AT&T Q2 Earnings: Higher Net Revenue, Improved Margins and Solid Operating Cash Flow Growth

Investment thesis

Despite the recent widespread withdrawal from the market, AT&T Inc. (NYSE:T) has seen the stock trend higher over the past 12 months, with the positive price reaction following mixed results in Q2. Although the increase The outlook remains subdued, and the company missed the Q2 revenue consensus, investors are more focused on the company’s margins and FCF trajectory. AT&T has significantly improved its FCF profile in recent quarters due to a significant decline in supplier financing payments. With a 5.8% dividend yield, I believe investors seem satisfied with the modest return on capital appreciation from owning the stock.

In a previous article, I rated it a Buy in July 2023 due to a deep value opportunity with an attractive dividend yield. Since then, T has delivered a 40% total return, including 31% capital growth and a 9% dividend, significantly outperforming The S&P 500, which has returned 18.6% over the past 12 months. As potential Fed rate cuts make short-term bonds less attractive, I maintain my Buy rating on the stock given its low valuation and attractive dividend yield. The recent shift from “large-cap growth” to “small-cap value” will also benefit stocks.

Increasing customer numbers through lower customer turnover

Let’s take a look at T’s Q2 earnings. The company’s total revenue fell 0.4% YoY, missing market consensus, driven by continued declines in its Business Wireline and Wireless Equipment segments. As shown in the chart, AT&T’s revenue growth is largely supported by its Wireless Service segment, which maintained a 3% YoY increase. The company expects this segment to continue growing in the 3% YoY range in fiscal 2024.

However, it is encouraging to see a 29% YoY increase in postpaid phone network additions, reaching 419,000, compared to 349,000 in Q1 FY2024. This increase was driven by a decline in churn. During the Q2 earnings conference call, management mentioned that the success of their fiber business is driving the growth in mobility. Therefore, the core business is not deteriorating as we have seen strong customer growth in the last quarter.

Margin expansion is still on the way

I believe the stock’s post-earnings rally was largely due to significant margin expansion. As shown in the chart, the company achieved a record-high adjusted EBITDA margin of 38%. In addition, adjusted EBITDA margin improved 110 bps quarter-on-quarter to 21.1%. They reiterated their guidance for a 3% YoY increase in adjusted EBITDA for fiscal 2024.

Despite a low-single-digit revenue growth trajectory, AT&T has significantly improved its margins in the previous quarters, supported by the Wireless segment. The company increased its adjusted EBITDA margin from 30.4% in FY21 to 35.4% in FY2023 and continued to grow in Q2 FY24, primarily due to increased depreciation and amortization expenses. Additionally, adjusted EBIT margin remains resilient, maintaining the 20% level amidst a slowdown in revenue growth. Furthermore, the company’s margin outlook could continue to improve on the back of the ongoing copper phase-out process. During the previous Investor Day event, management indicated that the move would allow the carrier to rationalize its $6 billion total cost base.

Focus on FCF amid sluggish growth prospects

As a deep value stock with a muted growth outlook, investors should pay more attention to its quality metrics like FCF. The company achieved 39.2% year-over-year FCF growth in FY2023 after three years of decline from FY2020 to FY2022. Meanwhile, its FCF margin improved from 9.3% in FY2022 to 13.7% in FY2023.

In Q2 FY2024, despite a strong year-over-year comparison in Q2 FY2023 (up 204% year-over-year), the company still achieved 9% year-over-year growth in FCF, driven by a significant decline in supplier financing payments that offset higher capital expenditures and a decline in OCF. Excluding dividend payouts, its FCF after dividends increased 16.5% year-over-year.

Management also reiterated FY2024 FCF guidance in the range of $17 billion to $18 billion. While this indicates a potential decline in FCF in 2H FY2024, I believe the guidance may be conservative and likely exceeds $18 billion.

Quotation

According to Seeking Alpha, T’s valuation still looks very attractive, especially the P/CF ratio. We know the company has been growing its FCF in recent quarters, which has made this multiple cheaper. The stock is currently trading at 3.6x P/CF TTM, which is below its 10-year average and 55% below the sector average. Notably, the multiple is 23% lower than Verizon’s (VZ) 4.67x and 66% lower than T-Mobile’s (TMUS) 10.5x.

Because AT&T has significantly improved its margins, the company’s shares are trading at 6.7x EV/EBITDA fwd, which is not only 8.7% below the 5-year average, but also 4% below 6.95x VZ and 33% below 10x TMUS.

Finally, despite the expected YoY decline in non-GAAP EPS for FY2024, with the company reiterating its guidance range of $2.15 to $2.25, its non-GAAP P/E fwd is 8.7x, which is in line with VZ. Hence, I believe the stock is still a buy given the prospects for margin expansion and improving cash flow generation from operations.

Downside risk

However, I believe there are two major downside risks that investors should focus on. First, as a value stock, T could start to underperform if the Fed rate cuts are delayed due to a rebound in CPI data, causing the market to revert to large-cap growth stocks, as it did in 1H FY2024 when stocks were nearly flat. A delay in rate cuts would also keep short-term Treasuries yielding 5.4%, nearly risk-free and similar to AT&T’s dividend yield.

Second, while investors may be paying less attention to the company’s growth prospects at the moment, the stock could trigger a sell-off if margins and cash flow from the stock start to deteriorate, which would impact valuation. Another risk is a potential dividend cut, which I don’t think is likely as the company continues to maintain strong cash flow from the stock.

Application

In summary, AT&T continues to send a buy signal amid recent market volatility. The stock has shown steady growth over the past year, driven by steady margin expansion and improved FCF, which was fueled by higher D&A costs and lower vendor financing payments. With an attractive 5.8% dividend yield and record-high adjusted EBITDA margin in Q2, T offers an attractive total return, especially since I believe the near-term treasury will fall below 5% this year. Despite a mixed Q2 quarter, investors should focus on the company’s cash flow. Most importantly, the stock is still valued lower compared to VZ and TMUS, with multiples trading below historical and sector peer averages. As such, I believe the company’s improved margin outlook, solid FCF generation, and attractive valuation convince me to re-rate the stock as a Buy.