AT&T (NYSE:T) has not featured on my watchlist for a while now. Yet its undoubtedly impressively reliable cash flows has always kept it on my mind. Recently, therefore, I included it on my public poll to see which company should face my five FCF tests next. AT&T appeared to polarize voters somewhat by receiving both the most votes for being reviewed last and first. Nonetheless, all told it came out ahead of its fellow poll constituents (incidentally to vote on which company to be reviewed next head over to the updated poll).
Industrial giants 3M (NYSE:MMM) and Cummins (NYSE:CMI) were the most recent to face the tests. Although far from exhaustive, they give me a good indication of a company's competitive advantages, FCF health and efficiency, as well as the debt and dividend position. Fair value based on FCF alone is also calculated to give a little taste of whether it offers value today. These tests merely mark the first step in what may develop into a more thorough analysis of the business in the future.
In AT&T's case, what emerges is a pretty complex picture. It emerges as an attractive business with strong cash flow characteristics and what appears to be a fair valuation based on FCF alone. Yet what is also clear is that a lot is demanded of their FCF resulting in a fairly disappointing set of tests results.
A Little About AT&T
First, however, a little summary of the company may be helpful. Naturally, AT&T is most famous for their US-focused telecoms related business across consumer and business markets. Yet, increasingly, AT&T has been expanding their business into the entertainment sector with - most prominently - their acquisition of DirecTV in July 2015:
The international segment has also been growing in recent years. Nonetheless, they remain a largely US-focused business with over 95% of revenues in FY2015 coming from their home market. As you can see, however, from above the international segment (of which not all non-US revenues is included) has grown in importance in the three quarters of FY2016 reported so far.
AT&T is, therefore, a company with a strong market position in the US in an industry with a strong, reliable business model. What is more, they are increasingly diversifying their revenue streams away from their core, mature US telecoms business towards the entertainment and international markets. This certainly has appeal from a long-term growth perspective.
Despite these attractions, however, AT&T does struggle against some of my tests. Let's explore this in more detail below.
1: Positive FCF
We open for the simplest of all tests. All we look for here is that AT&T has managed to consistently generate positive FCF figures over the last decade. So how does AT&T do? Very well indeed, it would seem:
Consistently it has generated significant amounts of FCF (2006 is considerably lower as this was before the massive BellSouth acquisition). A great start. What is more, FY2016 looks set to remain equally cash-generative with FCF to Q3 2016 at a similar level as the same period in FY2015 despite increased CapEx spending:
For me, however, for AT&T (and its fellow telecom peers) there is another thing worth considering on the CapEx front. Despite my recent article, this is not the addition of capital disposals back to CapEx to provide net CapEx figures (the above figure is still gross CapEx).
Instead, it is the matter of wireless spectrum license costs. Ordinarily these are considered in the same way on the cash flow statement as an acquisition. To some extent this is understandable. Yet whereas a telecom company can do without regularly acquiring another business, they cannot do without regularly acquiring wireless spectrum access. Consequently, spectrum licenses strike me much more as a CapEx than an acquisition item.
The issue from a cash flow perspective is that spectrum costs are variable year from year. Generally speaking, they make their big purchases of spectrum access during key auction years:
Clearly, in 2008 and again in 2015, AT&T shelled out massive amounts of their spectrum costs on just two FCC auctions. Smaller transactions were usually subsequent purchases from other spectrum holders.
If we are to fairly adjust CapEx to reflect this cost, an annual average over the last decade is perhaps better. Since 2006, therefore, on average $3.9 billion was paid in each year. Taking this off the original FCF figure will provide us with a spectrum-adjusted FCF figure, which will be used alongside the normal FCF in this article.
It should be noted that this spectrum-adjusted FCF is, in itself, likely to be conservative going forward. The difference in size between 2008 and 2015 totals is a stark reminder of just how much spectrum licenses have inflated in recent years.
Analysts had expected the entire auction to raise between $10 and $20 billion. This would have been in line with the $13.7 billion raised in the 2006 AWS-1 auction 66 (costs in 2006 for AT&T were smaller above as this was before their BellSouth acquisition) and the $18.9 billion raised in the 700MHz auction 73. Instead, it came in just shy of $45 billion. Hence, awareness of spectrum costs is an increasingly important consideration in assessing cash flow.
Nonetheless, despite these adjustments AT&T certainly PASSES this test.
2: CROIC: Cash Return on Invested Capital
We now raise the bar of difficulty quite a bit Here we take a look at AT&T's cash return on invested capital (or, CROIC). Calculated by dividing their FCF by their capital invested (that is, total debt and shareholders' equity), it helps us ascertain the efficiency with which they generate their FCF. If they generate a CROIC of 10% then for every $100 of capital invested, they generate an attractive FCF return of $10. Indeed, this is what I want to see: a 10-year average CROIC of 10% or more. In this regard, AT&T does not do quite as well:
Their CROIC-based on non-spectrum adjusted FCF suggests a 10-year average of 8.4%. That is pretty strong, yet clearly below my 10% target. More strikingly, however, their spectrum-adjusted CROIC comes in at just 6.1%. Again, comfortably below my 10% threshold.
What is more, both CROIC figures show AT&T as struggling to grow their CROIC with both considerably below their 10-year average in the last couple of years. Assuming that Q4 2016 provides a similar amount of full year CROIC as in FY2015, my predictions for FY2016 CROIC does not look likely to be any different:
Although CROIC looks set to be modestly ahead of 2015 at 6.98% it still remains well below AT&T's historic average and my 10% target.