My InvestorPlace colleague Luke Lango recently laid out a compelling argument why AT&T (NYSE:T) is too cheap to ignore. Never a fan of AT&T, I’ve given his case the fair consideration it deserves. Lango’s good at what he does and if he thinks AT&T stock is ready to pop, I ought to at least consider his argument.
In a nutshell, Lango views the pending green light of the merger between T-Mobile (NASDAQ:TMUS) and Sprint (NYSE:S) as excellent news for AT&T because it removes a major price cutter from the wireless equation; a headwind that’s weighed on T stock for some time.
He goes on to say that AT&T’s mobility business generates 40% of the company’s revenue and 50% of its EBITDA. With one less competitor to deal with, it’s likely that its EBITDA margins will move higher in the future due to less discounting in the mobility marketplace.
Higher margins and revenue combined with dirt cheap financial metrics, and you’ve got the makings of a good value stock.
For example, Lango points out it’s got a 6.3% dividend yield, three times the average dividend yield for the market itself. In other words, you’re getting paid handsomely to wait for T stock’s revival.
Also, its forward P/E and P/CF are both well below the market averages and its historical five-year average, making it hard to deny there’s unlocked value in AT&T stock.
What About Debt?
Value isn’t just about higher margins, less competitive headwinds, etc. It’s also about the strength of the balance sheet.
If I’m looking at two companies and one has a forward P/E and P/CF of 20 and 8, respectively, and the other has a forward P/E and P/CF of 15 and 6; based on a value supposition, I’m going to go for the latter stock every day of the week.
However, if the latter stock’s net debt was $168.9 billion in the most recent quarter or 71% of its market cap, and the former stock’s net debt was $111.3 billion or 45% of its market cap, the extra leverage of the latter’s stock makes the former a better value on a relative basis due to its superior balance sheet.
The latter stock in this example is AT&T and the former is Verizon Communications (NYSE:VZ). The forward P/E and P/CF aren’t those of the two wireless carriers. They were merely meant to illustrate why valuation metrics based on price don’t always tell the entire story.
The real metrics, according to Morningstar, are as follows:
AT&T Forward P/E = 9.0
Verizon Forward P/E = 12.5
AT&T P/CF = 5.0
Verizon P/CF = 7.1
The question for investors interested in AT&T stock is whether the 28% discount on the forward P/E and 30% discount on P/CF is worth it given AT&T uses significantly more leverage to generate its earnings and cash flow.
Furthermore, Verizon currently yields 4.1%, which isn’t bad for a company that utilizes far less leverage to pay for these dividends.
Getting back to Lango’s argument about the merger removing the discounting headwind from AT&T’s sails, the same effect would apply to Verizon.
AT&T might generate more free cash flow than Verizon, but it does it at the expense of the balance sheet. Furthermore, AT&T’s cash flow as a percentage of revenue is virtually the same as Verizon’s, which means it’s not doing a better job generating cash flow than its biggest competitor.
Is AT&T Stock Too Cheap to Ignore?
If you’re looking for less risk, Verizon is the better stock to buy.
Sure, AT&T might have paid down $538 million in net debt (repayment less issuance) in the first quarter, but that’s a drop in the bucket for a company with $169 billion in net debt.
If you’re an AT&T investor, you better hope that interest rates don’t move higher, because if they do, it’s in a whole heap of trouble.
Value sometimes comes at a price.
At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.