2 Telecom Giants… 1 Trade, 1 Investment

In today’s low interest environment, investors seeking high-yielding investment vehicles have limited options. One such option is a pair of telecom giants in AT&T Inc. (NYSE:T), and Verizon Communications (NYSE:VZ). Each stock has a juicy dividend yielding north of 4.5%, yet they are not created equal. AT&T is much more fundamentally sound, and poised for growth, which will position it for higher returns moving forward – regardless of how the pending merger with Time Warner Inc. (NYSE:TWX) shakes out. Verizon on the other hand, has a lot to prove in regards to its digital advertising strategy.

The dividends are juicy

Each stock well out-yields your typical 10-year notes, so each stock has been an obvious choice for income-oriented investors.

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T Dividend Yield (TTM) data by YCharts

Verizon’s dividend yield is approximately double that of 10-year treasuries, while AT&T is even more so with a yield at 5.37% at current levels. These dividends have consistently risen with AT&T raising its dividend for 33 consecutive years, and Verizon having raised its dividend for 13 consecutive years. These dividends represent a rare find in today’s investing environment – that is a stock that pays a dividend out-yielding inflation. With the historical inflation rate in the United States at 3.18%, US Treasuries are still a rip-off, with investors losing buying power on an annual basis.

Cash flows tell the true story on dividend funding

When you first look at the payout ratio with a basis from earnings per share, Verizon seems to be much more well off.

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T Payout Ratio (NYSE:TTM)) data by YCharts

The dividend consumes more than 90% of AT&T’s earnings per share. Meanwhile, only about 60% of Verizon’s earnings are paid out towards the dividend. However, telecom companies – specifically AT&T and Verizon are very CAPEX-intensive as the infrastructure to maintain and upgrade the networks over time is very cost-intensive. At the end of the day, dividends are paid with cash so we will compare the payout ratios based on free cash flow per share instead.

Going back five years, the payout ratios based on cash flows are vastly different than what is paid out of earnings. The dividend paid by AT&T is easily covered by cash, while Verizon’s drop in cash flows over the past couple of years has put stress on the dividend. Quite a flip of the story from the chart above.

AT&T FCF/share AT&T Dividend Payout Ratio Verizon FCF/share Verizon Dividend Payout Ratio

2012

$3.39 $1.77 52.2% $3.97 $2.03 51.1%
2013 $2.92 $1.81 62.0% $6.23 $2.09 33.5%
2014 $2.16 $1.85 85.6% $4.29 $2.16 50.3%
2015 $2.61 $1.89 72.4% $2.18 $2.23 102.3%
2016 $2.64 $1.93 73.1% $2.68 $2.29 85.4%

While AT&T is not yet at the high end of its cash flow payout ratio, cash flows have been relatively stagnant for the past five years. Meanwhile, you could probably surmise from the drastic change in payout ratio, that Verizon’s cash flows have degraded over that same time span.

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T Free Cash Flow Per Share (TTM) data by YCharts

For both companies, growth is needed over the long term – at least a little (hard to drastically move a revenue needle that is well over $100B) to aid cash flows. The dividends don’t grow very fast – both have grown between 3.4% and 3.7% per annum over the past decade (and they really don’t need to grow much given the high yield).

Similar growth strategies, each with bumps in the road

Both companies have taken a similar (not identical) approach to growing the businesses in recent years. AT&T has vertically branched out to unify its existing network and new media (both content and delivery) to form a fully contained ecosystem that it can profit from at each phase. Sort of an all inclusive media experience if you will.

The first leg of this was the 2015 deal for AT&T to acquire DirecTV. This has enabled AT&T to begin bundling TV services with the wireless business. Its growing “DirecTV Now” service has grown to about 800K subscribers in under a year, and can be bundled as a value-add with the wireless business to attract new customers, while simultaneously reducing churn.

The second leg of this has been the pending, and high profile potential acquisition of Time Warner. Time Warner is a media company that contains an umbrella of brands including Warner Bros. movie studios, HBO, and various top cable networks.Aside from the obvious addition of content to complete the concept (full system with wireless/TV as vehicles for delivery of in-house owned content), Time Warner would also give AT&T as shot in the arm with robust revenue and free cash flow growth over the past several years.

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TWX Revenue (TTM) data by YCharts

Unfortunately, the Justice Department announced on November 20th its intent to sue in order to block AT&T’s acquisition of Time Warner. This will play out over the coming months as the two sides are currently posturing for court dates, and will no doubt further discuss concessions in order to avoid going the distance in court.

Even if the deal is ultimately blocked, the DirecTV acquisition will still help AT&T moving forward. Streaming services are a growth category compared to traditional cable packages bloated with channels that consumers don’t want 85% of. The value-add of bundling should also help the wireless business add and retain customers in what is a very competitive environment.

Verizon has tried a similar approach with more internet-based acquisitions that are not quite as synergistic as what AT&T has tried to do. Verizon’s first move was to acquire AOL in 2015. Various popular websites were under the AOL name including The Huffington Post, Engadget, MapQuest, and TechCrunch. The main benefit from this acquisition however is the advertising technologies business that were the main revenue driver for AOL. These advertising technologies could be utilized to profit from the existing pool of Verizon’s massive wireless customer base. Basically, “getting more” out of each wireless customer.

The second leg of these efforts was to acquire Yahoo earlier this year. Yahoo is a web services provider that includes the Yahoo search engine, Yahoo mail, various Yahoo news segments, and Tumbler among many others. It was the sixth most visited website globally last year. Similar to the AOL deal, the main underlying benefit Verizon is aiming for is the advertising technologies and businesses within the Yahoo name.

By pairing these two acquisitions together, Verizon is hoping to further monetize its established wireless business. But before the deal could close, it was disclosed that Yahoo had suffered a massive data breach that affected 3B accounts, making it the largest data breach ever recorded. The deal ended up moving forward after Verizon was able to reduce their offer by $350M.

After the Yahoo deal, Verizon lumped AOL and Yahoo into one company under the Verizon umbrella. The result is a summation of digital advertising services, brands, and technologies that Verizon has deemed as “Oath.” I see the potential downside of this strategy as twofold. First, is whether or not Oath can be large enough to make a significant difference to Verizon in the areas that matter. It is still early, so more time is needed before making final judgment, but the early returns are small.With quarter revenues of $2B, it is a metaphorical drop in the bucket to the $31.7B in revenues Verizon generated for the quarter. Verizon is obviously playing for future growth, but it potentially missed the mark with this strategy. Especially considering that it is worried about alienating its own customer base with ad services.Source: Statista

Secondly, with Verizon currently the market share leader in a massive United States wireless market, I would have liked to have seen Verizon proactively implement a means to further grow/retain market share in a way comparable to what AT&T can offer by bundling services. Even though Verizon has a competing media vehicle business in the form of Verizon Fios, the infrastructure is so cost prohibitive and time consuming to build that market penetration is very limited (which is a shame, because I live in one of these markets and LOVE the product).

Ultimately, Verizon needs to come up with an effective solution for boosting its revenue and cash flow growth. If this strategy built on digital advertising fails, it will be a massive setback to Verizon, and bring pain to investors. It is interesting that Verizon is kicking the tires on assets that 21st Century Fox (NASDAQ:FOX) is potentially divesting. I like AT&T’s growth prospects over Verizon’s moving forward with or without Time Warner. The key here is that AT&T is augmenting their wireless business with value-add, rather than simply trying to profit more from it, as Verizon appears to be doing.

High leverage can harm flexibility

Part of the importance of executing these high-dollar strategies (aside from the obvious waste of billions of dollar if they should fail), is the fact that the balance sheets for both companies are very heavy with debt. This is generally accepted in the cases of Verizon and AT&T because the telecom business is very capital intensive, but also generates enormous cash flows.

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T Debt to Equity Ratio (Quarterly) data by YCharts

Verizon is very highly leveraged at more than 4X debt to equity. While AT&T is currently much less levered, this would change once the Time Warner deal goes through. Again, the problem for Verizon is that Verizon is highly leveraged DESPITE having unsolved cash flow issues, and a questionable growth engine in Oath. To do anything drastic from here without risking a credit downgrade would require divesting assets, which could be potentially disastrous for Verizon depending on the returns they get on said assets.

At least with AT&T, if the Time Warner deal is killed (even though it likely won’t be as it has been approved by all other regulatory agencies), at least AT&T would have fiscal flexibility to make other moves.

Don’t jump to conclusions based on price

At first glance, both stocks appear to be inexpensive.

Both stocks are at valuations significantly less than the market, which is priced at a steep 25X earnings.

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T PE Ratio (TTM) data by YCharts

Then consider that over the past 10 years, Verizon has averaged a higher valuation than AT&T. Despite AT&T currently trading in line with its 10-year average P/E multiple, Verizon is trading at roughly 28% below its 10-year average multiple. Additionally, there is an approximate 37% gap in P/E multiple between the two while the historical gap is a single-digit spread.

But similar to the dividend payout ratio, this does not tell the whole story. If we again flip our attention to cash flows, AT&T is actually yielding more cash flow on price than Verizon – despite the gap in the P/E ratio.

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T Free Cash Flow Yield (TTM) data by YCharts

Similarly, if we compare the enterprise to EBIT multiple between the two (because of the high CAPEX, I want to take the traditional P/E with a grain of salt), we will find that the valuation gap closes a bit, down to about 23%.

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T EV to EBIT (TTM) data by YCharts

Lastly, we will compare the price to book value for each company.

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T Price to Book Value data by YCharts

Interestingly enough, the price to book value is much higher for Verizon than it is for AT&T. AT&T appears to have held steady at a multiple just under two for several years. Meanwhile, Verizon’s price to book has actually been declining over the past couple of years – coming down from a high perch. As we know from the historical valuations, Verizon has traded at a premium to AT&T.

Wrap up

Both of these telecom giants have high-yielding dividends, and a storied reputation as income stocks. However, while the future is looking bright for AT&T, Verizon appears to have lost its way in recent years. It is highly leveraged, and banking on a strategy to further monetize its wireless business, which I deem questionable – both on impact, and effectiveness.

While Verizon used to command a premium over AT&T, times have changed, and it is now AT&T trading at higher valuations. You could justify Verizon as a short-term value play, but I would rather just put my money into AT&T. The dividend yields more, yet is much better funded. AT&T looks like it is going to succeed at generating growth by bundling DirecTV with the wireless business (things get even better if/when the Time Warner deal closes). If AT&T was overvalued, things might be different, but AT&T is priced to its past performance despite brighter days ahead.

Note: Charts sourced from YCharts. Unlabeled AT&T graphics sourced from AT&T. Unlabeled Verizon graphics sourced from Verizon.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.