New Investment – Dropped Call

by Enis February 24, 2014 12:44 pm • Commentary

Here’s our next addition to our investment portfolio:

AT&T has been one of the boring behemoths of the past 15 years.  The stock is trading in the same place it was in late 1997, a long period of stagnant equity returns.  The telephone conglomerate has been a staple of American business for decades, but some investors are concerned that the company is a potential victim of a rapidly changing wireless/wireline landscape.

Compared to Verizon, its main competitor, AT&T is an older, more conservative, slower-growing company.  VZ gets about 70% of its revenues from wireless (and its recent acquisition of all of Verizon wireless from Vodafone is another step in gaining ground in the wireless battle), while T gets about 55% of its revenues from wireless.  For both companies, wireless revenues have averaged 7-8% annual growth for the past 3 years, while wireline revenues have averaged about 2% annual contraction in that same period.

Both companies actually sport a similar Return on Assets (6.6% for T vs. 4.6% for VZ) and Return on Capital (12.9% for T vs. 15.7% for VZ).  VZ has historically grown sales at a faster rate (annual sales growth is around 1.5% for T vs. 4% for VZ) than T, mainly because of the larger wireless focus.  VZ’s Return on Equity (19.9% for T vs. 31.9% for VZ) and overall earnings growth (around 6% for T vs. 11% for VZ over the last 2 years) are also higher than T.  Verizon is a much more leveraged company, which helps to boost return on equity – VZ’s debt to common equity ratio is 241%, vs. 82.2% for T.

AT&T’s low leverage has not been a boon for the stock, as investors have been more interested in growth than value over the past couple years.  However, T’s valuation is relatively cheap on an enterprise basis, if not necessarily on a simple P/E basis.  At 13x P/E and 5-6% earnings growth expected over the next couple years, T’s valuation looks fair.  But on an Enterprise Value / EBITDA basis, T is cheaply priced:

[caption id="attachment_36695" align="alignnone" width="505"]T EV/EBITDA chart, Courtesy of Bloomberg T EV/EBITDA chart, Courtesy of Bloomberg[/caption]

The stock’s low on this metric was around 5 in mid-2010.

It’s quite rare that you see a non-distressed company selling at a sub-5 EV/EBITDA ratio.  T is still a cash cow with low debt, so I would be quite surprised to see the stock trade below 5x EV/EBITDA.  If earnings do not decline (which is no sure thing, though low probability), then the stock is unlikely to trade down more than 10%, or below $30, even on a broader market decline.

Technically, T stock has sold off to start 2014, nearing 2 year lows on the early year weakness:

T weekly, Courtesy of Bloomberg
T weekly, Courtesy of Bloomberg

The $32 support level in green, which was resistance in 2011 and 2012 before breaking out in mid-2012, held on the most recent selloff.  That’s a crucial spot to watch for T stock, with $30 the next level of support if $32 breaks.  Meanwhile, the daily chart shows a continuing downtrend for the shares:

[caption id="attachment_36682" align="alignnone" width="600"]T daily, 50 day ma in pink, 150 day ma in yellow, Courtesy of Bloomberg T daily, 50 day ma in pink, 150 day ma in yellow, Courtesy of Bloomberg[/caption]

Both the 50 day ma and the 150 day ma are declining, and the stock has a large amount of overhead supply between $33 and $35.

Putting the technicals and fundamentals together, I have higher-than-normal confidence that T is going to trade between $30 and $35 over the next 6 months.  Is there a trade to take advantage of that view?

The April 33 straddle is currently priced around $1.75.  Break-evens on that trade are $31.25 and $34.75.  That’s about a 5.5% return over the next 2 months – not bad if you collect all the premium, but that’s unlikely.  The May 33 straddle is more like $2.15, but you only collect an extra $0.40 to wait a full extra month.  Selling a 30/35 strangle doesn’t offer much premium, even all the way out to July (where it’s around $1.00), so the risk/reward of that structure is not a standout.

While there is no obvious outright options trade, the underlying value in T shares makes a different strategy interesting to take advantage of the rangebound view.  Buy T shares, with the 5.5% dividend yield, and look to overwrite the shares on a periodic basis to collect incremental yield.  This strategy expresses the rangebound view, but does so in a manner that also takes into account what we view as limited downside in T  over the intermediate term.

With that in mind, we’re going to add T to the investment portfolio today, and look to overwrite the shares on the next test of the 50 day moving average.

TRADE: Bought T for $32.60