additional spectrum, and they’ve had some success (i.e. in 2012, AT&T acquired $855 million of wireless spectrum from various companies (annual report, p69)). However attaining additional spectrum is increasingly difficult because the amount available is limited. Yet without increased spectrum it becomes very difficult for AT&T to grow. AT&T believes there is some potential to attain additional spectrum from other industry participants as well as the possibility of the government making more spectrum available (Annual Report, p41).
AT&T’s defined benefit pension plan is a ticking time bomb. The plan is exposed to huge interest rate and capital market risks that could drastically increase AT&T’s liabilities. Specifically, if interest rates increase or equity markets fall, AT&T would be required to make large contributions to the plan. For example, AT&T made a $1 billion contribution in the fourth quarter of 2011 which significantly reduced the entire company’s earnings per share. If the markets don’t meet plan assumptions, then the pension obligations have the potential to literally bankrupt AT&T and leave tens of thousands of pensioners standing empty-handed in the cold (more information on this will be provided in the financial shenanigans section).
AT&T’s Free Cash Flow (FCF) is dwindling.
Unlike accrual based accounting measures such as net income, cash flows are difficult to artificially manipulate, and therefore are useful as an input in understanding the value of a company. In the case of AT&T, free cash flows (cash flow from operations minus capex… with some minor adjustments) may have peaked in 2012, the firm’s best ever FCF at $19.4 billion. However, according to AT&T’s January 24, 2013 investor briefing, management expects 2013 FCF will be just over $14 billion. This is more consistent with 2010 and 2011 when FCF was $15.7 billion and $14.6 billion, respectively. Growing FCF significantly above these levels is an enormously daunting task considering the aforementioned challenges such as the shrinking wireline business, a decreasing growth rate in wireless, increased competition, a difficult regulatory environment, spectrum constraints, higher than expected capital expenditures, and the exclusivity loss of the iPhone. As described previously, management is scared to death they won’t be able to growth their business from here. And management’s fear becomes even more evident when you consider the financial shenanigans they’ve recently started employing.
Financial Shenanigans: AT&T management has elected to address a challenging business environment by using financial shenanigans to kick the can down the road. Directors of the company have incentive to keep the stock price high because a large part of their compensation comes in the form of AT&T stock. For example, AT&T CEO and Chairman, Randall Stephenson, received $12.6 million in AT&T shares in 2012. Some of the larger and more obvious shenanigans are as follows:
Using share repurchases to artificially prop up AT&T’s earnings-per-share (and stock price) is an unsustainable financial shenanigan. On page one of AT&T’s annual report, Chairman and CEO Randall Stephenson brags about increasing earnings per share. But if you look at AT&T’s financial results you will see that while earnings per share (EPS) has increased, total earnings (net income) hasn't increased as quickly. Why? Because there are less shares outstanding because the firm bought back its own stock. AT&T surprised shareholders in Q4 of 2012 by repurchasing $4.4 billion of its own stock- significantly more than most analysts expected, and causing earnings per share to grow faster than earnings (a good thing for investors in the short term, considering most analysts are laser focused on earnings per share).
As a shareholder, you might say “So what. Share repurchases just return cash which is a good thing.” While this may be true, it is not sustainable. AT&T repurchased $12.8 billion of shares in 2012, which is a huge number (6% of total shares outstanding, annual report p2), and even huger considering the relatively small amount of cash on the balance sheet (only $4.9 billion) and the fact that 2013 free cash flow is expected to decline to only $14.1 billion. Research suggests AT&T's repurchase activity is an "earnings management" technique, not a sustainable business strategy (Stock Repurchases as an Earnings Management Device (Hribar, Paul, Jenkins, Nicole Thorne and Johnson, W. Bruce, March 2004). The bottom line is that management is using share repurchases to prop up earnings per share (and the stock price), and this is not a sustainable business model (it’s just a short-term financial shenanigan). If AT&T had any significant long-term growth potential, they’d grow earnings per share by doing more business, not by buying back shares.
AT&T’s decision to borrow money to pay out dividends is an unsustainable financial shenanigan. According to AT&T’s annual report, free cash flow in 2012 was $19.4 billion. Yet they spent $12.8 billion to buy back their own shares, and another $10 billion to pay dividends. Company-wide, AT&T increased long-term debt by $5 billion in 2012. Spending more cash than your business generates is not a sustainable business model. However, management continues to do so because they know the short-term success of AT&T’s stock price (and their personal compensation) depends on it. Shareholders buy the stock for the near 5% dividend yield, and management keeps earnings per share high by reducing the number of shares outstanding. AT&T intends to continue to aggressively buy back shares in 2013, and has no intention of cutting the dividend anytime soon (cutting the dividend would have a huge negative impact on the stock price). This is a short-term financial shenanigan, and it is not a sustainable strategy in the long-run.
Using preferred equity to fund unfunded pension liabilities is a shenanigan.
Yet this is exactly what AT&T hopes to do. In the fourth quarter of 2011, AT&T had to make a $1 billion contribution ($0.65/share charge) to fund its defined benefit pension plan. To avoid this type of charge again in the near future, AT&T is seeking approval from the Department of Labor since October 2012 to fund the pension by issuing preferred stock. Per page 51 of the 2012 annual
“In October 2012, we filed an application with the U.S. Department of Labor (DOL) for approval to contribute a preferred equity interest in our Mobility business to the trust used to pay pension benefits under plans sponsored by AT&T. The preferred interest does not have any voting rights, has a fair market value estimated at $9,500 [$9.5 billion] and a liquidation value of $8,000 [$8 billion] and is entitled to receive cumulative cash distributions of $560 [$560 million] per annum. So long as we make the distributions, we will have no limitations on our ability to declare a dividend or repurchase shares.”
This is clearly a shenanigan to avoid using cash to fund the pension. It kicks the can down the road without impacting management’s ability to declare dividends or repurchase shares. This is not a common technique to fund a pension, and the preferred method would be to use cash instead of equity. It is an unsustainable technique as well because there are common sense and legal limits to how much of its own equity a company can use to fund its own pensions. Using more than 10% of its own equity to fund employee pensions is an unacceptable concentration of risk (it’s like putting too many eggs in one basket). This is not a strategy AT&T can use over and over again (and they may not receive approval from the DOL to do it even once). Clearly a financial shenanigan.
AT&T’s pension assumptions are a risky financial shenanigan. As mentioned previously, AT&T’s defined benefit pension plan is a ticking time bomb that could literally bankrupt AT&T and leave tens of thousands of pensioners standing empty-handed in the cold. For example AT&T assumes a long-term rate of return on plan assets of 8.25% (annual report, p80). This is an aggressive assumption, and considering 34% of the plan’s $45 billion in assets is invested in fixed income, this assumption is a little absurd. In the current market environment, fixed income securities are returning historically low rates, well below 8.25% (8.25% is a realistic assumption for a high-risk 100% equity portfolio). Additionally, if interest rates were to rise it would have a significant adverse affect of the value of the plan’s fixed income investments. The reason AT&T has an unrealistically high return assumption is because it increases the plan’s “funded status” and reduces AT&T’s liabilities, drastically. This is a financial shenanigan, and if AT&T were to use a more realistic assumption, there would be significant adverse impacts on AT&T’s stock price. Additionally, as soon as equities or fixed income have a bad year, expect to read news headlines about how AT&T’s pension is drastically underfunded and the firm must make huge contributions. The required contributions will have a significant adverse affect on AT&T’s stock price. And it’s not a question of “if” this will happen, it’s a question of “when.”
Valuation: In light of the business environment and AT&T's financial shenanigans, what is AT&T stock worth? I value AT&T using a Discounted Cash Flow (DCF) model and also using a formula published by Warren Buffett’s mentor, Benjamin Graham, in the 1940’s. The Capital Asset Pricing Model (CAPM) is also useful in valuing low beta stocks like AT&T.
Discounted Cash Flow: Assuming management’s 2013 FCF guidance of approximately $14.1 billion will remain constant indefinitely into the future (i.e. no growth), and assuming a Weighted Average Cost of Capital (WACC) of 7.5%, gives AT&T a value of $32.24/share [($14,100,000,000/0.075)/5,490,000,000 shares]. Even if we assume a 1.0% FCF growth rate indefinitely into the future, AT&T is still only worth $39.51/share [($14,100,000,000/(0.075-0.01))/5,490,000,000 shares]. However, given the competitive pressures AT&T currently faces, a negative one percent annual growth rate in FCF is not unreasonable, and in this scenario AT&T is worth only $30.22/share [($14,100,000,000/0.075)/5,490,000,000 shares].
Benjamin Graham Formula: In the 1940’s, Ben Graham published a simple formula to value a company: stock price = EPS x 8.5 + (2 x growth). The average 2013 EPS estimate by 32 professional analysts covering the stock is $2.52. If we assume a 0% growth rate, AT&T is worth only $21.42 per share (well below its current market price). Using this formula, AT&T would have to grow earnings by around 3.4% per year, forever, just to justify its current market price. By using financial shenanigans (discussed previously) AT&T has the ability to grow earnings per share (not total earnings, just earnings per share) by 3.4% (or more) for the next several years. However growing by 3.4% indefinitely seems highly unlikely given all of the challenges discussed previously (e.g. competition, regulation, spectrum constraints, etc). Wall Street believes AT&T can grow earnings-per-share 5.5% for the next five years. I suppose this rate can be achieved, but only through shenanigans, and only for a few years, after which growing at the rate of inflation would be generous. Modeling this out (5.5% growth for 5 years, then growing at 2% indefinitely) gives AT&T a value of $41.17 per share (not all that attractive given the current stock price). And to be completely realistic, I wouldn’t be surprised to see AT&T eventually experience negative earnings per share growth as the wireline business declines, competition eats away at the wireless business, and management uses up all its financial shenanigan dry powder.
Capital Asset Pricing Model (CAPM): For added perspective, the current beta of AT&T is around 0.53, and plugging this into the CAPM (required return = risk free rate + Beta x (expected return market - risk free rate) gives the company a required rate of return of around 5.4% (assuming the risk free rate is 2% and the required return on the market is 8.5%). I believe earning-per-share may achieve this type of return over the next five years through financial shenanigans, but based on the current business there is essentially zero chance the company’s overall earnings can grow at this rate forever.
In a nutshell, AT&T’s stock price may achieve its required rate of return (roughly 5.4%) over the next several years, but only via shenanigans. Beyond the next several years, it seems highly unlikely that AT&T will offer an attractive risk/reward profile, and matters will likely be made worse as management realizes it’s not able to effectively manage the company’s financials via shenanigans.
What will ultimately happen to AT&T? In the best case scenario, management may be able to shrink the company with share repurchases, keep the stock price inflated, and avoid cutting the sacred dividend. This would involve initiating a lot of share repurchases at just the right times to offset the effects of disappointing net income and keep earnings-per-share compelling for stock holders. It would also involve a brilliant execution of the company’s cash management charade. Essentially, AT&T needs to flawlessly continue their financial shenanigans, while simultaneously hoping they can somehow miraculously defeat the competition and grow their business. Maybe AT&T’s U-verse will be a huge success. Or perhaps AT&T can out-muscle the credit card companies and generate big profits in the growing mobile payment industry. Or maybe AT&T will find fortune in the vehicle-to-vehicle communications concept. All of these things seem very unlikely to me.
The more likely outcome is that AT&T’s financial shenanigans will fail, and the stock will dramatically underperform. The dramatic underperformance may be initiated by a few quarters of low cash flow. Or it could be caused by unfavorable investment performance forcing large cash contributions to their pension plan. It could also be caused by labor disputes. For example, AT&T may not be able to effectively reduce the size of their workforce and/or payroll as business declines because of unionized workers (this is essentially what recently caused Hostess to file bankruptcy). Or, AT&T management might start wasting cash flows on risky, high-cost acquisitions in an attempt to grow their business inorganically. These types of acquisitions almost always detract from a company's value (see: Why large M&A deals destroy value (Financial News, Matt Turner, Jan 2012) and The Sources of Value Destruction in Acquisitions by Entrenched Managers (Journal of Financial Economics (JFE), Vol. 106, No. 2, 2012)).
Conclusion: So if AT&T is such a risky company, with all of these financial shenanigans, why has the price held up so well?... It’s the dividend. Investors are chasing yield from public equities because they’re perceived by many to be immune from the depreciation dangers of fixed income in a rising interest rate environment. To some investors, AT&T appears to be the “holy grail.” They believe AT&T is a high-yielding, low-volatility, company that will pay them dividends and give them some price appreciation, even in a rising interest rate environment.
In my opinion, AT&T isn’t worth the risk. I don’t recommend short-selling AT&T because management may actually be able to keep the stock price and dividend compelling for a while (the market may stay irrational longer than you can stay solvent). I believe strongly there are better investment opportunities elsewhere. Bottom line: just avoid AT&T.