Found this interesting analysis on the GADR website --
AT&T: The Facts Have Changed
For the long term Value Investor, when, if ever, to sell a stock is always a problem. Peter Lynch has suggested that the time to sell is when the facts that formed the basis for buying the stock have changed. The facts have changed significantly at AT&T. But Lynch has also pointed out that he has made more money in the 3rd, 4th, and 5th years of owning a stock than in the first 2 years. Given these competing considerations, our discussion of the pros and cons of keeping AT&T on the list will not, unfortunately, be brief.
A major factor in putting AT&T on the Dow Value Portfolio was the choice of John Walter as heir apparent to then-CEO Robert Allen. It must be confessed that we got snookered on this one. We thought that with a new CEO, AT&T's upward valuation was all but certain. Our conclusion turns out to have been correct. But, our premise, in the short term, was completely mistaken. AT&T did not get a new CEO in the Fall of 1996. Instead, AT&T got a last ditch stratagem by Allen to remain as CEO for another 2 years or so, "while Walter got up to speed".
Last Spring, in a stunning turnaround, the AT&T Board of Directors unceremoniously dumped John Walter and, incredibly, retained Robert Allen.
AT&T, during Walter's brief tenure as its President, was humming with a sense of unified team effort, in a way that it had not in decades. In fact, there was only one person who wouldn't play on the team, and couldn't be removed from the team by Walter: Robert Allen.
More recently, C. Michael Armstrong, fresh from re-making Hughes Electronics, has been appointed AT&T's new CEO, and it is Allen who has been forced to walk the plank. Ever since then, T's share price has skyrocketed -- on the order of 100% from its 12 month low. (Next time, we will wait until the old CEO is really out the door.)
There is little doubt that Armstrong will continue the AT&T turnaround begun by Walter, just as GM and IBM, two companies that had far more serious problems than AT&T, eventually were turned around. Dominant players in essential industries, as a general rule, don't just go away. Rather, they adapt.
The long term case for AT&T is basically a macro one: Every country, whether already economically developed or still developing, has to have an up-to-date telephone system to attract and retain investment in other industries. As the world's largest telco, AT&T will find ways to make money from this irreducible fact. Whether the future of telephony is digital subscriber line, fibre optic, wireless, or
Internet-based, AT&T has an iron in every fire.
The various components of voice/data delivery may all become low profit margin commodities, but making them work together seamlessly for the commercial market will continue to be profitable. Just as IBM's biggest growth segment is bundling computer services (see below), we predict that eventually the same will be true for AT&T in the area of bundled telco services.
On The Other Hand ...
Though AT&T does finally have a new CEO, two other facts of significant import have changed over the past year. AT&T's share price has risen greatly; and its projected future flow of cash earnings (operating cash flow minus capital spending) has shrunk by an even greater amount.
Last March, then-CEO Allen, rather than doing the job himself, trotted out John Walter to admit to an increasingly skeptical financial community that AT&T would be spending far more on capital equipment than Allen had previously been willing to concede.
More recently, new-CEO Michael Armstrong has begun to sell off relatively low-capital-consumption businesses (like AT&T's Universal Credit Card to a Citicorp that can't believe its good fortune) to finance relatively high-capital-consumption businesses (like local phone service).
11 Billion Here, 11 Billion There -- Pretty Soon You're Talking About Real Money
Just in the past week or so, AT&T announced it will pay $11.3 billion (possibly eliminating the next 4 or 5 years of its cash earnings) for Teleport, the first and largest of the competitive local exchange companies (clec's). Wall Street reacted very favorably to this solid evidence that AT&T is finally serious about entering the local phone market. However, we are less than enthusiastic about this acquisition,
from a Value Investing perspective.
Press accounts indicate that Teleport has about 250,000 customer lines. A quick calculation puts the purchase price at about $45,000 per line. A (very) rough estimate is that it will require $400 per month in operating margins on each line, just to break even on the purchase price -- before a penny of cash is generated for shareholders.
The precedents are not auspicious. Reportedly (WSJ, 1/9/97, p. A6), Teleport "doesn't yet earn a profit." AT&T's own 2-year effort at providing local phone service has cost almost $4 billion and generated just $65 million in revenues.
Whether AT&T will be able to reduce Teleport's overhead by consolidating marketing and back office functions, or whether AT&T will increase Teleport's overhead by bogging it down with the larger company's still Byzantine bureaucracy, remains a major question mark.
A Hands-On CEO At Teleport
Armstrong's response is that the gifted entrepreneur, Robert Annunziata, will remain in charge of Teleport. Annunziata is a hands-on kind of CEO. For example, after the World Trade Center bombing in 1993, he was in the building's basement, standing ankle-deep in water, helping his engineers keep Teleport's lines functioning.
Annunziata went to work as a salesman right out of high school. He spent 17 years working at a large corporation that vetoed his many ideas on doing things a better way. So, in 1983 he went to work for Merrill Lynch, which was willing to back his initiatives. Some 15 years later, the corporation he originally left is now paying $11.3
billion (of shareholder money) to get him back, along with the country's largest clec, which he built from the ground up.
But, At The Bottom Line ...
As inspiring as Armstrong and Annunziata are, we remain focused on the bottom line of the Statement of Cash Flows. Our basic building block in the calculation of Intrinsic Value is cash earnings (cash flow minus capital spending). (See: web.idirect.com
AT&T's increased spending on capital equipment will greatly diminish AT&T's future flow of cash earnings, and therefore decrease its Intrinsic Value. Indeed, AT&T's cash earnings are forecast to be well under a dollar for full year '97, and little more than a dollar for '98 (even before the Teleport acquisition). Since AT&T's share price
has risen more than 50% in the past year to around 65, its price-to-cash-earnings ratio is perhaps 55 for the coming 12 months -- well above that for the DJIA average, which is more in the neighborhood of 22.
A (Lengthy) Footnote: "Extrinsic Value"
We cannot leave the subject of AT&T without reviewing some of the extrinsic factors which affected AT&T's share price in 1997.
Shortly after the beginning of 1997, a number of prominent financial institutions downgraded AT&T's stock -- all within a period of 24 hours or so. The effect on T's share price was swift and severe. Before long, T was the worst performing stock on the Dow.
The reduced estimates on AT&T's 1997 earnings turned out to be justified. On top of that, there was Allen's ill-conceived attempt to merge with SBC, which itself had just merged with PacTel.
The Dumbest Idea Of 1997
Anyone with the slightest familiarity with the Justice Department's 1984 separation of AT&T and the Baby Bells, combined with this year's political heat over the Boeing-McDonnell Douglas merger, the Bell Atlantic-NYNEX and SBC-PacTel mergers, and the impending takeover of MCI, had to know, upon sober reflection, that this merger would never have been allowed to take place at that time. And, the principals at both companies were more than familiar with these circumstances.
But, such a merger would have extended Allen's tenure to the date he had originally set for his own retirement (so that he could "smooth the transition"). And it would have allowed Allen to eventually exit the scene with a reputation as an "industry visionary". Since Walter had no chance of becoming CEO at the proposed merged entity, he also became "damaged goods" at AT&T.
As things turned out, the merger did not take place, though Walter got paid $27 million for the AT&T Board's breaking of its promise to make him CEO -- not at the Board's expense, but at that of the shareholders.
The New Kid On The Block
Meanwhile, some securities analysts were saying that AT&T's declining
fundamentals would be matched by the ascent of relative newcomers, like WorldCom. The gist of their case for WorldCom is that large telcos can only lose market share, and, therefore, small telcos can only gain market share, at the expense of the former.
Let us examine this argument a bit more closely:
We must confess to having a soft spot in our heart (but not our wallet) for upstarts everywhere. After all, we are something of an upstart ourselves, lacking as we do the vetting and vigilant oversight a widely recognized institutional affiliation would no doubt provide.
But, if telco industry fundamentals have soured, they have soured for all of the players, not just the established ones. If anything, as is the case with, for example, the auto industry, the survivors in an industry with declining fundamentals are likely to be the oldest ones with the deepest pockets, not the newest ones with the thinnest
margins.
To argue that the smaller, more nimble players will take market share from the larger ones doesn't address the overall industry-related concerns of shrinking margins and declining cash returns on equity and assets. It's merely a prediction about whether speedy little people, or slow rotund ones, are more likely to grab the most deck chairs on the Titanic, not which are more likely to command a seat on one of the
lifeboats. Otherwise, Apple, the Yugo, the corner bookstore, et al., would inevitably take market share from Compaq, GM, and Barnes and Noble -- always a possibility, but far from guaranteed.
A Decade Of "Growth"
As noted below, AT&T's cost structure contains a lot of fat, the trimming of which could finance a significant portion of added capital commitments. What will be WorldCom's source of capital for future expansion? The record to date is not promising from a Value Investing perspective.
Since coming public 10 years ago, the much leaner WorldCom has financed almost all of its expansion by increasing shares outstanding about 22-fold, and long term debt about 125-fold. This has diluted the equity interest of then-existing shareholders by reciprocal amounts.
Yet, in spite of the 125-fold increase in long term debt, accrual-basis operating earnings as a percentage of shareholder equity have shrunk from over 21% to just 3% annually. And, on a cash earnings basis (inclusive of accrual-based "nonrecurring losses"), the figure Value Line projects for WorldCom's 1997 capital spending will more than wipe out all of its cash earnings of the past decade.
Hence, in spite of an infusion of about $20 billion in investor capital over a 10 year span of "growth" (with accrual-basis operating earnings reported in all but one year), less than $19 billion in the shareholders' long term assets remain -- and not a penny in dividends has been paid along the way.
In other words, WorldCom's stupendous 350-fold growth in assets has come virtually entirely from the issuance of more stock and bonds, not from internal cash generation from the underlying business. So, all of the net "growth" of the past decade at WorldCom has come from the pockets of investors, not those of customers.
Ma Bell As Empty-Nester
By comparison, for the same 10 year span, AT&T's (accrual-basis) return on shareholder equity was about 20% in 1988, and after much volatility (both up and down), is about 20% now -- at the high end of the range for a telco, particularly a long distance one.
AT&T's long term debt and common shares outstanding have increased about 60% since 1988. This is not in itself an occasion for celebration, but the figures are typical for the financing of a utility's normal need for capital.
Determining The Indeterminant
Unfortunately for the making of a direct comparison with WorldCom, a precise analysis of AT&T's use of capital is complicated by a number of factors, including the fact that "non-recurring events" recurred in 7 out of the past 10 years, during which time Allen was first building an empire and then dismantling it.
For example, NCR was acquired; McCaw Cellular was acquired; NCR was spun off; Lucent was spun off; and AT&T Capital was spun off. Further complicating the calculation of AT&T's internal cash generation is that some of the largest special charges against accrual-basis earnings (and, by inference, eventual cash flow) are from the early 90's, when changes in accounting rules required that companies
deduct from their balance sheet the present value of estimated future liabilities for the healthcare of workers not yet retired.
Besides the essential indeterminacy of a charge based upon estimating employee turnover, morbidity rates, life expectancy, and interest rates 20 or so years into the future, some of those workers are now working for Lucent, some for NCR, etc. And, the longer AT&T delays admitting that some of these accrual charges will never actually get paid out in cash, the longer they can hold onto the portion that otherwise must be paid to the IRS. (The IRS has argued that AT&T is taking tax deductions for future "restructuring charges", which, when the future comes, turn out to be ordinary sg&a expenses, at least in the view of the IRS. In effect, the IRS argues, this is an involuntary loan from taxpayers to AT&T. At all events, AT&T is in no hurry to undo any of these charges.)
Also, neither Value Line nor S&P break out the portion of non-recurring charges that are, say, severance pay at a discontinued operation (an actual cash expense), the present value of already-accrued future medical benefits (maybe an eventual cash
expense, maybe not), and write downs of assets (no cash outlay at all).
The Shareholders' Bottom Line
So, we will just look at certain net changes in AT&T's position and that of its shareholders over the same 10 years, the worst decade of AT&T's modern history.
After much volatility along the way, AT&T's share price is now double its high point of 1988 (around 30 at the time). Further, besides the $30 rise of its own share price, AT&T has spun off, for every share of the common, a portion of Lucent now worth about $50, and shares of NCR worth another $2.50 or so (all $82.50 of which is tax free).
And then there are the close to $13 of dividends paid to holders of each share of T during the past 10 years -- $13 more than WorldCom paid to its shareholders. Therefore, all of AT&T's blunders notwithstanding, those investors who just patiently held onto their shares (of what is perhaps the world's safest common stock) have
seen that portion of their portfolio's valuation rise about 17% to 18% annualized (assuming reinvestment of dividends) over the last decade. Those who were dollar cost averaging along the way did even better.
In 1997, the "Year of the Extrinsic Factors", T's total return was about 50%, and WorldCom's a bit over 18%.
In other words, for the conservative investor, there seems to be almost no way to lose money as a long term investor in AT&T -- which is not a statement that we can confidently make about WorldCom.
for the rest of the analysis (companies other than T)
see web.idirect.com |
